Sarine Technologies’s Business Model
Sarine Tech is a technology-based company incorporated in 1988 and headquartered in Israel. It is a worldwide leader in the development and manufacturing of advanced evaluation, planning, cutting, polishing and grading systems for diamonds and gemstones production. Sarine used to be an investor’s darling but has since fallen from grace. It is an unloved stock these days with low liquidity. However, Heartland Boy thinks that there is potential for a turn-around soon. To rationalize Heartland Boy’s investment thesis, it is better to first understand the value chain of the diamond industry.
Diagram 1: Value chain of the diamond industry
Source: World Diamond Council
De Beers has a monopoly over the mining and production of rough diamonds. Therefore, it has the ability to control and influence the prices of rough diamonds which are sold to manufacturers. These manufacturers, which mainly reside in India, will sort, plan and cut the diamonds into polished diamonds. Polished diamonds are then graded by institutions such as Gemological Institute of America. (Readers can read about Heartland Boy’s experience of buying a GIA certified engagement ring here) Some wholesalers may design and set the polished diamonds into rings before trading them to retailers. Readers will be most familiar with the segment of retailers, as they might have walked past the shops of Tiffany & Co, Chow Tai Fook etc.
Sarine largely operates in the middle segment of the diamond value chain by providing smart solutions for every aspect of diamond design and manufacturing. Its customers are therefore mainly worldwide diamond manufacturers and wholesalers. Sarine’s technology helps to remove the “human” factor out of the process and allows manufacturers to maximize the yield of a rough diamond. The following are some of the products provided by Sarine.
Diagram 2: Products from Sarine
Source: Sarine’s website
Let’s see how Sarine fares in terms of Fundamental Analysis.
Investment Merits of Sarine
Solid track record
Sarine’s revenue, earnings and operating cashflow were on an upward trend from 2012 to 2014. However, a perfect storm arrived in 2015 as De Beers raised the prices of rough diamonds when the prices of polished diamonds were falling due to excess inventory and falling demand from Chinese consumers. This squeezed the margins of manufacturers at both ends. As a result, demand for Sarine’s products basically dried up.
Table 1: Increasing Revenue, Net Profit, Net Operating Cashflow of Sarine from 2012 to 2014
High Return on Equity and consistent margins
Besides the blip in 2015, ROE has been at an enviable level of 35%, far exceeding the 12% minimum benchmark that Heartland Boy is prepared to accept. Similarly, gross margins are maintained at around 70% while net margins are maintained at 30%. The ability to maintain these margins is indicative of Sarine’s pricing power and tight cost control.
Table 2: Consistent Gross and Net Margins and ROE of Sarine
Net Cash Situation
Sarine has zero debt, enough said. Its net cash position translates into $0.13 cents per share or roughly 7.6% of the current share price.
A Formal Dividend Policy
At a stock price of $1.68, it has a dividend yield of 2.4%. In light of the poor performance in 2015, its formal dividend policy is now US 2 cents per share semi-annually instead of US 2.5 cents semi-annually. Heartland Boy feels that this is nothing to be alarmed about as it is simply the management being prudent.
As recent as March 2016, the Executive Chairman was still buying Sarine at an average share price of S$1.52. Insider buying is always a good indication that the stock may be undervalued in the eyes of insiders.
Sustainable Competitive Advantage
Sarine has a proven track record of product innovation and consistently delivered new products from time to time. In addition, its key technologies are also patented and hence raise the barriers to entry for its competitors. This has enabled Sarine to enjoy a near monopolistic position (70% market share) in the diamond planning and manufacturing equipment segment.
Good Growth Story
At the end of 2015, Sarine’s management expressed confidence that it will be able to realise significant delivery of the Galaxy Family system in 2016. Its recent products such as Sarine Light, Sarine Loupe and Sarine Profile also signal Sarine’s intention to capture the downstream segment of the diamond industry. This is a significant new segment for Sarine as it has higher margins and better potential for recurring revenue. In 2015, Sarine also developed the Allegro system which processes rough gemstones directly into cut and shaped gems. This new product should enable Sarine to diversify into a new market with the aim of increasing its recurring revenue.
Investment Risks of Sarine
1.Monitor the spread between the prices of rough and polished diamonds
The spread between the prices of rough and polished diamonds is critical to Sarine because this dictates the operating margins of diamond manufacturers. If the spread narrows, it will compress the margins of the manufacturers and they may reduce their orders for Sarine’s products. Therefore, it is imperative that readers should be well versed with the health of the diamond industry and here are a few research sources to monitor the performances of the upstream and downstream segments:
2.The rise of synthetic diamonds
Synthetic diamonds are man-made and produced in a laboratory. They are cheaper compared to mined-diamonds and hence can potentially dilute the value of the diamond industry. Heartland Boy has decided not to give this factor too much weight as counterfeits will always be prevalent in any consumer segment. For instance, counterfeits have been around for ages but companies such as Richemont and Louis Vuitton Moet Hennessy are still thriving!
Conclusion of Sarine
Is Heartland Boy out of his mind by buying into a stock with a PE ratio of 120x? The truth is Heartland Boy was dying to own Sarine since Dec 2014. However, he did not purchase it then as it reached the dizzy heights of $3.20 per share as there was simply no margin of safety. Readers only need to look at the tumbling share prices of Super Group and Osim. However, Heartland Boy believes that the operating circumstances have since changed and a turn-around is in sight. Here are the reasons why:
- Prices for rough diamonds have fallen 20% in the past year and recent auctions by De Beers have reported higher volume sold.
- Prices for polished diamonds have started climbing in 2016 after falling in 2015.
- As a result, diamond manufacturers are reporting healthy operating margins again and a record number of stones were scanned by inclusion mapping systems in 1Q16.
- Sarine revealed that the orders it received for the first 2 months of 2016 had already surpassed the entire 4Q 2015.
Heartland Boy has a personal price target of $2.2 for Sarine.
Vested at 1.68 cents since April 2016 and will add more if Sarine’s 1Q16 results confirm his thesis.
This article was written on 13 April 2016.