Description

Summary

Sarin Technologies is the global leader in the niche market for rough diamond analysis and planning equipment. The company generates exceptional returns (~35-40% ROCE), has shareholder friendly management, and is in the process of transforming its business model with the launch of proprietary technologies that are increasing its high-margin recurring revenue base. While this transformation has not gone completely unnoticed by the market (the stock is up ~50% this year), I think the limited sell-side coverage, low liquidity, and orphan status (no listed peers / Israeli company with Singapore listing) has kept the valuation too cheap for the quality and growth prospects of the business. Additionally, two factors have caused a sell-off in the stock over the past 6 months and created a good entry point in my opinion. First, a cyclical industry slowdown which started in June caused a very weak Q3 result. Encouragingly though, there are already signs that demand is recovering. Second, the Israel / Hamas conflict may have caused some concern because Sarin is based in Israel. I see significant upside from the core business over the next 12-24 months as demand rebounds and the new products installed base and recurring revenue stream grow. I also see multibagger potential if one or more of the new opportunities being pursued in the polished diamond market are successful.

Description

Sarin Technologies is the dominant provider of high-tech solutions for the evaluation, planning, manufacturing and finishing of rough diamonds. The company was founded in 1988 in Israel where it is still headquartered and is listed in Singapore where it IPOed in 2005. Sarin provides a range of equipment that allows diamond manufacturers (and some vertically integrated diamond miners and retailers) to assess, process, and add value to rough diamonds. Sarin does not have any public competitors and reliable industry data is scarce, but management estimates their global market share in traditional planning equipment is approximately 60-75%. The primary competitor is Octonus from Russia, which has an estimated 10-15% of the traditional planning equipment market. The diamond processing industry has migrated to India over the past decade because polishing the rough diamonds is a labor intensive process, and therefore the vast majority of Sarin’s revenue is generated from Indian manufacturing customers (75-80%). Sarin also generates revenue from other diamond processing centers like southern Africa, Israel, Antwerp, and New York.

Planning Equipment

Prior to 2009, Sarin generated the vast majority (90%+) of its revenue from its traditional planning equipment product line. Planning equipment and software helps diamond manufacturers plan how to cut the rough stone based on its geometry, size, and weight in order to maximize its value in the wholesale market.  This type of analysis is difficult to do quickly with any accuracy without planning equipment and adds material value to the manufacturers’ output which is why it has become an industry standard. You can think of planning equipment as a way to help manufacturers maximize the Cut & Carat from a rough diamond, which are two of the four Cs. Sarin also sells laser sawing equipment to cut the diamonds based on the plan developed by the planning machine as well as Color and Cut grading equipment for polished diamonds, the latter being the de-facto global standard used by virtually all the diamond grading labs. Planning machines sell for around US$20,000-$40,000 each and the laser sells for about US$150,000. Traditional planning equipment still accounted for more than 50% of revenue in 2011 (down from 90%+ in 2009) but the real growth is now coming from Galaxy & Solaris inclusion mapping equipment discussed below.

Inclusion Mapping (Galaxy / Solaris)

Sarin acquired a company called Galatea for $10.8m in 2008 which had developed proprietary technology that enables automated mapping of a rough diamond’s internal inclusions within minutes. Previously, traditional planning technology could not “see inside” the rough diamond and therefore did not provide a way to maximize the Clarity in the cut stones. Sarin commercially launched this technology under the Galaxy and Solaris line of equipment in 2009 and this new product line is in the process of transforming the company. Galaxy and Solaris equipment is similar but Solaris is used primarily for smaller stones (2.5 carats or less). Optimizing the Clarity of the diamonds during the planning stage before the rough stones are cut can typically increase the value by 5-10% and in some exceptional cases by 100% or more. This is significant for manufacturers who typically operate with only single digit margins. As a result, this is quickly becoming a must have technology for customers and Sarin is the only supplier with the technology right now (competitive risk will be discussed later). Management also made a very clever tweak to the business model which creates a significant recurring revenue stream. Manufacturers use the Galaxy/Solaris equipment to scan the rough diamond into an encrypted file. They then have to send the data back to Sarin to process the encrypted file into meaningful data for the planning software. Sarin sends it back to the manufacturer who must pay a fee on a per carat basis. The manufacturer uses the processed data with a Sarin planning machine to cut the stone in a way that maximizes 3 Cs (Carat, Cut, and Clarity). This might mean cutting a rough diamond into three or more smaller stones rather than only one or two, depending on where the inclusions in the rough stone are located. If customers don’t want to pay upfront for the machine they can take stones directly to the Sarin service centers (currently 7 worldwide) although the scanning cost per carat is double or more at the service centers.  Starting prices are approximately $15/carat at the India service center, $30 at the Belgium service center, and less than $10/carat if a customer buys the machine. Sarin sells a full-size Galaxy machine for about $200,000 and the installed machines are generating recurring revenue of approximately $200,000 per machine per annum. The Solaris machine cost is about half of the Galaxy and the recurring revenue about a third. Sarin now has an installed base of just under 90 Galaxy/Solaris machines globally, with approximately one quarter of them at Sarin’s own service centers and the rest at customer sites. Management thinks within five years there could be an installed base of 300-400 Galaxy/Solaris machines (which compares to an installed base of approximately 10,000 traditional Sarin planning machines globally).

The impact of Galaxy / Solaris on Sarin’s results has been dramatic. In the first half of 2012, before industry demand started to weaken, Sarin’s sales grew 36% y/y with Galaxy/Solaris accounting for 35% of revenue. Recurring revenue, the majority of which is from Galaxy/Solaris, accounted for over 20% of group revenue. Operating profit grew a much faster 74% y/y, largely because the service revenue has a very high gross margin. Operating margins in the first half were 45%. Management is targeting taking recurring revenue to half of total revenue in the next several years which should further benefit margins. I estimate that earnings could nearly double between 2012 and 2015 just from the deployment of more Galaxy/Solaris equipment and the rise in recurring scanning revenue from the rising installed base.

Why Now?

Sarin’s share price has declined by about 25% since peaking in late May 2012. The primary reason is the industry slowdown which has impacted diamond manufacturers, especially in India. More specifically, manufacturers’ margins have been squeezed by rising rough diamond prices and falling polished diamond prices while at the same time working capital credit lines were tightened partly due to the depreciating Rupee. This all happened with the backdrop of the global macro uncertainty this year. As a result, diamond exports from India dropped 40% in Q3 and by 15-20% in other major diamond manufacturing centers. These issues were well flagged by management at the time of the Q2 results announcement in August but it has naturally caused some consensus earnings downgrades. Sarin still generates the majority of earnings from capital equipment sales so the impact on Q3 results was significant. Sales and net income fell 35% and 62% q/q respectively. However, in the past few months the outlook has improved materially. Importantly, DeBeers lowered rough diamond prices by ~10% at the most recent sightholder meeting, with Alrosa, Russia’s government rough diamond trading arm, following suit with an 8% reduction. Furthermore, polished diamond prices have largely stabilized, access to working capital credit lines has improved somewhat, and the macroeconomic outlook has arguably improved slightly in the key markets of the US and China. Q4 is a seasonally weak quarter for Sarin, but I expect to see significantly sequential improvement moving into 2013.

Sarin’s market has some inevitable cyclicality. But the change in business model to drive recurring revenue is already proving its merit. In the 2008-09 downturn, Sarin was loss making for three quarters in a row as demand for equipment plummeted. But in Q3 this year, Sarin’s recurring revenue only declined 9% q/q and the company remained solidly profitable. In three years, Sarin’s business should be even more stable through the cycle as the recurring portion of revenue continues to climb.

The secondary factor for the recent sell-off is I believe the Israeli / Hamas conflict. Sarin’s headquarters is in Kfar Saba, Israel which is about 24 km northeast of Tel Aviv and about 2-3 km from the West Bank. Israel certainly has its share of geopolitical risk and investing in Israeli companies entails some inevitable tail risk, but overall I think a selloff on this type of news probably presents a good buying opportunity.

Polished Diamond Opportunity

Up until now, Sarin has primarily operated in the market for rough diamonds and focused on the diamond manufacturing customer base. In the next 6-12 months, Sarin will launch two new products to focus on the polished diamond market which if successful could significantly expand the business and the Group’s recurring revenue base.

The first product is Sarin-Light. It allows diamond retailers to measure light performance parameters (brilliance, fire, sparkle, and symmetry) to better capture the visual characteristics of a polished diamond beyond the 4-Cs. Sarin has already received positive feedback from retailers and industry experts in the US, HK/China, and Japan and expects to announce some major contracts in the next six months. The business model will be a recurring revenue model where a fee is charged per diamond graded under the system. The potential market size is estimated to be in line with the 5 million stones which are certified annually for the 4-Cs. Management hopes to grow the business to about 1 million stones per year within several years and could charge around $10 per stone. $10 multiplied by 1m stones at an 80% gross margin would add about 20% to the trailing-twelve month gross profit.

The second product is Sarin-Loupe, which is an imaging technology that captures an accurate, objective three-dimensional image of a polished diamond. The technology will be used to enable diamond wholesalers to assess polished diamonds for sale on the internet without requiring the diamonds to be physically shipped before purchase. If successful, this will cut down on the cost of shipping and even more importantly the time required to complete transactions which can tie up a lot of working capital. Perfecting this type of imaging is apparently much more difficult than it sounds. Sarin has had some encouraging trials in 2012 but is making some modifications and hopes to make a commercial launch sometime around mid-2013. The business model will likely involve charging a fee per image. The market size again could be the 5 million stones certified annually. Assuming $10 per stone and a 20% market share would add another 20% to the trailing twelve month gross profit.

It’s difficult to assess the probability of success in the polished diamond market but management’s track record with new products has been good and I don’t think you are paying anything for the polished opportunities in the current share price. I have not included anything for polished diamond products in my forecasts.

Competitive Risk

Aside from the previously discussed cyclical and geopolitical risks, I think the major risk for Sarin is competition. The #2 competitor Octonus is working on a competing inclusion mapping technology. Sarin management thinks Octonus might be ready to commercially launch their product by mid-2013. They also believe that based on conversations with customers, the technology is inferior to Sarin’s Galaxy/Solaris system, which has significant patent protection. You might expect Sarin to say this, but incidentally we have heard similar things from a limited number of conversations with customers. For Octonus, commercializing a competing inclusion mapping system is critical because they have been losing market share the last two years and some customers have entirely switched their planning equipment from Octonus to Sarin so that their production lines are compatible with Galaxy / Solaris. The major risk is if Octonus comes out with a system that is similar in quality but without a recurring revenue business model. That might force Sarin to lower pricing or abandon the current business model. Sarin management thinks this is unlikely because Octonus has never competed on price in the past. Nevertheless, that’s probably the biggest risk to the thesis and something that warrants monitoring. On the other hand, if Octonus fails to launch a commercially viable system in the next few years, Sarin will probably own the entire market.

Catalyst