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Is time running out on memo and long-term credit?

24 august 2009

Financial experts like to say that a crisis is actually an opportunity. The current global recession is no exception. So does it offer a prospect for the diamond sector to overhaul some of its more controversial business methods? And could those changes prepare it for a more solid footing for the future? These questions are asked by Antwerp Facets in an analysis of the memo system in polished sales.

Over the past 15 years or so, the diamond sector's way of doing business has changed significantly. Trading in diamonds used to be carried out predominantly in cash, with accounts settled up regularly, usually at the end of the working week. Gems were literally worth money because the seller was paid on the spot. However, while the major rough producers still operate on a diamonds for cash basis, at the polished end of the business credit has become king.

There is no single cause for the polished diamond trade’s transformation into a cash deprived business. The policies of the largest rough diamond producers certainly played a role. Tight control of client lists helped create a supply driven industry, which resulted in rough prices frequently rising at a rate higher than those of polished. The demand that diamond manufacturers become involved in downstream marketing initiatives frequently led to higher than expected overheads.

What had been a relatively simple business became considerably more complex. Manufacturers started offering retailers increasingly long-term credit, memo inventory and return privileges. Diamond dealers handed over their goods to retailers, effectively saying pay when you have the cash.

By general consensus, the memo system was conceived of by Indian diamond manufacturers in the 1980s, as they battled to gain a foothold in the American market. The practice mushroomed at the start of the 1990s, during the buildup to the first Gulf War. With Israel under imminent threat of attack, foreign air carriers began ceasing service to Tel Aviv, and the number of buyers travelling to Ramat Gan fell considerably. To cope, Israel dealers shipped out large volumes of polished diamonds to clients in New York on consignment. At the time they saw memo as a stop gap measure.

But when the war ended and travel restrictions were relaxed, the American clients were reluctant to turn the clock back. And the Israelis now supplying a large percentage of their merchandise on memo, the Belgian and Indian trades felt they had little choice but to follow suit.

Whereas memo goods represented a few percentage points of the diamond trade's total business 20 years ago, such sales have now become the norm rather than the exception. Retailers are used to receiving goods on consignment, without a financial commitment. Today, more than 50 percent of the polished diamonds imported by the United States are later returned unsold to the suppliers. And while they are sitting at clients' premises, they are out of circulation and financed at no extra cost by manufacturers.

Diamond manufacturers are stuck between a rock and hard place, since they pay the rough diamond producers in cash and according to the producers' time conditions, while retail clients ask for generous payment terms of 60, 90, and 120 days and even longer. That means that as much as a year could pass before a manufacturer sees a return on the investment made when buying the rough diamonds. Twenty years earlier, manufacturers would often pride themselves on their ability to turn their stock over three or four times a year.

Memo, coupled with long-term credit, also carries with it a fair degree of risk, particularly during difficult economic times. During the current recession in the United States, retailers have gone bankrupt leaving suppliers unpaid and without their goods, either.

Memo is frowned upon by senior figures in the diamond business, including Mahiar Borhanjoo, the Diamond Trading Company's executive director for sales and client services. "I have yet to be convinced of the merit of some companies offering very long term credit, or offering goods on memo. I find it difficult to see these approaches as a sustainable industry practice," he said.

In Antwerp, Stephane Fischler, a partner in Fischler Diamonds, says that many companies involved in the U.S. market have become "contaminated" by the practice of memo goods and long-term credit. These include Indian, Israeli and Belgian companies as well as others. "If you wanted to be a supplier to large chains, or the independent jewelers, many manufacturers had little choice. I have seen colleagues going along with this, and continuing to do so," he stated.

Can there be a turnaround in the way of conducting business? Fischler says it is possible, but he is not that optimistic that it will take place. "For that to happen, the large diamond companies and the banks have to come together and change their way of operating. The banks have to see that this is detrimental to their bottom line as well otherwise the situation will not change."

As for retailers who are enjoying the business terms offered by some manufacturers, Fischler said they had little incentive to change their business models since they are being offered the goods for free, while the larger retailers had the financial muscle to insist they carry on receiving goods this way. "Retailers are willing to pay manufacturers of expensive watches up front because that is what they demand, but not diamond manufacturers. That has to change."

The problems for some members of the diamond business may soon become compounded if and when interest rates, which are at historic lows, begin to rise. That is forecast to happen as inflation takes off as the recession bottoms out, expected to happen towards the end of this year or the start of 2010. Diamantaires will not be able to afford long-term credit deals and may even have to sell off their inventory to be able to make their high interest payments. The diamond industry is facing unprecedented financial risk as it continues to overextend credit to buyers while failing to prepare for the advent of significantly higher interest rates.

Diamonds sold on long-term credit or memo get stuck in the diamond pipeline. Retailers are under no pressure to sell them because they have no money invested in them. In addition, they don’t earn a good profit margin on the goods since their suppliers are charging a large financing premium. With no money tied up in the stones and low profit margins, jewelers have little incentive to push diamond sales. As a result, the average American jeweler only turns diamond inventory once a year.

The upshot is that in the past 15 years or so diamond manufacturers have become the jewellery retail sector's primary financier. But, now, with the markets changing and as the banks reconsider their credit strategies under new international banking regulations, the time may have come for change. "The burden of financing the diamond pipeline needs to be more evenly distributed," as one diamantaire put it. "Both the rough producers and the jewellery trade must play a more active role."