Dear Fellow Shareholders,
Digressing from the format of my previous years' statements, I would like to focus this year on the macro view of what transpired in 2017 and on our plans for 2018. The Business Review section provides our usual commentary on the actual financial results and the specific goals of our Research and Development and Sales and Marketing teams for 2018, along with a detailed discussion of our business, its various midstream and downstream activities, our product lines, etc.
2017 in Perspective
2017 was characterised by a more-than-normal excessive build-up of polished diamond inventories in the midstream in the second half of the year. The normal production cycle of the diamond industry is driven by the fact that half of the annual retail sales worldwide are concentrated from November – China's Singles' Day, India's Diwali and Black Friday in the U.S., through February – Chinese New Year and Valentine's Day. Polishing is catalysed by the sell-off of inventories throughout the industry value-chain during this four-month period. As downstream wholesalers and retailers replenish their inventories, midstream manufacturers adjust their output accordingly and typically slow polishing activities when the downstream demand cools. However, as the industry is fragmented, and little, if any, information is shared, and as the cycle time from buying rough diamonds to finishing polished diamonds is at least three months, the midstream usually overshoots with production. There is a consistent cycle wherein in Q3 there evolves an oversupply of polished diamonds in the midstream. The degree of overstocking varies from year to year and is dependent on many factors – actual consumer demand, how aggressive the producers are at offering rough diamonds, how aggressive the manufacturers are at competing for said rough, at what point the manufacturers realise the demand for polished has slowed, relative prices of rough and polished stones, etc. This year, primarily due to the aggressive sale of rough by producers still working down their excessive inventories from 2015 (they sold more carats in 2017 than they mined), and correspondingly aggressive buying by the manufacturers, the build-up of inventory was significantly higher than the norm. This is evidenced by the very significant drop in rough stone sales by the producers in the second half of the year (e.g., the DeBeers sights from July onwards), after the manufacturers realised their situation. Consequently, the corresponding slowing of manufacturing activities in the second half of the year is the primary reason for our weaker results in the second half of the year. Notwithstanding these challenging industry conditions, we scanned 10 million stones with our inclusion mapping family of systems in 2017, a new record, despite both reduced sight volumes in the second half of the year and the illicit IP-infringing competition discussed below. We estimate that upwards of 70 million stones, were planned utilising our DiaExpert® family of planning platforms and our Advisor® software – some 40 million stones having been planned using our latest Advisor® 7.0 software alone, which is currently in use at just over half of our worldwide installations.
Intellectual Property (IP) Infringement
Intellectual property infringement is still, regrettably, part and parcel of our doing business in India. This year we saw a sharp increase both in the number of infringements and their audacity. Mostly, the illicit IP infringements are centred on our industry-leading inclusion mapping and rough planning systems.
The primary infringing parties are Diyora & Bhanderi Corporation and a number of their related entities (hereinafter collectively, "DBC") in Surat, India. We have filed lawsuits claiming that DBC have essentially copied Sarine's patented Galaxy® inclusion mapping and are using pirated and manipulated versions of Sarine's proprietary and copyrighted Advisor® software for rough diamond planning. Primarily, we assert, based on our extensive investigations and the on-site inspections of the defendants' premises executed by commissioners appointed by the court, that DBC are operating a rough diamond scanning operation that utilises the same technology and processes as Sarine's patented family of inclusion mapping systems and copyrighted Advisor® rough planning software. Diamonds that were submitted by Sarine's investigators to DBC for scanning and analysis, and the digital reports provided by DBC with respect to those scans, as well as other subsequent tests performed on the stones, clearly show that the patented processes are being duplicated. Furthermore, expert analyses of the digital files containing the scanning reports demonstrate that the software being used by DBC to produce such files is an illegally modified version of an older release of Sarine's proprietary Advisor® program (version 5.x), which, we further assert, could not have been done without illegally hacking our software. DBC are, of course, disputing this. We understand that a substantial number of duplicated systems are installed at DBC's facilities, along with multiple pirated and illegally manipulated copies of the Advisor® software program. We are pursuing parallel lawsuits for patent infringement and software copyright infringement. In both actions we have requested interim injunctions to put an immediate halt to the infringing activities pending the trials and final outcome of the matters. In the patent case, we are in the midst of the hearings related to this request. Concerning the copyright suit, the High Court of Gujarat overturned the decision of the lower court to deny our request for an interim injunction and ordered the lower court to reconsider the matter using specific criteria, based on actual comparison of the software versions. The lower court is now hearing arguments by the parties on how that is to be done and by whom. In addition, we have alerted major U.S. diamond importers and dealers that their supply of polished diamonds from India may contain goods that infringe our U.S. patents and copyrights, which, if not abated, could lead, under U.S. law, to the banning of importation of said infringing goods. We have encountered a spirit of cooperation from key U.S. retailers, and, at the request of other retailers, we are preparing additional information regarding the infringements. The supply chain inquiries submitted by some of the leading U.S. retailers have notably increased pressure on DBC in India.
However, we are not only relying on judicial recourse. We are also leveraging the numerous technological and commercial advantages we have. The Advisor® version that the infringing parties are using is a version over three years old. The newest Advisor® 7.0, protected by proprietary home-grown cloud-based cyber protection, has many enhanced features. Comparative testing between Advisor® 7.0 and the older version hacked by the illicit competition shows the polished stones planned using the newer software have a significant tangible added value in actual dollar terms. Advisor® 7.0 also has functionality specifically aimed at enabling the manufacturer to better meet today's retail trends for branding – optimising modified cuts, light performance enhancement, etc. These valuable add-ons, along with other commercial incentives noted below, motivate manufacturers to migrate upwards to the latest version of our Advisor®, thus precluding DBC from offering them infringing services. To provide even more added value from using our advanced solutions, we have launched the revolutionary DiaExpert® Edge for the significantly refined modelling of a rough diamond's concave surfaces. As DiaExpert® Edge only interfaces with Advisor® 7.0, this provides further impetus to migrate to the latest release. We are also leveraging our new relationships with major retailers launching Sarine Profile™-enhanced programs, who initiate same only with suppliers who have migrated to Advisor® 7.0. Again, this creates another strong incentive to migrate upwards. All these initiatives are, we believe, bearing fruit as we see continued adoption of our Advisor® 7.0. To date, users of just over 11,000 installations of our 20,000 odd installed planning systems have adopted the latest software. Finally, we have launched our new Meteorite™ system, an extremely costeffective system for scanning very small rough diamonds, under 0.35 carats in weight. The Meteorite™ specifically competes with the illicit competition on their main turf, as our analyses show that most of their scanning activities are of very small rough stones. Overall, we believe we are containing the impact of DBC's infringements, but expect some continued impairment into at least the first half of 2018.
We have also encountered additional challenges from other would-be IP infringers. Mid-year three Indian nationals were arrested in Israel (and are awaiting indictment) having tried to buy the operational source code and hardware design sheets of our Galaxy® system for US$ 1M in cash from our employees.
And one more related issue – we have filed a lawsuit against Rose Gems (also known as Rose Diam) who had purchased a Galaxy® system and who unlawfully and purposely manipulated the reporting of the sizes (carat weights) of the stones processed by their system in order to reduce the use fees owed the Group. This infringement was uncovered by various software control tools we have implemented in our systems to prevent misuse.
2017 saw significant transitions in our Management and Board. At the Board level Messrs. Ehud Harel, Eyal Mashiah and Hanoh Stark retired after many years of service, and Ms. Varda Shine, who retired as CEO of DeBeers Diamond Trading Corporation in 2014 and has 30 years' experience in the diamond industry, joined. On the Management level, Mr. Uzi Levami stepped down as CEO on May 1, 2017 after 8 years of service, and was replaced by Mr. David Block, who has worked at various positions in the Group for 17 years. Mr. Uzi Levami continues to serve on our Board as a Non-Executive Director. Further information may be found in the Board of Directors and Key Management sections of this Annual Report.
Looking Ahead to 2018
Coming off the 2017 year-end holiday season sales, which were significantly stronger than the preceding year's comparable period – up 5.8% in the key U.S. market, retail and wholesale inventory levels have been significantly reduced. Further bolstered by robust Chinese New Year and Valentine's Day spending, there are evident shortages of specific categories of polished diamonds, and their prices have consequentially seen modest increases. The initial DeBeers sights for January and February 2018 are markedly higher than the sights in the second half of 2017, but January's is US$ 100M lower than the comparable sight of 2017. We believe this is a positive indication of more prudent planning and stocking on the part of both producers and manufacturers. Hopefully, this should preclude the very excessive inventories manifested in the second half of last year from repeating themselves this year. Looking forward to the first half of 2018, midstream industry sentiment is positive, and we thus expect healthier industry activity, with revenues and profitability reverting to the levels of previous strong industry years (e.g., 2016).
The Midstream Sector
We will continue adding value to our solutions in order to continue being the industry standard for rough diamond scanning and planning, also as a key strategy to thwart DBC's and others' attempted IP infringements. The newly launched, completely revolutionary, unmatched DiaExpert® Edge will be further refined for even more accurate rough stone modelling. This upgrade to our existing systems, or optional add-on to new ones, which we believe will, over time, be installed on several thousand machines, provides numerous benefits to the polisher, as detailed in our press release from January.
Another new feature we will be introducing in 2018 is the extension of the Galaxy® family of inclusion mapping systems' capabilities beyond straightforward inclusion detection. By enhancing these systems' functionality to detect internal tension (stress) in a rough stone's crystal structure, and to map the same for the planner, we will be providing another unique unmatched proficiency. Knowing the location, direction, structure and magnitude of the stress inside a rough stone is key to reducing potential damage to the stone, which can occur during laser sawing and other manufacturing processes. We are proceeding with large scale testing and expect to commence beta-installations of this feature in the second half of 2018.
Finally, we will be releasing the third generation of our standard-setting Axiom™ system for the ultra-accurate (better than 10 micron accuracy) measurement of a polished diamond's proportions. The new system will provide for unmatched accuracy in the measurement and analysis of fancy shaped diamonds' polishing craftsmanship, including that of special modified branded shapes. This ability will enable the Sarine Profile™ to support far more accurate renditions of fancy and special shapes, and to provide accurate classification of their quality. As these diamonds typically do not get a Cut grade from other gem labs, by empowering the precise analyses of these diamonds, our Sarine Technology Lab will be able to provide a better means to score their quality.
The Downstream Sector
As elaborated upon in the Business Review section, sales of global personal luxury items experienced real growth of some 5% in 2017 and are projected to continue growing at 4-5% annually for the next three years. Chinese consumers are the single largest market for personal luxury goods (32%), followed closely by North America. For diamond jewellery, North America is still the single largest market with some 40% of global sales, followed by China. Brands are establishing an online presence more and more, with 31% of their sales now online. Still, forecasts project that even in 2025, online sales will only account for 25% of luxury item sales, with 75% remaining in stores. The 'millennial state of mind' has permeated the luxury industry and stores need to reinvent themselves to create an on-going engagement with customers.
The above noted trends are exactly those to which the Sarine Profile™ caters. In 2018 we are enhancing the Sarine Profile™ with several new features - Artificial Intelligence (AI)-based 4Cs, including Clarity and Color grading, the Sarine Diamond Journey™ and an even higher level of consumer personalisation.
We formally opened our new Sarine Technology Lab on 18 February 2018, enabled by our automated, consistent and objective AI-based Clarity and Color grading of polished diamonds. Along with our industry-leading technology for Cut and Symmetry grading, as well as technology acquired for the authentication of the graded polished diamonds, we can now provide the first-ever technology-driven 4Cs diamond reports.
The Sarine Diamond Journey™ graphically and informatively documents and depicts the stone's transition from a unique rough stone to a one-of-a-kind polished gem. Leveraging on our extensive presence in the diamond industry's midstream, having scanned over 10 million stones in 2017 for inclusion mapping and having planned many tens of millions of rough stones, this new captivating visualisation paradigm shows the consumer the entire process undergone by his/her unique diamond. The stone's various stages are imaged – rough, modelled, scanned, planned, cut and polished, culminating in its final polished form. This provides the consumer with insight as to the meticulous craftsmanship that went into creating his/her unique jewel. It may, depending on data provided, also verify for the consumer where (and when) their rough stone was mined, thus reinforcing their confidence in the responsible sourcing and manufacture of their jewellery. As multiple stages of the stone's journey from the mine to the consumer's possession are documented, this may, in the future, even enable a secure chain of events for authentication record purposes.
Personalisation of the Sarine Profile™ experience in accordance with the diamond's buyer's unique wishes will allow his/her creation and importation of personalised messages to the stone's ultimate recipient, comprised of text, imagery, music and video – e.g., his proposal, all as a means of personifying the purchased jewel and adding value to the experience (and the brand).
We are thus able to provide a unique packaged service tailored to each retailer's needs, comprising the baseline Sarine Profile™ with its various levels of imagery, hearts and arrows analysis, Cut 2D/3D proportions graphics, laser inscription viewing, etc. and unique add-ons – our AI-based 4Cs grading report (including authentication of the polished stone), our light performance grading and our new Sarine Diamond Journey™, as described above. Our forte is that only we have the capability to package all the above informative features as one report. The fees for these services will range from US$ 30 per carat for stones of around one carat (between 0.90 – 1.2 carats; prices for smaller or larger stones vary according to industry norms) to US$ 128 a carat, based on actual content. The guiding principle is that the customer pays less and gets more – e.g., the customer pays the current industry norm as for standalone 4Cs reports from other gemmological labs, but gets added-value content – the Sarine Profile™ and light performance grading or the Sarine Diamond Journey™. Based on the value proposition created by the very cost-effectively priced packages, all uniquely provided as a single-stop service, we believe we can double the number of stones scanned in 2017 and triple the revenues generated therefrom, as the average selling price should increase by some 60%.
The Board of Directors has recommended that a final ordinary dividend of US 1.5 cents per ordinary share (approximately US$ 5.7 million) be distributed for FY2017. This will bring total dividends for FY2017 to US 3.5 cents per share, approximately US$ 12.3 million. This sum is a bit over our cash flow from operating activities for the year (US$ 10.8 million) and demonstrates the Board's and Management's belief that 2018 will show more robust activity with commensurate revenues and profitability.
On behalf of the Board of Directors, I would like to again thank our ever-growing circle of customers, conscientious suppliers and business partners, and devoted management team and employees for their ongoing support of and dedication to the Group. We believe that these long-term relationships will continue to foster the means by which we will bring innovation and value to the global rough and polished diamond trade in 2018 and beyond, as we inspire confidence in the industry's players, its global consumers and in our loyal shareholders.
Daniel Benjamin Glinert