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2013 Review of Anglo America's De Beers

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De Beers is an 85 percent owned subsidiary of Anglo American Plc. The government of Botswana has minority ownership. …

De Beers is an 85 percent owned subsidiary of Anglo American Plc. The government of Botswana has minority ownership.

Together with its joint venture partners, De Beers remains the world’s largest diamond producer by value, with mining operations across Botswana, Namibia, South Africa and Canada.

With its Forevermark brand, De Beers is also the largest supplier of branded diamonds to the retail markets.

De Beers is very much a company in transition after the exit of the Oppenheimers - a family that shaped the fortunes of the diamond industry for over a century. We present a review of De Beers operations from 1999-2013, also anticipating that Anglo American could take the company in a new direction in the coming months and years.

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  • 1. www.diamondshades.com/diamondreport publication 1 Companies Diamond Industry Series Equity Communications De Beers Group 2013 Review July 24, 2013 Table of Contents Overview Page 2 Mine Portfolio Page 3 Exploration Program Page 14 Rough Diamond Sales Page 16 De Beers Diamond Jewellers Page 22 De Beers Forevermark Page 23 Conclusion Page 29 Outlook Page 31
  • 2. www.diamondshades.com/diamondreport publication 2 Companies Diamond Industry Series Overview De Beers is an 85 percent owned subsidiary of Anglo American Plc. The government of Botswana has minority ownership. Originally established in 1888, De Beers is the world’s premier diamond company. Together with its joint venture partners, De Beers remains the world’s largest diamond producer by value, with mining operations across Botswana, Namibia, South Africa and Canada. With its Forevermark brand, De Beers is also the largest supplier of branded diamonds to the retail markets Figure 1: De Beers Group De Beers Group Main Office London, UK Mining Operations Botswana 50% Namibia 50% South Africa 74% Canada 100% Development Projects Northwest Territories, Canada Explorations Projects India Canada Angola South Africa Botswana Rough Diamond Sales and Marketing Global Sightholder Sales 100% DTC Botswana 50% DTC Namibia 50% Auction Sales 100% Perth, Australia Diamond Jewellery Sales Forevermark Brand Licensing De Beers Diamond Jewellers 50%
  • 3. www.diamondshades.com/diamondreport publication 3 Companies Diamond Industry Series Mine Portfolio 1. Namdeb Figure 2: Namdeb Diamond Production Source: Company Reports, Equity Communications Namdeb is a 50:50 partnership between De Beers and the government of Namibia. Diamonds are recovered from the land and sea floor. Namdeb has faced severe operating challenges in the last few years with no consistency in profitability. Marine operations have become the mainstay of Namdeb's production with land-based operations expected to have experienced steep decline by 2014. Namdeb operations are currently unprofitable for De Beers. Safety concerns, equipment failure and the occasional strike have conspired to disrupt operations. Furthermore, for sea operations, extraction costs are above budget while resource recovered is below budget, combining to add an extra 50 percent on budgeted cost per carat of production. For land operations, the Daberas mine is at the end of its life, producing at lower grades and at higher costs. The Elizabeth Bay mine restarted operations in 2012 after being placed under care and maintenance in 2009. In the coming years, the mine will provide up to half of the annual production expected from Namdeb's land operations. Essentially, Namdeb requires fresh investment of at least US$1 billion to extend and optimize the life of its mines. The company has split its investment plans between short-term projects to be attained by 2020 and long-term projects to the year 2050.
  • 4. www.diamondshades.com/diamondreport publication 4 Companies Diamond Industry Series Namibia is the source of high value diamonds for De Beers with average prices ranging from US$450 to US$611 per carat but this comes at significant cost to the company. Namdeb is required to pay a royalty on turnover of 10 percent and company tax of 55 percent on its profits, the net effect being an effective tax rate of around 65 to 72 percent that increases as profitability decreases due to the fixed element of the royalty. At current tax and profitability rates, many of the projects that Namdeb would like to pursue are not financial justifiable because it would take up to ten years to gain return on investment. Furthermore, there are significant technological challenges to overcome before the achievement of reasonable extraction costs. For the above reasons, Namdeb hopes its new US$34 million Sendelingsdrif project will produce enough large diamonds to help ease funding pressures. Sendelingsdrif is expected to replace production from Daberas Mine toward the end of 2013 as well as extend the Orange River operations to at least 2022. The mine is expected to yield about 45,000 carats per annum, with a single average size of 1.5 carats. Namdeb is also optimizing its marine operations to help boost production. Debmarine Namibia is currently operating at 100 percent of its fleet capacity with a total of five mining vessels, including the Grand Banks mining vessel which was recommissioned in 2012 after being laid-up since 2009. The previously chartered Peace of Africa vessel was purchased from De Beers Consolidated Mines at a cost of US$79 million. The vessel is expected to produce an estimated 330,000 carats annually, equating to around 30 percent of Debmarine Namibia’s total production. Capacity enhancements to the Peace in Africa and the Debmar Atlantic will be implemented during 2013 to target currently unmineable areas within Atlantic 1, the sea operations. Nevertheless, we still expect reduced revenue and profitability for Namdeb in the period 2014-2017 mainly because of continuing inefficiency, reduced overall production and the mining of lower ore grades. Production may increase in the medium term if Namdeb manages to overcome the signficant technological challenges it currently faces. Crucially for De Beers, the sales contract which allows De Beers to exclusively market Namdeb production expires in 2013. Just as in Botswana, the Namibia Diamond Trading Company (NDTC) is compelled to support efforts to grow the local manufacturing industry. The increase in the number of sightholders to 13 from 10 suggests that more diamonds will be sold locally in future. We expect that Namibia will want to emulate Botswana's new agreement with De Beers.
  • 5. www.diamondshades.com/diamondreport publication 5 Companies Diamond Industry Series 2. De Beers Canada Figure 3: De Beers Canada Production Source: Company Reports, Equity Communications In Canada, De Beers wholly owns its two mining operations; Victor mine located in Northern Ontario and Snap Lake mine in the Northwest Territories. De Beers also has a 51 percent shareholding in a joint venture in Gahcho Kué, a project in the vicinity of Snap Lake. The project is at an advanced permitting stage. Figure 4: De Beers Canada Projects Development Costs Operating Costs Revenue Snap Lake Mine 975 1200 682 Victor Mine 1022 650 1560 Total 1,997 1,850 2242 US$ millions…as at 31 December 2012 Source: Company Reports, Equity Communications Estimates De Beers Canada's mining projects have so far proved to be an exercise in shareholder value destruction. In 2007, De Beers took an impairment of US$965 million on its Canadian assets and shaved off about a third of the carrying value of Snap Lake and Victor mines before they had even started commercial production. Another impairment of US$696 million followed in 2009, essentially halving the carrying value of Snap Lake and Victor mines in the second year of full operations.
  • 6. www.diamondshades.com/diamondreport publication 6 Companies Diamond Industry Series Initially conceived at an investment cost of US$500 million, Snap Lake mine has been a technical and financial disaster. Through the end of 2012, De Beers had invested more than US$2 billion to build and operate the Snap Lake mine. Additional capital investment was made in 2012, with De Beers Canada battling significant operational issues at the mine. Combined revenue for the two mines operated by De Beers Canada since 2008 is roughly equal to what has been spent at Snap Lake alone. According to the initial mine plans, Snap Lake was expected to produce 1.4 million carats a year for 20 years at a recovery rate of 1.2 carats per tonne. In 2012, Snap lake mine produced 870 000 carats at a recovery rate of 0.95 carats per tonne. Carat recovery decreased marginally from the previous year due to higher than expected ore dilution and lower than expected ore grade. Figure 5: De Beers Canada production economics Source: Equity Communications Estimates Figure 6: De Beers Canada revenue Source: Equity Communications Estimates Figure 7: Snap Lake and Victor Mines combined costs Source: Equity Communications Estimates
  • 7. www.diamondshades.com/diamondreport publication 7 Companies Diamond Industry Series That being said, an Optimisation Study at Snap Lake mine was completed in 2011 with the hope that this would help De Beers achieve its investment and production goals for the forecast 20-year life of mine. Full production capacity of 1.4 million carats per year is now expected for 2014 after being initially planned for 2012. To achieve this, new areas of the Snap lake kimberlite are being opened up. However, all indications are that Snap Lake will remain a value destroying asset for the foreseeable future. De Beers faces severe technical challenges at the mine that have a lot to do with water management. Furthermore, while the diamond bearing rock itself is quite high grade, significant dilution means that out of every tonne of rock that goes through the processing plant, up to 40 percent is worthless. It is probable that the mine may never provide a positive return on investment. The Victor mine has approximately eight years remaining of the forecast life of mine. Extraction costs per carat are within a similar range to those for Snap Lake, the difference being that the Victor pipe produces enough high quality diamonds to sufficiently cover mining costs. Plans are underway to extend the life of mine beyond 2020 but this is going to be very difficult. After several years of analysis of other diamond-bearing kimberlites in the Victor cluster, the Tango Extension kimberlite, while smaller and of lower grade than Victor, currently offers the best potential to extend the life of the mining operation. However, it will not be profitable without a significant reduction in current operating costs. Tense relationships between De Beers and indigenous communities living near its mines are also of major concern. De Beers Canada has recently had conflict with the Attawaspikat community, leading to blockades of the road that provides access to the Victor mine during winter. Providing background knowledge, De Beers and Attawapiskat First Nation entered into an agreement whereby De Beers pays an annual royalty to the Attawaspikat in exchange for mining diamonds in the area. Many in the Attawaspikat community feel this is not enough and they now want much more. In general, moves to renegotiate mining agreements have gained traction in many of the indigenous communities in Canada where there are mining operations. The crust of the matter is this: Indigenous communities insist the compensation agreements entered into with mining companies are payments for being displaced from traditional homelands. What they now seek is co-ownership of the resources being mined - what they feel is real sharing of natural wealth. For Victor mine, increased tensions between De Beers and the Attawaspikat community could frustrate efforts to extend the life of mine. The economics of extension are already poor before any additional concessions to local communities.
  • 8. www.diamondshades.com/diamondreport publication 8 Companies Diamond Industry Series Gahcho Kué Project Figure 8: Gahcho Kué Project Gahcho Kué Project Estimated Project Cost US$686 million Probable Mineral Reserves 31.3 million tonnes Grade 1.57 carats per tonne Production Year 2015-2016 Life of Mine 11 years Source: Company Documents The Gahcho Kue project is a joint venture between De Beers Canada (51 percent) and Mountain Province Diamonds (49 percent). It consists of a cluster of four diamondiferous kimberlites, three of which have a probable mineral reserve of 31.3 million tonnes grading 1.57 carats per tonne for total diamond content of 49 million carats. Known as 5034, Hearne and Tuzo, these three pipes will be mined in sequence as open pits over a forecast 11 year mine life. The Gahcho Kue Project is at the advanced permitting stage. We fully expect the required regulatory approvals and permits will be obtained eventually. The time frame is what is not certain but the development schedule is not threatened at present. Once all required licenses and permits are in place, construction is expected to take about two years. Commercial production will likely begin in the last quarter of 2016. From a financial standpoint, the economics for De Beers Canada are quite poor. It will be a long time before any positive return on investment if any. From a strategic standpoint, it sounds better for De Beers in the current global social environment to say it is a global miner instead of a Southern Africa miner. Crucially, production from De Beers Canada is very important for the long-term survival of De Beers' supply contract system. Closure of unprofitable De Beers Canada operations would greatly compromise De Beers' market share and influence in the diamond industry pipeline. When the supply contract system was first conceived, De Beers could count on contracted production from all major producers to fulfil client requirements. De Beers no longer markets rough diamonds produced by other producers, effectively halving its market share of global rough diamond sales from fifteen years ago. Furthermore, decision making authority on the marketing of production from its Southern Africa operations has gradually been taken over by its producer-government partners. For this reason as well, we believe De Beers will at some point try to purchase Mountain Province's 49 percent interest in the Gahcho Kue Project once commercial production begins.
  • 9. www.diamondshades.com/diamondreport publication 9 Companies Diamond Industry Series 3. Debswana Figure 9: Debswana Diamond Production Source: Equity Communications Estimates In Botswana, De Beers’ interests are held through the Debswana Diamond Company, a 50:50 joint venture with the Government of Botswana. Debswana’s operations include Jwaneng, the world’s richest diamond mine; Orapa, the world’s largest open-pit diamond mine; Letlhakane; and Damtshaa. Figure 10: Debswana Diamond Sales Debswana contributes disproportionately to De Beers' earnings. Jwaneng, in turn, is the most valuable of Debswana’s mines, contributing 60-70 percent of Debswana’s total earnings. It is also the most profitable of all diamond mines in the world.
  • 10. www.diamondshades.com/diamondreport publication 10 Companies Diamond Industry Series Debswana's average annual production in the period 2000- 2008 was 30 percent greater than the 24 million carats achieved in 1999, following a decision to boost output. For the period 2009 -2012, average production has been 17 percent lower than in 1999 in response to reduced global demand but also including operational challenges at Jwaneng. Debswana is very much a company in transition. We have gradually observed a changing of roles at Debswana in recent years with the government of Botswana increasingly taking over chief decision-making roles. Our opinion is that management of Botswana's principal diamond asset was a bit irresponsible in the last decade. It remains to be seen whether Debswana can do better with greater input from Anglo American and the Botswana government. Figure 11: Jwaneng Mine contribution to Debswana Production Source: Equity Communications Estimates Figure 12: Jwaneng Mine diamond production Source: Company Reports, Equity Communications Estimates Figure 13: Jwaneng mining costs per carat Source: Company Reports, Equity Communications Estimates
  • 11. www.diamondshades.com/diamondreport publication 11 Companies Diamond Industry Series Late-life mines continue to pose a sustainability challenge for Debswana. Botswana is determined to get as much as possible out of its diamond resource before the shaky decade after 2020 when its flagship mines will start to rapidly lose lustre. Nevertheless, the crucial Jwaneng Mine extension project continues to proceed smoothly and on budget. The project will strip 713 million tonnes of waste, exposing an additional 75 million tonnes of diamond bearing ore. At least 115 million tonnes of waste has so far been moved since 2010. Cut-8 will provide access to approximately 95 million carats of mainly high quality diamonds and officially extend the life of the world’s richest diamond mine to at least 2028, at an annual production rate of 8 to 10 million carats. Going forward, the challenge for Debswana is to achieve optimum returns from its mines. In the last decade, Debswana could not take advantage of increased output and rising diamond prices because growth in production and overhead costs considerably outpaced growth in revenue. In effect, Debswana depleted more of its resource without getting proportionate returns. Our view is that there is no reason for Debswana to produce at capacity in the short term. Debswana should first ensure mining efficiency with the view of boosting production in the medium term. Furthermore, we do not subscribe to the idea that Debswana will run out of diamonds to mine in the next twenty years. With balanced production, the cut 8 extension should extend the life of Jwaneng to at least 2030. After cut-8, we predict the commencement of cut-9 or underground mining to further extend the life of Jwaneng to at least 2050. All things considered, it is the long-term profit outlook for Debswana that is less impressive because of the expected increase in extraction costs. Debswana's mines will be around for a long time.
  • 12. www.diamondshades.com/diamondreport publication 12 Companies Diamond Industry Series 4. De Beers Consolidated Mines (DBCM) Figure 14: DBCM diamond production Source: Company Reports, Equity Communications Estimates In South Africa, De Beers has a 74 percent interest in De Beers Consolidated Mines (DBCM), with the remaining 26 percent held by Ponahalo Holdings, which is a black economic empowerment consortium. DBCM’s operations include Venetia, which produces about 70 percent of De Beers’ production from South Africa; Voorspoed, a source of large and exotic coloured diamonds; and Kimberley Mines, a tailings processing facility. De Beers Consolidated Mines, in its presence form, is a shadow of its former illustrious self. DBCM has sold five of its mining operations that it was failing to operate profitably to focus on the Venetia and Voorspoed mines. DBCM was guilty of over-mining in the period leading up to the onset of the global financial crisis. For instance, by the end of 2008, Venetia mine had incurred a backlog of 40 million tonnes in waste stripped. Consequently, current focus for DBCM is on improving mining efficiency. The job is made difficult by the significant problems that afflict the whole mining industry in South Africa such as persistent skills shortages and often tense labour relations. DBCM will invest US$2 billion to build the Venetia underground mine. When completed, the new underground mine will extend the life of Venetia beyond 2040 and replace the open pit as South Africa’s largest diamond mine. The life of mine plan contains an estimated 96 million carats in approximately 130 million tonnes mined.
  • 13. www.diamondshades.com/diamondreport publication 13 Companies Diamond Industry Series Section Commentary Figure 15: De Beers Group diamond production Source: Company Reports, Equity Communications Estimates Figure 16: De Beers Group quarterly production Source: Company Reports, Equity Communications Estimates De Beers practiced unbalanced mining in the decade 2000-2010 in its efforts to crank up production. Production was boosted by working high grade areas and by reducing stripping. Now De Beers has got to work lower grade areas and at the same time make up for the stripping that was postponed until 2010. This mainly affects Debswana where the Jwaneng mine appears to have been mismanaged for years. Mines which were overmined in South Africa have been sold off to smaller specialized operators who have since turned them around. De Beers is now focused on rationalizing its operations in Southern Africa. We are also waiting to find out just how Anglo American will tackle the very costly Snap Lake mine in Canada in the coming years. Perhaps it would be in the mine's long-term interest to mothball operations until De Beers can comprehensively determine the best way to get the mine closer to the initial plans for it. We believe De Beers will maintain the current level of production until at least the second quarter of 2014. In the current year, the higher level of production from Debswana will offset reduced production from South Africa.
  • 14. www.diamondshades.com/diamondreport publication 14 Companies Diamond Industry Series Exploration Program Figure 17: De Beers Group exploration spending Source: Company Reports, Equity Communications Estimates Figure 18: De Beers Group exploration spending Exploration Ground Holdings (square kilometres)…as at 31 December 2012 2007 2008 2009 2010 2011 2012 Angola 12000 9000 6000 6042 3017 0 Botswana 28800 10000 3300 3383 7655 7804 Canada 148000 2100 700 605 248 170 DRC 18800 12000 0 0 0 0 India 0 19700 9300 8733 2128 0 Namibia 0 0 0 0 0 0 South Africa 0 700 1000 995 325 455 Total 207600 53500 20300 19758 13373 8429 Company Reports, Equity Communications Estimates Figure 19: De Beers Group exploration spending Source: Company Reports, Equity Communications Estimates
  • 15. www.diamondshades.com/diamondreport publication 15 Companies Diamond Industry Series De Beers’ exploration focuses on the discovery of diamondiferous kimberlites with the best potential to go into commercial production within five years. De Beers prioritises its exploration activities in Angola where more than 117 kimberlites have so far been discovered at a cost of US$250 million. 22 of these have been prioritised for deposit-phase diamond grade testing to confirm their economic viability. Drill testing for diamond grade in the Lunda Northeast concession was completed on 14 of the 22 priority pipes with results expected in 2013. The concession’s seven-year term expired in August 2012. Negotiations are underway for a Mineral Investment Contract under the more favourable terms and conditions set out in the new Angolan Mining Law, which came into force in late 2011. The conceptual study for the Mulepe-1 kimberlite was completed in November but indications suggest a stand-alone deposit is uneconomic under current assumptions In India, the Mahabubnagar reconnaissance permit period expired during 2012. Application is underway for the prospecting licence and a number of other reconnaissance permit applications remain pending. In South Africa, ground geophysical surveys were completed in the Finsch area, and targets selected for drill testing. South Africa remains highly prospective and specialist reviews of the historical databases continued in 2012. Several of the De Beers prospecting licence applications are pending. In Canada, Peregrine Diamonds purchased BHP Billiton's 51 percent participating interest in the 8,580 square kilometre Chidliak project for US$9 million dollars paid over three years. The company subsequently received US$10 million funding boost from Newstar Securities and the Dundee Corporation plus a US$5 million investment from De Beers, effectively securing working capital to fund administrative costs and planned exploration to 2014. The deal also gives DeBeers the option to acquire up to 51 per cent ownership of the Chidliak project before the end of 2013.
  • 16. www.diamondshades.com/diamondreport publication 16 Companies Diamond Industry Series Rough Diamond Sales Around 1999, with the help of Bain and Co, De Beers reviewed its struggling operations and concluded that it was no longer viable and also no longer in the company's interest to seek to physically control other producers' supply of rough diamonds. Instead, De Beers would focus on marketing its own diamonds and become 'Supplier of Choice' for the downstream market in the diamond value chain. The Diamond Trading Company (DTC) was then incorporated to replace the Central Selling Organization (CSO) as the new marketing arm of De Beers. This would also appease regulators in USA and Europe who had become frightfully dissatisfied with De Beers' monopolistic inclinations. De Beers subsequently implemented a Sightholder System through which a small number of carefully selected companies would be contracted to move De Beers produced diamonds down the diamond value chain. These companies would also be required to adjust their business strategies and align them with De Beers' new goals. At least 90 percent of De Beers' annual rough diamond sales are to sightholders. Figure 20: De Beers Sightholders Source: Company Reports, Equity Communications Estimates In 2011, a 10 years sales agreement was signed with the government of Botswana that requires the transfer of all of De Beers’ functions which relate directly to the sale of Debswana diamonds to Botswana by the end of 2013. Furthemore, the government of Botswana is now entitled to purchase the equivalent of 10 percent of Debswana production on a run of mine basis and growing to 15 percent by 2016. At capacity, Debswana produces up to 80 percent of De Beers' annual supply of diamonds. Because De Beers prefers to mix production from its mines located in Canada and Southern Africa before distributing it to its clients, the DTC was therefore compelled to move its sales and marketing operations to Botswana in order to maintain efficiency. DTC Botswana has capacity to handle 40 million carats of diamonds at any given time. Through various sales agreements in South Africa, Namibia, Botswana and Canada, the DTC is also compelled to supply local processors with usually up to 10 percent of locally produced diamonds.
  • 17. www.diamondshades.com/diamondreport publication 17 Companies Diamond Industry Series Figure 21: De Beers rough diamond sales Source: Company Reports, Equity Communications Estimates Figure 22: DTC price index Source: Company Reports, Equity Communications Estimates
  • 18. www.diamondshades.com/diamondreport publication 18 Companies Diamond Industry Series Section Commentary De Beers will gradually phase out its global sales of diamonds and concentrate its sales in Southern Africa. This is inevitable because of the push by its producer government partners for more 'local' sales. For instance, Botswana intends to demand a greater local allocation of diamonds from De Beers for beneficiation purposes in the remaining two years of the 2012- 2015 contract period. Furthermore, Botswana has indicated that it will demand even greater local allocation of Debswana production in the next sales agreement for the post 2020 period. In addition to this, the Botswana government will soon be distributing up to 15 percent of Debswana production outside of De Beers' sales channels. Figure 23: DTC sightholder sales Source: Company Reports, Equity Communications Estimates Figure 24: DTC sightholder sales Southern Africa Source: Company Reports, Equity Communications Estimates Consequently, diamond processors in other regions of the world should expect a sharp decline in the availability of De Beers produced rough diamonds. The DTC forecasts that over 50 percent of global availability of high quality diamonds will be offered to producer countries. Therefore, we expect greater consolidation in diamond processing of high quality goods. (More analysis is provided in the Manufacturing Review section of the 2013 Diamond Report)
  • 19. www.diamondshades.com/diamondreport publication 19 Companies Diamond Industry Series Figure 25: Botswana Beneficiation Drive Botswana Beneficiation Drive  25 Companies licensed in diamond cutting and polishing since 2004  21 cutting and polishing factories with DTC guaranteed rough diamond supply and 4 with different sources of supply  Goods polished locally grown from US$28 million in 2005 to just above US$748 million in 2012  One of the companies cutting and polishing diamonds in Botswana opened a jewellery factory in 2011  Licensing conditions that require new mines to market their diamonds locally New goals  Botswana's new marketing agreement with De Beers places greater emphasis on the introduction of advanced cutting technologies  Government of Botswana established a Okavango Diamond Company (ODC) to market 10-15 percent of Debswana production independently  Grow value of rough diamonds polished locally to US$800 million
  • 20. www.diamondshades.com/diamondreport publication 20 Companies Diamond Industry Series Auction Sales Figure 26: Diamdel Auction Sales Source: Company Reports, Equity Communications Estimates Diamdel is a business, wholly owned by De Beers, focused on auctioning rough diamonds. Diamdel traditionally sold rough diamonds sourced from DTC to non-sightholders through face to face negotiations. In recent years the company has been transformed to conduct international online auction sales of rough diamonds. These now account for at least 95 percent of all rough diamond sales by Diamdel. Furthermore, De Beers has now extended participation in auction sales to the entire market of rough diamond buyers including current sightholders.
  • 21. www.diamondshades.com/diamondreport publication 21 Companies Diamond Industry Series Section Commentary Beginning in the year 2000, De Beers has tried to sideline pure dealers in rough diamonds, preferring to take on clients that can demonstrate strong manufacturing ability and so forth. Consequently, sightholders in De Beers' Supplier of Choice system for the distribution of diamonds are obligated to participate in downstream pipeline activities. For this reason, Debeers prefers to enter into long-term supply agreements with vertically integrated companies. (Analysis is provided in the Rough Trade Review section of the 2013 Diamond Report) Key points  Historical working stock valued at US$2.5 billion is no longer available  Current stocks available to clients range from US$400 million to US$800 million  Availability of goods changes from sight to sight in response to short-term production,  Greater volatility in supply volumes and quality We believe it is purposeless for De Beers to push its clients further downstream when the company does not have the ability to provide all the necessary inputs required for efficient and sustainable manufacturing operations. First,De Beers no longer maintains stocks of rough diamonds, striving to produce according to client demand. Second, De Beers no longer markets rough diamonds from other producers. Finally,the company continues to experience production shortfalls in some categories for various reasons that include poor mining strategies at some of its mines. This results in stockouts for some categories. Consequently, some long-term clients have experienced shortfalls in their allocation of diamonds. The impact varies from sightholder to sightholder because of De Beers' obligations to government selected sightholders in Southern Africa and Canada. In reality, no producer has the ability to provide all the diamonds required by a verticallly intergrated manufacturer in the right quantities. Sightholders based in Southern Africa routinely process 30 percent of allocations in producer countries and export the rest that often cannot be processed economically in Southern Africa. With so many forced specialist manufacturers in the dynamic secondary markets, space for profitable trading activities has opened up in rough and polished diamond markets.
  • 22. www.diamondshades.com/diamondreport publication 22 Companies Diamond Industry Series De Beers Diamond Jewellers Figure 27: De Beers Diamond Jewellers store network Source: Company Reports, Equity Communications Estimates Figure 28: De Beers Diamond Jewellers Revenue Source: Company Reports, Equity Communications Estimates De Beers Diamond Jewellers (DBDJ) is an independently managed 50/50 joint venture partnership between De Beers and LVMH Moët Hennessy Louis Vuitton SA. The joint venture was formed with the aim of developing a retail strategy for the De Beers brand based on the De Beers name which has a very strong consumer awareness and credibility. The idea was to gradually open 150 stores in the main diamond markets from 2002 to 2012. Key Points  DBDJ is precluded by EU competition authorities from sourcing diamonds directly from De Beers  The joint venture is not yet profitable The idea has caught on in the diamond industry that it is possible to launch instantly successful international luxury diamond jewellery brands without first acquiring the heritage and legacy of outstanding craftsmanship. However, on the other hand, prestigious international luxury jewellery brands with the heritage and legacy like Tiffany spend at least US$200 million annually on marketing.
  • 23. www.diamondshades.com/diamondreport publication 23 Companies Diamond Industry Series De Beers Forevermark After carefully looking at the dynamics of the global diamond industry value chain, we have had to significantly reconsider our analysis of De Beers Forevermark. It appears De Beers is using Forevermark to create a diamond pipeline more in tune with its ambitions for the industry. De Beers Forevermark provides incentives for salespeople to mention to customers that a particular diamond has been produced by De Beers. It wants consumers to be aware of De Beers as the premium diamond producer with the aim of greatly boosting the impression that a De Beers diamond is the best diamond to purchase. Figure 29: De Beers Forevermark retail doors Source: Company Reports, Equity Communications Estimates Forevermark is fast gaining momentum; in a few years competitors will have to respond in one way or another. Business Model for the Forevermark Brand Forevermark, unlike De Beers Diamond Jewelers, is a brand targeted at the diamond industry pipeline, a point missed by industry observers. The ultimate goal of Forevermark is to make De Beers’ rough diamonds more valuable than diamonds of other producers. Essentially, De Beers is branding its diamonds so that the diamond industry pipeline prefers them to diamonds of other producers.
  • 24. www.diamondshades.com/diamondreport publication 24 Companies Diamond Industry Series Stage 1 Ninety-percent of Forevermark diamonds come from De Beers owned mines. De Beers selects only top quality diamonds - within the top 2 percent of global supply - for its Forevermark brand. Stage 2 Leaning on the strength of its sightholder system, De Beers urges selected manufacturers (Forevermark Diamantaires) to produce high quality polished diamonds suitable for the Forevermark pipeline. These diamonds are brought back to De Beers to be graded at the Forevermark Diamond Institue in Antwerp, which issues a passport-sized report. Manufacturers pay the normal certification fee. De Beers then provides a Forevermark Diamond Grading Report, featuring the unique identification number inscribed on the diamond and a specifically designed security hologram, providing reassurance that the Forevermark Diamond Grading Report is valid and genuine. Stage 3 De Beers encourages pre-selected retailers to become Forevermark Jewellers. Forevermark Jewellers sell the branded diamonds to consumers. The license fee is US$10, 000 per store or US$25, 000 per Forevermark vendor. The sweetener is that De Beers handles all marketing for the Forevermark brand using its vast financial resources and considerable diamond marketing expertise. It is a win-win for everyone involved. De Beers gets to control distribution of its top quality diamonds, Forevermark manufacturers gain pre-qualified retail clients, Forevermark retailers do not have to spend a fortune to market branded diamonds. De Beers' vision is for Forevermark to be the world's leading luxury diamond brand by 2015. This is easily achievable because no other organisation is actively stamping diamonds for branding purposes to De Beers' level. Assumptions and Analysis Stage 1 In theory, the more Forevermark-licensed Jewellers there are out there, the greater the strain on De Beers already limited high quality production. If the assumption is that consumer demand for expensive high quality diamonds is strong and growing, the end of it all is that De Beers will sell its top diamonds at a higher price. These diamonds are already a significant component of De Beers' total production by value.
  • 25. www.diamondshades.com/diamondreport publication 25 Companies Diamond Industry Series Top end retailers who are not a part of the Forevermark system may eventually lose their ability to access high quality diamonds from the De Beers production system. Tiffany has responded to this competitive assault by entering into long-term supply agreements with small diamond mines that produce or seek to produce high quality diamonds. (Please refer to the production section of the 2013 Diamond Report for this analysis. Harry Winston diamond brand is largely protected because of its association with Dominion Diamond Corporation, majority owner of Ekati mine and part owner of Diavik Mine. It can also rely on the sourcing strength of the Swatch Group, its new owner. Stage 2 In theory, De Beers can now trace all of its gem diamond production from mine to store. That could still happen within the next decade. So far De Beers has chosen to concentrate its branding effort at the top end of the market. Starting branding initiatives at the top end makes sense because consumers in this segment are less price conscious and decidedly more brand focused. There already exists a market for Tiffany diamonds, routinely sold at a premium to other diamonds of the same specifications. The requirement for ethical diamonds has gained momentum amongst members of the diamond trade who are based in traditional markets for diamonds. De Beers is responding to popular pipeline concerns and has positioned itself well. Forevermark branded diamonds give De Beers’ diamonds protection against reputational risks like treated diamonds and conflict diamonds. It is quite possible that the majority of all high quality diamonds will eventually end up being Forevermark diamonds. The nature of the diamond market is that De Beers' strongest manufacturers are also clients of the leading diamond producers like Dominion, Alrosa and Rio Tinto. Forevermark manufacturers have the freedom to produce polished diamonds as they please - as stones or finished pieces, relying on collaborative research with De Beers on popular trends in the consumer markets. If De Beers' marketing initiatives manage to grow demand for Forevermark-inscribed jewellery, logic dictates that manufacturers will switch an increasing proportion of their high quality production to Forevermark. As such, we expect that grading of high value diamonds may shift from the traditional grading institutions like the Gemological Institute of America (GIA) to De Beers' Forevermark Institute. Tiffany already successfully produces its own grading reports. De Beers is of the opinion that those who sell Forevermark diamonds should not add another report on top of the one it provides to discourage comparison-shopping.
  • 26. www.diamondshades.com/diamondreport publication 26 Companies Diamond Industry Series Consumers do not normally differentiate between grading laboratories but De Beers new marketing focus may reshape opinions. De Beers is improving its grading systems, targeting consistency. The issue of different grading labs providing different colour grades for similar diamonds has taken centre-stage as it considerably impacts the final value of a diamond. To gain competitive advantage, De Beers is working with proprietary colour grading machines at the Forevermark grading facility in Antwerp which have so far proved to be more consistent and reliable than human graders on colour and clarity. The machines work at high speeds and, crucially, De Beers is not willing to share the technology with other grading labs. The Forevermark Institute does some private label for grading for other diamond brands. De Beers only does this for diamond brands that meet its stringent requirements. Since certification is an important component of the diamond purchase decision in emerging markets where consumers are less trusting of diamond retailers, Forevermark can move in to capture significant market share based on the strength of its strong marketing push. In 2012 De Beers' Forevermark launched FMX, an online trading platform for its partners to buy and sell Forevermark diamonds. This platform will likely provide the backbone for the Forevermark pipeline and is only accessible to those companies - traders, manufacturers and jewellers - that are part of the Forevermark system. FMX allows authorized suppliers to upload details directly and elect to have their diamonds appear online automatically, within a few hours or less of when they are graded by the Forevermark Diamond Institute The U.S. Patent & Trademark Office (USPTO) issued in 2013 the trademark 'Forevermark Diamond Institute' to De Beers. De Beers filed for the trademark in 2011. The description of the trademark includes the words "FOREVERMARK DIAMOND INSTITUTE" inside an outer circle with two black dots adjacent the word FOREVERMARK. There is an inner circle within the outer circle and that inner circle contains the view of a diamond from above. The goods and services provided under this trademark cover scientific and technological developments through research and design in the fields of minerals and gems; industrial analysis and research services in the fields of minerals and gems; design and development of computer hardware and software all relating to the grading, identification, observation, measuring, testing, checking, analysis, inspection, inscription for the purpose of certifying diamonds, jewellery, precious and semi-precious stones.
  • 27. www.diamondshades.com/diamondreport publication 27 Companies Diamond Industry Series Stage 3 The diamond industry has bemoaned the lack of generic marketing of diamonds in consumer markets. Generic marketing of diamonds was the responsibility of De Beers when it exclusively sold much of the world’s annual production of diamonds. Times have changed, it is a different world today. However, what is clear is that the absence of generic marketing has slowed the growth of diamond markets. Retailers operating in the targeted segment may find it to their advantage to join the Forevermark system if it means shifting some of the marketing costs to someone else. Forevermark retailers have a high degree of freedom to display the Forevermark as they wish and one could use the association to drive store traffic. For example, Forevermark's Center of My Universe campaign appears to have done extremely well in the United States market. So far the Forevermark brand has focussed its marketing efforts on diamond products that are generally resilient in periods of weak demand - bridal jewellery and diamond stud earrings. The target mrket is the luxury focussed consumer with an annual income of at least US$70,000 and is in the market for large size high quality diamonds. Incidentally, this is the most popular segment in the top market of USA where Forevermark has targeted 750 retail doors as quickly as possible. The Forevermark brand was introduced in Asian markets in 2008 after years of testing. It has now spread to traditional diamond markets such as the US. De Beers says it has inscribed 500 000 Forevermark diamonds since 2008. Forevermark has gained momentum since it experienced 40 percent volume growth in 2012 in the number of diamonds branded. De Beers expects to inscribe 200 000 diamonds in 2013. US$1 billion of Forevermark diamonds have also been sold in consumer markets since 2008. De Beers hopes that the growth of Forevermark will eventually allow the company to produce rough diamonds annually to exactly match world demand.
  • 28. www.diamondshades.com/diamondreport publication 28 Companies Diamond Industry Series Section Commentary DeBeers is aggressively inscribing its diamonds so that jewellers can easily identify diamonds sourced through the official De Beers network. Forevermark has not yet reached tipping point. This may happen within five years if volume growth continues at current pace. Forevermark growth feeds off sentiment in the diamond industry pipeline. There are two main issues that fuel the growth of Forevermark: 1. If we exclude De Beers and Rio Tinto Diamonds, the other diamond producers have neglible marketing spend in the diamond industry pipeline. 2. Then there are diamond producers who do more than enough to ruin the image of diamonds The diamond pipeline is being remodelled to try and emphasize that diamonds from different producers should not be treated equally. The movement has been growing for years and attention now appears to have shifted to polished diamonds. The movement seeks to devalue diamonds produced from regions that carry significant reputational risks through their exclusion from marketing initiatives in consumer markets. Of the major diamond producers, diamonds from Angola, Zimbabwe and DRC face the greatest risk of exclusion. Nevertheless, diamonds from these regions would still find acceptance in emerging consumer markets, where the ethical diamonds movement is not strong. Balancing things out, the ethical diamonds/branded diamonds movement is only as strong as the chaos, real or imagined, in Angola, Zimbabwe and DRC - diamond producers with questionable diamond production policies. When all is said and done, the majority of consumers will always choose the cheaper diamond if there is little to no difference in quality and specifications.
  • 29. www.diamondshades.com/diamondreport publication 29 Companies Diamond Industry Series Conclusion Figure 30: De Beers Group Revenue Source: Company Reports, Equity Communications Estimates We get the sense that De Beers is a company that is trying to achieve too much in the diamond industry. It appears De Beers is still trying to implement recommendations that were borne out of the strategic review of 1999. This is despite the fact that De Beers is a very different company from what it was at the turn of the century. Ultimately, De Beers wants to be the preferred supplier of diamonds for the diamond pipeline. This is a very flawed strategy that has also ultimately confused issues for De Beers. Somewhere along the road it got lost to De Beers that the reason for buying diamonds from other producers was actually for the purposes of controlling supply into the diamond pipeline. It was Ernest Oppenheimer who first correctly observed that supply and demand for diamonds needed to be expertly balanced. Nowadays, all diamond producers compete to get their diamonds into the industry pipeline without much consideration for its health. Can De Beers brand its diamonds and achieve higher prices in the long-term? The answer is no. A different producer will soon flood the market and depress prices for De Beers branded diamonds. Afterall, a 1.00 carat F- color, VS2-clarity, excellent cut round diamond has the same properties the world over no matter who the producer. Furthermore, it is virtually impossible to stamp diamonds in a way that is visible to the naked eye, effectively taking away the bragging factor that drives the sales of many luxury goods.
  • 30. www.diamondshades.com/diamondreport publication 30 Companies Diamond Industry Series DeBeers can brand its diamonds to prove that they have been sourced responsibly but this can never be used to achieve differential pricing for diamonds the commodity. If it cannot be done for gold, it certainly cannot work for diamonds. When prices for a certain category of diamonds rise, they rise for all producers. When prices for that same category fall, they fall for all producers. If we look at the Kimberley Process statistics for 2012, we can see that the year was generally not good for producers of high quality diamonds like Botswana, Canada and Lesotho. On the other hand, Australia, Zimbabwe and Russia did well. DeBeers appears to be envious of the mark-ups and margins achieved by true luxury goods producers, believing that their business model can be copied. However, this just adds to the confusion on profit margin expectations. Luxury goods are proprietary products while diamonds are luxury commodities. Luxury goods producers can manipulate global distribution of goods by virtue of ownership. For De Beers to control global distribution of diamonds, it would have to corner the market for diamonds. Put differently, De Beers would have to become a global monopoly again. It remains that the best way to manipulate the price of a commodity is to control supply. In this regard, Alrosa is behaving more like the old De Beers. When diamond markets are soft, Alrosa has the ability to stockpile diamonds through its arrangement with Gohkran. For this reason, the company has achieved better margins and less price volatility than De Beers since 2008, the last year of Alrosa sales through De Beers. De Beers, on the other hand, reversed its strategy of a century by first offloading its substantial stockpile of diamonds and then subsequently cranking up production (over mining) in its efforts to maintain market share of sales. Debswana mined more of its high value diamonds while achieving less profit for the efforts because costs rose faster than revenue. To this day, polished diamond markets are still feeling the impact of De Beers' decision to offload a substantial volume of diamonds into the pipeline in a short space of time. Since there are too many companies seeking to enter into long-term supply contracts with a limited number of major producers, a number of producers have cranked up production to satisfy insatiable pipeline demand. However, we believe demand fundamentals at the retail end should ultimately influence supply strategies. All major producers including Alrosa, De Beers, Dominion, Rio Tinto and the Zimbabwe groups have specific categories of diamonds that they specialize in. We believe it is possible to optimize supply of specific categories of diamonds with the aim of steadily increasing prices in the long-term. Alrosa appears to be implementing this strategy quite well, maintaining its average supply at 33 million carats in the last six years. In the same period, the average price of Alrosa's gem quality diamonds has gone up by 67 percent while the average price of its non-gem quality diamonds has gone up by 348 percent.
  • 31. www.diamondshades.com/diamondreport publication 31 Companies Diamond Industry Series It is well understood that producers need to stimulate consumer demand for the type of diamonds that they produce. Producers like Zimbabwe and Alrosa have benefited from the growing consumer demand for affordable diamond jewellery in Asia without having to spend a fortune on marketing initiatives. De Beers had hoped to grow consumer markets for diamonds to US$90 billion by 2010 through its branding- inspired marketing initiatives introduced after its strategic review of 1999. The company suspended generic marketing of diamonds to concentrate its marketing initiatives at the top third of consumer markets for diamonds, where much of its production is directed. However, De Beers has not been able to meet its goal for various reasons:  Mature traditional markets are in a period of decline while emerging markets are growing from a very small base.  De Beers oversupplied its markets cheaply from 2000 and 2008.  Incorrectly targeted marketing initiatives introduced by De Beers have greatly underperformed. The Forevermark/ethical diamonds/branded diamonds movement is only as strong as the chaos, real or imagined, in Angola, Zimbabwe and DRC. It is therefore not sustainable to let the threat of conflict and human rights diamonds be the chief basis for De Beers' long-term strategy. Such issues are a moving target. Moreover, De Beers cannot guarantee that its mining operations in Canada - where relationships with indigenous communities are sometimes tense - will never come under attack. Outlook Extensively, De Beers has been in the doldrums for more than a decade now, losing a lot of value since the turn of the century. The recent shareholding change, along with changes at the top of the company, is therefore viewed in a positive light. Anglo American appears to be in the middle of a comprehensive review of De Beers' operations, following their acquisition of the Oppenheimer family's stake in the company. For this reason, it would be superfluous to make future predictions for De Beers at this juncture. A revision of rough diamond sales processes is already underway.
  • 32. www.diamondshades.com/diamondreport publication 32 Companies Diamond Industry Series Progression of the Diamond Market Our expectations for the diamond market in the short-to-medium term are less aggressive. In the next three years, we believe annual world production of rough diamonds will receive a boost of 10 to 15 million carats in mainly lower quality diamonds as the Argyle underground mine also expands to full production. We already anticipate increased production from Zimbabwe after four new companies were awarded mining licences for different areas of the Marange concession, doubling the number of companies mining diamonds in Chiadzwa. What this means is that diamond prices will likely rise at a slower pace than had been anticipated just two years ago. Add to this the fact that emerging diamond markets are not growing quickly enough to replace diminishing demand in developed diamond markets.
  • 33. www.diamondshades.com/diamondreport publication 33 Companies Diamond Industry Series General Disclaimer This document is produced and circulated for general informational and educational purposes only. It is provided by Equity Communications. Equity Communications research utilizes data and information from public, private and internal sources. While we endeavour to keep the information up to date and correct, we make no representations or warranties of any kind, express or implied, about the completeness, accuracy, reliability, or suitability of this publication. The information and analysis contained in this publication has been compiled or arrived at from sources believed to be reliable but Equity Communications does not make any representation as to their accuracy or completeness and does not accept liability for any loss arising from the use hereof. Furthermore, the material contained herewith has no regard to the specific investment objectives, financial situation or particular needs of any specific recipient or organisation. It is not to be construed as a solicitation or an offer to buy or sell any commodities, securities or related financial instruments. For more information, please visit http://www.diamondshades.com/research-reports © Copyright 2013, Equity Communications Private Limited, ALL RIGHTS RESERVED. This publication is part of the Diamond Industry Series, a series of diamond industry reports produced by Equity Communications ahead of the 2013 Diamond Report. Equity Communication’s Diamond Report provides detailed analysis of trends in the diamond industry value chain in 2012-2013, from the production end to the retail end. It is in its third edition. About Authors Alrosa 2013 Review is based on research by the Diamond Industry Research Team at Equity Communications: Tinashe Takafuma, Gerald Manyengavana, Romeo Takafuma and Fred Divine. Supervision was provided by Tinashe Takafuma, Head of Research at Equity Communications. You may contact him by email at: ttinashe@equityzw.com For Further Contact If you would like to discuss this report, please contact Tinashe Takafuma on the above e-mail address. To find the latest Equity Communications content and register to receive notifications on new diamond industry reports and luxury goods sector reports, please visit www.diamondshades.com Please Note The views expressed herein are solely those of Equity Communications as of the date of this report and are subject to change without notice. Data Tables, Survey Results and Financials provided in this report are not intended, nor implied, to be a substitute for the professional advice you would receive from a qualified accountant, attorney or financial advisor. Always seek the advice of an accountant, attorney or financial advisor with any questions you may have regarding the decisions you undertake as a result of reviewing the information contained herein. Nothing in this report should be construed as either investment advice or legal opinion.

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