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AFRICA - King of Diamonds

Transforming De Beers from a monopoly gem supplier into a luxury retailer was never going to be easy. But its leaders insist the company will benefit from growing diamond demand.

To experience the power of De Beers Group, the South Africa°©based company that has dominated the diamond industry for more than a century, one has only to peer over the edge of the open-pit Jwaneng Mine in neighboring Botswana. Measuring 2.5 kilometers across and almost 400 meters deep, the mine produces 10 percent of the world's annual diamond supply. Mammoth trucks with ten-foot-tall wheels haul ore from the pit, and once a week an armored vehicle stuffed with rough diamonds speeds away from Jwaneng escorted by security cars. The convoy's sirens send warthogs and baboons scampering into the underbrush of the Kalahari Desert as the treasure heads 160 kilometers northeast to Botswana's capital, Gaborone, and from there to traders, polishers, manufacturers and jewelers across the globe.

To experience the glamour of De Beers, one has only to walk into its palatial, three-story retail establishment on Manhattan's Fifth Avenue. The cheaper stuff -- jewelry with a fraction of a carat and a price tag under $1,500 -- is on the ground floor. By the time shoppers ascend to the third floor, the number of carats reaches double digits and prices soar into the millions. On a recent morning store manager James Turi was helping an attractive blonde woman try on a $1.4 million necklace with 87 carats of pear-shaped stones. "Don't even dream about it," says her husband, who suggests they retreat a floor or two.

With millions of newly affluent fiancées in China and India hoping for engagement rings and with world supplies tightening, the future for De Beers looks bright indeed. Last year global revenues from diamond sales rose 5 percent, while output of rough diamonds increased by only 2.3 percent. "There are few resource markets in the world that have such good fundamentals," says Tim Clark, a Johannesburg-based mining industry analyst for Deutsche Securities.

It's the present that vexes some analysts and investors. "With this company you have to focus on the long term, not the bumps on the road," says David Winters, portfolio manager for Mountain Lakes, New Jersey°©based Wintergreen Fund, which has $596 million in assets under management, including $16.4 million in the largest De Beers shareholder, global mining giant Anglo American.

Those bumps come in all sizes. In Botswana rising nationalism is gradually cutting into De Beers's share of diamond revenues. At Jwaneng, for example, 84 cents of every dollar in rough diamond sales went to the Botswana government last year. That compares with the roughly 50 cents on every dollar that De Beers made when Jwaneng began operation in 1984. In South Africa black economic empowerment demands led the company to sell 26 percent of its subsidiary, De Beers Consolidated Mines, to a black-owned investment group last year. And for all their glitter, the Fifth Avenue De Beers store and 14 others like it around the world aren't yet making money. "Just because De Beers knows how to find diamonds doesn't make them retail geniuses," says Martin Rapaport, chairman of New York°©based Rapaport Diamond Report, the industry's most influential publication. Part of the problem is that De Beers is going up against more glamorous, long-entrenched market leaders like Tiffany & Co., Cartier and Bulgari, which offer a full range of gems.

De Beers and the Oppenheimer family that has long controlled it insist that any difficulties are transitory and linked to a momentous transformation at the company that began in 2000. That year, De Beers abandoned its monopoly over the world's diamond supply because it was proving too costly and controversial to maintain. The company had accumulated a growing inventory of unsold diamonds, and some diamond producers in other African countries and Australia began to sell on the open market. Meanwhile, in the U.S. and in Europe, De Beers was hit with charges of engaging in uncompetitive practices.

Since surrendering its monopoly, the company's market share in rough diamonds has dropped to 40 percent -- less than half what it was two decades ago. The slack has been largely picked up by Russia's Alrosa Co., which controls 20 percent of the market, and Anglo-Australian mining giants Rio Tinto and BHP Billiton, which have 8 and 7 percent, respectively.

To compensate for its reduced clout, De Beers has embraced a new strategy that seeks -- with only partial success thus far -- to add value to diamonds under its control through branding and more-sophisticated marketing. "Our success in overcoming these challenges in the next few years will define our future," notes Nicky Oppenheimer, the family's 62-year-old patriarch and chairman of De Beers, in an e-mail exchange with Institutional Investor.

Those challenges are daunting. In 2005, De Beers set a lofty target of doubling earnings before interest, tax, depreciation and amortization to $2 billion by 2009. "No doubt, it's a stretch," concedes Gareth Penny, 45, chief executive officer of De Beers Group, in an interview at company headquarters in Johannesburg. "But are we on track? Yes, we are."

Last year's figures suggest otherwise. Ebitda fell 12 percent from 2005, to $1.23 billion. Net earnings increased 32 percent, to $730 million, but that was largely the result of nonrecurring income from sales of holdings in South Africa and Canada. Underlying earnings of $425 million were half the 2005 total. Meanwhile, sales declined 6 percent, to $6.15 billion. Sales fell a further 7 percent in the first half of 2007, to $3.4 billion, while underlying earnings rose 5 percent, to $324 million, because of a tax credit and lower finance charges.

The decline in sales reflects a drop in the supply of rough diamonds from Russia after the European Commission in 2006 ordered De Beers to end a trade agreement with Alrosa, arguing that it was keeping too many rough stones off the open market. (Last month the European Union's Court of First Instance overturned that decision; the Commission has not yet decided whether to appeal. De Beers says it is too soon to say what impact the ruling will have on its business.)

To carry out its dramatic change in business strategy -- from monopoly toward a more market-oriented approach -- without resistance from shareholders, De Beers delisted from the Johannesburg Stock Exchange in 2001 and took itself private in a $9.3 billion buyout. De Beers is now owned by Anglo American (45 percent), the Oppenheimer family (40 percent) and the government of Botswana (15 percent). According to Forbes magazine's 2007 list of the world's richest people, the Oppenheimers have a fortune of more than $5 billion, making them the wealthiest South African family.

Ties between De Beers and Anglo American go back to Ernest Oppenheimer (1880-1957), Nicky's grandfather, who by the 1930s controlled both companies as their leading shareholder. Today his descendants own only 2.26 percent of Anglo American, which has a market capitalization of $77.6 billion. Anglo American's other shareholders -- Standard Life Group, Threadneedle Investments, Legal & General Group and Fidelity Investments are among the biggest, with stakes of 2 to 4 percent each -- have been forced to demonstrate patience over the lagging performance of De Beers. Its underlying contribution to Anglo American's profits fell 47 percent in 2006, to $227 million, and De Beers's return on capital was just 11.5 percent, far below Anglo American's 32.4 percent.

The contrasting financial performances of the two companies has led some investors to predict that, sooner rather than later, De Beers will have to consider an IPO to give Anglo American an exit.

"I think it's inevitable," says James Passin, managing partner at New York°©based Firebird Global Fund, a hedge fund whose diamond-mining investments include an undisclosed holding in Anglo American. "Anglo keeps talking about restructuring, and it isn't benefiting enough from its 45 percent stake in De Beers."

Nicky Oppenheimer, who splits most of his time between London and Johannesburg, flatly denies that De Beers will go public again. "There are no plans for an IPO in De Beers's future," he states in his e-mail. "Anglo American, the Botswana government and my family have all expressed their confidence and support for the present management structure."

According to Nick von Schirnding, London-based head of investor relations for Anglo American, investors' most-frequent question is whether the company will sell its diamond subsidiary. "Our response is that De Beers is a core asset for Anglo American, and thus by definition, we would want to own more -- not less -- of it," he says. Asked if Anglo American might consider purchasing the Oppenheimers' stake, von Schirnding responds: "Clearly, we would buy it at the right price if the opportunity arose."

THE OPPENHEIMERS HAVE WEATHERED far more difficult circumstances during their long involvement with diamonds. De Beers was founded in 1888 by Englishman Cecil Rhodes, the empire builder who bought out thousands of claim holders to take control of the Kimberley Mine in South Africa -- the site of what was then the world's largest diamond deposit. Ernest Oppenheimer, a German-born, naturalized British citizen, began his association with De Beers in 1902 when a London firm of diamond merchants sent him to Kimberley as its representative.

In 1917, with the backing of John Pierpont Morgan Jr., Oppenheimer founded Anglo American Corp. of South Africa, soon a major producer of gold and other minerals. That gave him the clout to claim the chairmanship of De Beers's board in 1929. Oppenheimer subsequently created a complex cross-shareholding arrangement that enabled him to control both De Beers and Anglo American.

By the 1930s, De Beers's global monopoly over rough diamond sales was well entrenched. Through its London-based Central Selling Organization, De Beers sold more than 80 percent of the world's rough diamonds. About half came from its own mines. Even into the 1970s and '80s, as Johannesburg's apartheid policies were causing increasing outrage across the world, De Beers -- the best-known South African company -- still persuaded other producers that only a CSO-managed monopoly could ensure that supply never outstripped demand and that diamond prices never fell.

But by the 1990s, the monopoly was tottering. "We no longer saw it as our business model," says De Beers chief executive Penny. "It wasn't profitable, and it wasn't legally robust." In a failed effort to maintain stable prices, the CSO almost buried itself under a $5 billion inventory of rough diamonds. Key producers, like Australia's Argyle Diamonds, ended their contracts with De Beers to seek better prices on the open market.

In the U.S., which accounts for about half of the $62 billion-a-year retail diamond market, consumers in 1994 brought a class-action lawsuit charging De Beers with price-fixing. And in Brussels the European Commission accused the company of stifling competition with its exclusive contract to market diamonds from Russia's Alrosa.

In recent years De Beers has moved to address these issues. In 2004 it settled the U.S. lawsuit by paying out $250 million without admitting liability. Two years later it reached an accord with the European Commission to phase out its purchases of Alrosa diamonds by 2009. Last year it bought $600 million of diamonds from the company, down from $800 million in 2005; it intends to buy $500 million worth in 2007.

To cover the Russian shortfall, De Beers is counting on two new diamond mines in Canada on which it has spent $1.7 billion. The Snap Lake Mine in the Northwest Territories will start production in October, and the Victor Mine in Ontario will follow in the last quarter of 2008. Along with smaller new projects in South Africa, De Beers expects to add some $700 million to annual production by 2009.

De Beers's current strategy was shaped in 2000 with the help of Bain & Co. The Boston-based management consultancy urged De Beers to stop buying diamonds from other producers and sell off its $5 billion inventory. With its 40 percent share of diamond production, De Beers would still exercise enormous influence over the industry. And, Bain suggested, this influence should be used to induce the industry to invest far more than its paltry 1 percent of revenues on advertising to raise the brand value of diamonds. The watch industry, by contrast, spends 5 percent of revenues on advertising.

"Traditionally, diamonds have competed solely on the basis of price, which is something totally alien to other luxury goods," says Stephen Lussier, branding guru and London-based director of corporate affairs at De Beers. "We need to create more interest and excitement around design and brand image."

At the heart of its new strategy is what De Beers calls Supplier of Choice, under which the company sells rough diamonds by preference to buyers who demonstrate they can add value to the gems. Five times a year, 93 sightholders, or favored customers, from around the world congregate at the London offices of De Beers's Diamond Trading Co. subsidiary. They are handed boxes, or "sights," containing rough diamonds -- in combinations of 14,000 varieties, according to size, shape, quality, origin, color and value -- intended to meet the requirements of the manufacturers and retail jewelers who are their customers. The sightholder system survives from the days when De Beers did not hesitate to enforce its monopoly power over even its wealthiest clients. Harry Winston, a leading sightholder and the world's most famous retail jeweler until his death in 1978, once refused to accept a De Beers box because he did not like its mix of diamonds. Unable to find diamonds elsewhere, he never again dared to turn down a De Beers box.

Nowadays, De Beers doesn't have to be so high-handed. With fears of a shortage of rough diamonds in the next few years, sightholders are willing to comply with a requirement that they purchase a set number of boxes a year. "A large jewelry manufacturer or retail chain needs De Beers for a steady supply of rough stones because they don't have enough time to run around, hat in hand, buying from a bunch of smaller suppliers," says industry analyst Rapaport.

According to De Beers, the showcase example of how the new strategy generates value is the marketing arrangement between longtime sightholder Leo Schachter Diamonds and big jewelry retailer Signet Group around a product called the Leo Diamond. Created by Leo Schachter designers, the Leo has a distinctive, multifaceted cut that reflects more light than most diamonds. "Leo Schachter has a differentiated product that enables them to distribute their stones through a large retailer and not be subject entirely to price competition," says Lussier. "And Signet can offer something that consumers are willing to pay more for."

The new marketing arrangement irks many old-time De Beers sightholders, especially the diamond manufacturers among them. "De Beers feels that we have to be part of their new business model and bring more to the table than just skilled manufacturing," says Jeffrey Fischer, the New York°©based president of the International Diamond Manufacturers Association. "But not everybody can go downstream and find the right retail partners."

Sometimes a sightholder rebels. The most publicized case involves Mahdu Mehta, managing director of Antwerp-based jewelry manufacturer Jayam NV, a De Beers sightholder for three generations. Jayam sued De Beers and its Diamond Trading Co. for breach of contract, claiming the Supplier of Choice system unfairly slashed its annual supply of diamonds to $50 million in 2003 from $142 million previously. But De Beers won the case in London's High Court in March of this year. Mehta says Jayam is considering an appeal.

In seeking to add value, De Beers contends that it is demanding as much from itself as from its clients. It spent $200 million last year on marketing, or just over 3 percent of sales. Since 2001 it has waded into the high-end retail business by forming a partnership with French luxury conglomerate LVMH Moët Hennessy Louis Vuitton to open diamond outlets like the Fifth Avenue store in Manhattan. Today, De Beers's 15 stores generate $100 million in annual revenues -- but still lose money as they try to contend with the likes of Tiffany, which last year had net earnings of $254 million on sales of $2.6 billion. "We have to triple the network by 2009 to get the sort of scale that we need to become significantly profitable," says Lussier.

But some analysts wonder whether the diamond market is developing along De Beers's value-added model. Wal-Mart Stores has emerged as one of the largest retailers of diamond jewelry in the U.S. -- and branding has nothing to do with its success. "A fair question to ask is: Would you buy an engagement ring and put it in a Wal-Mart box?" says Kenneth Gassman Jr., a former Wall Street financial analyst who runs the Jewelry Industry Research Institute, based in Glen Allen, Virginia. Apparently, to De Beers's dismay, the answer is all too often yes. (Wal-Mart doesn't provide figures on its diamond revenues.)

Another important phenomenon in the U.S. retail market is the success of online diamond jewelry sales, especially by Blue Nile, based in Seattle. Founded only a decade ago, Blue Nile reported $256 million in revenues last year -- entirely from online sales. "Their typical customers are high-income, 25-to-34-year-olds from high-tech towns like Washington, Boston and San Francisco, who don't have time to visit stores and are used to shopping online," says Gassman.

Although it has struggled with its retail efforts abroad, De Beers has proved agile in navigating the political and racial minefields in its native South Africa. During the waning, brutal decades of white rule, Harry Oppenheimer (1908-2000), who controlled De Beers as chairman of Anglo American, became known as the more enlightened face of the South African business community for his criticism of the government's apartheid policies. Under his son, Nicky, De Beers has continued to anticipate change.

With demands for more black ownership and management in white businesses, Nicky Oppenheimer and his son, Jonathan, put forth in 2003 the Brenthurst Initiative. Named after the family's Johannesburg estate (where Nicky still lives amid a 45-acre garden tended by 48 gardeners), the plan proposed a scorecard system providing tax breaks to corporations that give blacks 25 percent ownership and promote them into management. The main outlines have been adopted by the South African business community.

In 2006, De Beers Consolidated Mines, the company's South African subsidiary, sold a 26 percent stake to Ponahalo Investment Holdings, a black investment group headed by Manne Dipico. He is a former labor leader and a ranking politician in the African National Congress, the ruling party. The stake cost $507 million, plus $206 million in financing arranged by Standard Bank of South Africa; Ponahalo is paying those sums out of dividends. In January 2006, Jonathan Oppenheimer, now 37, stepped aside after only 18 months as DBCM's chief executive to make way for David Noko, a black executive who had joined the company less than four years before from Air Chefs, a South African in-flight food caterer, where he was chief executive.

Noko has been required to carry out a painful restructuring that was decided upon while Oppenheimer was still CEO, including the closing or sale of four unprofitable South African mines and a 38 percent reduction of the company's workforce of 10,000. "We are in a no-choice situation here," says Noko. "We have some mines that are between 80 and 100 years old, and in terms of our cost-revenue ratio, they are moving into the red-ink zone."

Diamond production at DBCM last year was 14.6 million carats, or less than 30 percent of De Beers Group's total of 51 million carats. Botswana is by far the most important De Beers mining operation, with a 2006 output of 34.3 million carats; the company produced just over 2 million carats in Namibia. The two new De Beers mines that are scheduled to go into operation in Canada in 2007 and 2008 are expected to contribute an additional 3 million carats annually.

In its effort to retrench and increase profitability in South Africa, De Beers is depending on the political clout of Dipico, 47, who is deputy chairman of DBCM. A onetime labor organizer at De Beers, he was convicted for being a member of the then-banned ANC, did five years in prison at Robben Island alongside Nelson Mandela, later served two terms as premier of the Northern Cape province and today is parliamentary counselor to President Thabo Mbeki. "I add value to De Beers in terms of my relationship with the government," says Dipico candidly.

As an example, Dipico cites a deal he brokered in February between De Beers and the government to combine the assets of state mining group Alexkor, which produces only 40,000 carats annually, and the De Beers°©owned Namaqualand Mines, which has an output of 1 million carats a year. De Beers will issue a 20 percent stake in Namaqualand to South Africa's mining ministry, dilute its own interest over time and eventually relinquish its role as operator.

"This is part of our new business philosophy -- we want to deploy our capital more effectively," says CEO Penny. The deal also helps De Beers meet its obligations to the government's black empowerment program by creating a joint venture that employs more blacks and is willing to accept lower returns on capital than De Beers.

For Dipico, De Beers's obligations to black economic empowerment are open-ended. "We don't have a definite time frame, but history will judge us favorably only if we grow our stake beyond 26 percent," he says. Asked if he can imagine a De Beers that isn't controlled by the Oppenheimers, he responds: "Yes, certainly, because spaces are constantly opening for new players."

Nicky Oppenheimer insists his family has no intention of ceding control of De Beers in South Africa, or anywhere else on the continent. "I am a third-generation African married to a fourth-generation African, and with grandchildren that extend my family's connection to the continent to the sixth generation," he writes.