What are the must-haves for a successful and memorable marriage proposal? Flowers? A ton of love? Perhaps. But one cannot agree more that it would not be a complete and meaningful proposal without at least a diamond ring. The widely accepted impression of diamonds as a symbol of love, commitment and eternity has been so deeply entrenched in our culture, and is in a large part attributable to the relentless marketing campaigns by players in the diamond industry.
Sarine Technologies (Sarine Tech), a company which we are going to look into in this issue, is a developer and manufacturer of precision technology products for the processing and trade of diamonds and gemstones. While the value of a polished diamonds can be evaluated by its four Cs – namely carat, color, clarity and cut, how then may we assess the businesses that process diamonds?
There was a time when Sarine Tech’s share price went as high as $3.23 back in its glorious days in October 2014. With its share price trading at less than a dollar now, easily more than two-third of the group’s market capitalisation has dissipated in just less than three years. Once a well-regarded company for its growth, what are the reasons that could account for Sarine Tech’s loss of sparkle among investors?
Solid Balance Sheet
Sarine Tech’s balance sheet is rock solid. This has not changed over the years. Underpinned by strong cash flows generated from its operations coupled with relatively lower capital expenditure, the positive free cash flows year after year has allowed the group to maintain cash hoard consistently above US$30 million in the last five years. As at 30 June 2017, Sarine Tech has cash assets totaling up to US$37.1 million with zero borrowings from banks. It is noteworthy that this net cash of US$37.1 million accounts for almost 47.7 percent of the group’s net assets.
Beside the group’s high liquidity, we also like the fact that Sarine Tech’s total liabilities have always been kept at less than 25 percent of its total equity. As at 30 June 2017, the group’s financial strength was in a very healthy region with its debt-to-equity ratio standing at just 16.3 percent.
FY15 Results Took A Beating
FY15 was a record bad year for Sarine Tech owing to the extremely challenging industry conditions back then. Rough diamonds were being priced overly aggressively, while polished diamond prices slowed due to much higher than normal inventory levels as well as declining demand growth especially in China. This led to unsustainably low margins for midstream diamond polishers and manufacturers, further complicated by reduced working capital credit lines available to them. Consequently, diamond manufacturing activity drop considerably by as much as 50 percent compared to normal times.
Against this backdrop of ongoing lack of profitability, Sarine Tech’s clients found no incentive to acquire new technology, impacting the group’s sales miserably. In that year alone, Sarine Tech released two profit warnings, and reported a net loss of US$1.4 million in 3Q15. Over the full year, revenue sank 44.8 percent to US$48.5 million. Likewise, net profit plunged 86.8 percent to only US$3.6 million as compared to a profit of US$27.2 million a year ago.
Nonetheless, things took a turn for the better in the following year. FY16 saw a marked recovery in industry sentiment with the pricing of rough diamonds at relatively lower levels in comparison to FY15, and overall polished diamonds’ prices remained stable. As a result of the normalized industry, Sarine Tech’s FY16 revenue jumped 49.7 percent to US$72.5 million while net profit surged more than five times from a low base to US$18 million.
Market Irrationality Spells Opportunity
Sarine Tech broke its $1 support after the group released a profitability guidance on 10 October 2017, stating that estimated revenue for 3Q17 stood at around US$11 million while operating loss was minimal at some hundred thousand, owing to the buildup of surplus inventories of polished diamonds in the mid-stream.
According to the guidance, in spite of the third quarter loss, 9M17 revenue should come in at around US$46 million and operating income would approximately amount to US$7 million. As retailers prepare for the Christmas season and with Valentine’s Day coming up, sales in the second half of the year should likely pick up. In fact, Sarine Tech’s estimate for 9M17 operating profit has already surpassed FY15’s full year figure at US$5.5 million.
However, in spite of a possibly better year compared to FY15, Sarine Tech’s share price actually dropped below the historical low of $1.29 in September 2015. As such, we reckon that such market irrationality indicates that excessive fear was being priced into its current low share price.
Sarine Tech’s current price-to-earnings valuation of 16.3 times based on trailing-twelve-months earnings-per-share and share price of $0.93 as at 23 October 2017 is no doubt more attractive underpinned by the higher earnings and lower share price. Coupled with an appealing dividend yield of around 5.9 percent, we believe that market irrationality arising from extreme fear is presenting yet another compelling opportunity for value investors who are willing to take up the offer.