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Read the Case file ( ?Case Study – DeBeers Diamond Dilemma.pdf ) and follow the instruciton on the case report requirement pdf.CaseStudy-DeBeersDiamondDilemma.pdfCaseReportRequirement.pdf

Read the Case file (  Case Study – DeBeers Diamond Dilemma.pdf ) and follow the instruciton on the case report requirement pdf.

This case was prepared by Cate Reavis under the supervision of Professor David McAdams. Professor McAdams is the Cecil and Ida Green Career Development Professor.

Copyright © 2008, David McAdams. This work is licensed under the Creative Commons Attribution-Noncommercial-No Derivative Works 3.0 Unported License. To view a copy of this license visit http://creativecommons.org/licenses/by-nc-nd/3.0/ or send a letter to Creative Commons, 171 Second Street, Suite 300, San Francisco, California, 94105, USA.

07-045 January 7, 2008

DeBeers’s Diamond Dilemma David McAdams and Cate Reavis

The mystique of natural diamonds has been built by the industry. One hundred fifty million carats of mined diamonds are produced every year, so they are really not that special if you look at those terms.1

—CEO of Gemesis Corporation

We don’t see synthetic diamonds as a threat, but you cannot ignore it completely.2 —Stuart Brown, Finance Director, De Beers

It was early summer 2007 and Lee Mandell decided that the time was right to propose to Diane, his girlfriend of four years. Being the romantic he was, Lee wanted to pop the question over a candle light dinner that included an exceptional bottle of Bordeaux. Logistical details of where to buy the special ring and what type of diamond, however, were less certain in his mind.

Lee and Diane had recently rented the movie Blood Diamond, set in Sierra Leone in the 1990s when a civil war was raging and the rebel group, the Revolutionary United Front, relied on proceeds from smuggled diamonds to finance its military operation. The 11-year war, which ended in 2002, resulted in the deaths of tens of thousands and the displacement of more than 2 million people, nearly one- third of the country’s population. Both Diane and Lee had been disturbed by the story the movie told, the hardship and violence, the children who were forcibly recruited to fight, and the lives that were

1 Karen Goldberg Goff, “Cultivated Carats,” The Washington Times, February 4, 2007. 2 Danielle Rossingh, “DeBeers Says it Can’t Ignore Synthetic Diamonds,” Bloomberg, May 17, 2007.

DEBEERS’S DIAMOND DILEMMA David McAdams and Cate Reavis

January 7, 2008 2

destroyed all over gems that were worn by hundreds of millions of people, men and women alike, throughout the world.

As he thought about his options, Lee recalled a magazine article he had recently read about the growing market for synthetic diamonds. The article described the process by which diamonds could be grown in a laboratory environment, far from the war torn lands of Africa. Chemically, lab-grown diamonds were identical to diamonds that were extracted from the ground. Instead of taking millions or billions of years to form, hundreds of miles underground, however, a laboratory environment could produce a flawless diamond within days.

Lee was starting to think that a synthetic diamond was a great alternative. But how would Diane react upon learning he had bought her a diamond that was made in a laboratory just outside of Boston? Would she be relieved and touched by his humanitarian and eco-friendly purchase or would she wonder if the 20% to 40% he would save by buying a synthetic diamond was an indication of the depth of his love?

For producers of synthetic diamonds, it was consumers like Lee Mandell that proved there was a market demand for an alternative to the natural diamond. But for South Africa-based DeBeers, which up until the late 1990s single-handedly controlled the world’s supply of diamonds, Lee’s rationale was misguided and he was giving his girlfriend nothing more than costume jewelry. Nevertheless, the fact of the matter was that people were buying lab-produced diamonds and the number doing so was growing at a faster rate than those buying those extracted from the ground.

The dilemma that DeBeers faced came down to whether it should enter the market with its own synthetic diamonds or whether it should have faith that synthetics would be a passing fad and that, at the end of the day, consumers would always prefer buying what, in DeBeers’s mind, was the real thing. Complicating the company’s dilemma, however, was the fact that it was in the midst of trying to remake its image, tarnished from decades of anti-competitive business practices, to one that was demand driven and focused on brand development. While DeBeers at one time produced 45% of the world’s rough diamonds and sold 80% of total supply, by 2007 it was producing 40% and selling just 45%.3

Did synthetic diamonds in fact pose a threat to the diamond industry? If so, what should DeBeers’s response be, if any?

The Diamond Industry

Natural diamonds, the hardest, most transparent material in existence, were made of carbon atoms that over the course of millions of years and with tremendous heat and pressure deep under the earth’s

3 “Diamonds: Changing Facets,” Economist Intelligence Unit, February 26, 2007.

DEBEERS’S DIAMOND DILEMMA David McAdams and Cate Reavis

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surface bonded into a cubic structure.4 Due to their heterogeneity, unlike gold or silver, diamonds were not considered a commodity. As one diamond trader explained, “When you talk about commodities, you know that a ton of copper is worth this much, and an ounce of gold is worth this much because they are homogenous. But diamonds are not homogenous.”5

Supply

The global diamond industry produced an estimated $13 billion of rough stones and $62 billion in jewelry annually. Between 2000 and 2005, world production of diamond rough grew 31% by volume and 70% by value, highlighting the upward trend of diamond prices (Figures 1 and 2).

Figure 1 Diamond Rough Production by Volume and Value (2000-2005)

Source: “The Global Gems and Jewelry Industry – Vision 2015: Transforming for Growth,” KPMG, December 2006.

Figure 2 Diamond Rough Prices, 1996-2005

Source: “The Global Gems and Jewelry Industry – Vision 2015: Transforming for Growth,” KPMG, December 2006.

4 Karen Goldberg Goff, “Cultivated Carats,” The Washington Times, February 4, 2007. 5 James Dunn, “Glittering Prizes,” The Australian, October 4, 2006.

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DEBEERS’S DIAMOND DILEMMA David McAdams and Cate Reavis

January 7, 2008 4

Seven countries—Angola, Australia, Botswana, Canada, the Democratic Republic of the Congo, Russia, and South Africa—represented 88% of the value of diamond production and 96% of global production volume.6 As depicted in Figure 3, for some producers, there was great disparity in the relationship between the volume and value of production. While the Congo and Australia were significant producers on a volume basis, the value of their production was quite low. Angola presented the reverse scenario.

Figure 3 Top Diamond Producers by Volume and Value

Source: “The Global Gems and Jewelry Industry – Vision 2015: Transforming for Growth,” KPMG, December 2006.

Change in Industry Structure

The $19 billion processing industry (which involved the cutting and polishing of diamonds) was dominated by India. The 1 million people employed by India’s processing industry processed more than half of the world’s diamonds in value terms, at costs significantly lower than other processing countries—$10 per carat as opposed to $17/carat in China, $40/carat in South Africa and Israel, and $70/carat in Belgium. Israel and China were the second and third largest processors with 15% and 10% of the market, respectively.7 But this part of the value chain, at one time dominated almost exclusively by Belgium and Israel, was undergoing significant changes.8

6 “The Global Gems and Jewellry Industry: Vision 2015; Transforming for Growtrh, KPMG, December 2006. 7 Ibid. 8 Ibid.

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DEBEERS’S DIAMOND DILEMMA David McAdams and Cate Reavis

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Since the late 1990s, empowered by DeBeers’s shrinking market position, the voices from Southern African countries to keep more of the value added activities such as cutting and polishing in country had become noticeably louder and a number of countries were amending their diamond laws to support and build local diamond-related industries. In 1999, Namibia inserted a clause in a new law permitting the government to force miners to sell a percentage of their diamonds to local polishers,9 and in 2004, Lev Leviev, an Israeli of Uzbek decent who was one of Israel’s largest manufacturers of polished stones, opened the country’s first cutting and polishing factory. At the opening of the new factory, Namibia’s president was quoted as saying, “To our brothers and sisters of neighboring states, Angola, Botswana, South Africa, I hope that this gives you inspiration to try to imitate what we have here.”10 In 2005, South Africa passed the Diamonds Amendment Act establishing a State Diamond Trader as well as a Diamonds and Precious Metals Regulator. Under the new legislation, scheduled to take effect in 2007, producers would be hit with duties on exported rough diamonds.11 In response to Southern Africa’s attempts to enter into more downstream activities, one industry expert remarked, “There’s a political and an emotional point. [Africa] is saying, ‘We have these resources as Africans, why are we not able to capitalize on the beneficiation on these resources in our possession? Why are Indians cutting African diamonds?’”12

Alongside shifts in the value chain, the industry was experiencing an increasing level of forward and backward integration: mines were integrating forward into retail and retail outlets were integrating backward by investing in mines. In 1999, high-end jeweler Tiffany & Co. announced that it was buying a stake in a Canadian mining concern for $104 million and would no longer source its diamonds through DeBeers. In 2003, Aber Diamond, a Canadian mining group, purchased U.S. luxury jewelry retailer Harry Winston giving it storefronts in the United States, Japan and Switzerland.13 In 2005, Russia’s mining giant Alrosa opened up a diamond retail store in a shopping complex off Red Square.14 As DeBeers’s CEO remarked, “The verticalization of the industry is clearly its long-term trend; it’s absolutely the way to grow a business and build a brand. Retail clearly adds value. But there are several different kinds of know-how involved in the different levels of the chain and you have to respect, and learn, all of them.”15

Demand

The United States was far and away the world’s biggest purchaser of diamonds accounting for 46% of total demand followed by the Middle East with 12% and Japan with 9% (Figure 4). However, demand, particularly for diamonds over 2 carats (worth $15,000 or more), was soaring in India and

9 Nicole Itano, “Looking to Africa to Polish Its Diamonds,” The New York Times, September 17, 2004. 10 “The Cartel Isn’t For Ever,” The Economist, July 17, 2004. 11 John Reed and David White, “Beneficiation: A chance to spread southern African wealth,” Financial Times, July 14, 2006. 12 Nicole Itano, “Looking to Africa to Polish Its Diamonds,” The New York Times, September 17, 2004. 13 Danielle Cadieux, “DeBeers and the Global Diamond Industry,” Ivey Case Study No. 9B05M040, 2005. 14 Ben Aris, “A Diamond in the Rough,” The Moscow Times, September 11, 2001. 15 Vanessa Friedman, “The New Rocks on the Block,” Financial Times, May 10, 2006.

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China16 in concert with increasing disposable incomes and a growing middle class. India was the fastest growing diamond jewelry market with a growth rate of 19% in 2005.

Figure 4 World Sales of Diamonds, 2005 (polished wholesale price)

Source: “The Global Gems and Jewelry Industry – Vision 2015: Transforming for Growth,” KPMG, December 2006.

While at one time the diamond industry was supply-side driven, with little attention given to the end consumer, by the late 1990s the industry began focusing more on the demand side. The main catalyst for this shift was DeBeers’s decision to conduct business in a whole new way.

DeBeers Under Attack

In the early 1990s DeBeers ruled the diamond industry. While it only produced 45% of the world’s rough diamonds, it sold 80% of the total supply from its marketing unit in London. Its market dominance enabled its Central Selling Organization to choose whom to sell to, how much to sell, and at what price. Buyers who turned down an offer to purchase a parcel of diamonds might not be invited to purchase from DeBeers again. Meanwhile, buyers who strayed from DeBeers’s selling arm and purchased directly from a mine would be dropped by the company or financially punished.17 In 1981, after Zaire decided to stop selling its industrial-grade diamonds to the syndicate, DeBeers dipped into its stockpile and flooded the market bringing down the price of Zairian diamonds by 40%.18

DeBeers’s monopoly was shaken in the 1990s from the emergence of three producers that fell outside of its grasp, making its strategy of controlling supply costly both financially and legally. The first big hit came shortly after the collapse of the Soviet Union in 1991. Through a marketing agreement that dated back to the late 1950s when diamond deposits were first discovered in Siberia, the Soviets had sold their entire diamond production to DeBeers’s Central Selling Organization. Once the Soviet

16 James Dunn, “Glittering Prizes,” The Australian, October 4, 2006. 17 Danielle Cadieux, “DeBeers and the Global Diamond Industry,” Ivey Case Study No. 9B05M040, 2005. 18 Debora L. Spar, “Continuity and Change in the International Diamond Market,” Journal of Economic Perspectives, Volume 20, Number 3, Summer 2006.

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DEBEERS’S DIAMOND DILEMMA David McAdams and Cate Reavis

January 7, 2008 7

system disintegrated, however, DeBeers was unable to enforce contracts and Russian diamonds were soon being smuggled onto the international market causing prices to fall.

But DeBeers’s challenges in Russia could not be blamed solely on the country’s economic and political upheaval. Lev Leviev, one of Israel’s largest manufacturers of polished stones, was making his move in Russia where he was well connected politically. In 1989, two years after Leviev became a sightholder for DeBeers, Russia’s state-run diamond mining and trading group, now known as Alrosa, entered into a joint venture with Leviev to establish the country’s first cutting factory, the stones of which would be supplied directly by Russian mines, not through DeBeers.19 The partnership marked the first time in which rough diamonds were cut in their country of origin. Over the next five years, Leviev’s position in the Russian diamond industry grew to the point where, in 1995, DeBeers terminated his sightholder status.20

The second jolt to DeBeers’s position came in 1996 with the decision by Australia’s Argyle diamond mine, which produced low quality diamonds suitable for inexpensive jewelry, to terminate its contract with DeBeers and begin marketing its own diamonds. It sold 42 million carats directly to polishers in Antwerp that year.21

Finally, the emergence of Canada in the early 1990s as a diamond producer served as a further threat to DeBeers’s position. While the company was successful in acquiring stakes in a couple of Canadian mines, the majority of the country’s production fell outside of its control.

In order to keep prices high, therefore safeguard its market dominance, DeBeers was forced to both hold back a large portion of its diamonds from the market and purchase much of the excess supply from these producing countries often at inflated prices. By the end of the 1990s, DeBeers’s market share had fallen from 85% to 65% while its diamond stockpile had grown from $2.5 billion to $5 billion. Between December 1989 and 1998 DeBeers’s share price fell from $17 to $12, a nearly 30% drop.22

In addition to the financial sting DeBeers was feeling resulting from its supply-side strategy, antitrust regulators in the United States and the European Union were becoming increasingly aggressive in their attempts to formally end the company’s price control practices. In a 1994 indictment, the United States accused DeBeers of violating the Sherman Antitrust Act by fixing the price of industrial diamonds. The government contended that a subsidiary of DeBeers conspired with General Electric, another producer of industrial diamond products, to fix the world prices of industrial diamonds in 1991 and 1992. While the United States Justice Department was unable to prosecute DeBeers because

19 “The Cartel Isn’t Forever,” The Economist, July 17, 2004. 20 Phyllis Berman and Lea Goldman, “Cracked DeBeers,” Forbes.com, September 15, 2003. 21 Ibid. 22 Nicholas Stein, “The DeBeers Story: A New Cut On An Old Monopoly,” Fortune, February 19, 2001.

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its operations were overseas and it refused to subject itself to the jurisdiction of an American court, the company was prohibited from conducting business in the United States.

On a completely different front, DeBeers faced yet another threat, which was quickly turning into a public relations nightmare for the entire diamond industry. In the mid-1990s, Angola, the world’s third largest producer of rough diamonds, was overrun by rebel forces opposed to President Dos Santos. Gaining control of the country’s diamond supplies, the rebels flooded the market with up to $1.2 billion worth of rough diamonds. To maintain control over supply, therefore prices, DeBeers had little choice but to buy what were becoming known as “blood diamonds,” the proceeds of which went toward financing the armed conflict. Angola was not a lone participant in the blood diamond trade. Rebel forces in Sierra Leone, Liberia, and the Democratic Republic of the Congo were also using the illicit diamond trade to finance their respective armed conflicts.

DeBeers’s involvement in the “blood diamond” trade was exposed in a 1998 report by Global Witness which accused the company of “operat[ing] with an extraordinary lack of accountability.”23 As Martin Rapaport, publisher of the diamond industry pricing guide, asked rhetorically, “How can it be that tens of millions of dollars are exported from diamond areas and yet there is no electricity, no plumbing, no wells, no improvement in the lives of the people?” Rapaport went on to ask the more complicated question of, “Do we owe anything to the people of Africa just because we buy their diamonds? Are we responsible for what we buy?”24

For DeBeers, these challenges and threats in aggregate were creating a “perfect storm” of sorts. Significant changes to the company’s strategy that had served it well for decades had to be made.

A New Direction

In 1998, on the advice of U.S. consulting firm Bain and Company, DeBeers decided to “ditch its role of buyer of last resort” and develop a strategy that was demand-driven and brand- focused whereby profits were more important than market share.25 When explaining its strategic shift, DeBeers’s Managing Director stated, “We don’t have to go rushing about the world trying to buy every diamond. What is the point of us buying diamonds close to or over our selling prices? It’s silly. I’m perfectly happy to market 60%. What I want to do is differentiate the portion that does come to us and create value on those goods…in order to sell them first, more advantageously, and at better prices.”26

As a part of its strategy, DeBeers ended its practice of stockpiling diamonds, stopped buying diamonds on the open market, and began only selling diamonds from its own operations which

23 Phyllis Berman and Lea Goldman, “Cracked DeBeers,” Forbes.com, Spetember 15, 2003. 24 Kate Reardon, “Guilt Free Diamonds Sparkle Brighter for Ethical Shoppers,” The Times, June 17, 2006. 25 “The Cartel Isn’t For Ever,” The Economist, July 17, 2004. 26 Nicholas Stein, “The DeBeers Story: A New Cut On An Old Monopoly,” Fortune, February 19, 2001.

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enabled it to guarantee that its supply was “conflict free.” The company promised the European Union it would stop buying diamonds from Alrosa, the state-owned Russian firm that accounted for 20% of global production by 2009 to promote competition.27 The promise was formalized in a 2006 agreement with Russia.

A new demand-centered strategy required that DeBeers build new relationships with its suppliers. This came about in what was dubbed the “Supplier of Choice” program, the goal of which was to make DeBeers the supplier of choice in the eyes of its customers, in lieu of the buyer of last resort. DeBeers scaled down the number of its sightholders from 120 to 80 and formalized business relationships with those that were chosen with a written contract.28 Sightholders were no longer expected to purchase whatever stones DeBeers offered to them. Rather, they requested a specific package of stones based on sales and marketing strategies they had created.29 The criteria to being a sightholder were no longer based on financial strength and manufacturing capabilities but rather marketing savvy.

Under the new arrangement, sightholders were entitled to use DeBeers’s Forevermark, a tiny logo that was etched into natural diamonds which guaranteed the polished diamonds were natural, ethically traded and non-treated. (The Forevermark diamond was sold in Hong Kong, China, Japan, and India.) Sightholders also benefited from DeBeers’s marketing data including consumer buying habits and patterns and the number of engagements worldwide. Those sightholders that successfully built strong brands were partially reimbursed for the money they spent on advertising and marketing efforts. As Nicky Oppenheimer, DeBeers’s chairman, explained, “We want people to say, ‘While I can get diamonds from people other than DeBeers, the package DeBeers gives me is so valuable, I get a better return from them.”30 Accompanying DeBeers’s efforts at building a new identity, the company’s Central Selling Organization was renamed the Diamond Trading Company (DTC).

In step with the Supplier of Choice Program, DeBeers developed a marketing and retail strategy to position its diamonds as a branded luxury item. Unlike other luxury brand producers, diamond producers had suffered from poor financial performance over the years due to the lack of branding. In fact, many in the industry lamented that although not traded as one, diamonds had become a commodity of sorts. Lev Leviev implied that DeBeers was largely responsible: “There are two main reasons why diamond retailers fail. Lack of innovation—they have the same stones in the same settings in the window year after year—and dependence on one supplier for their stones. You can never plan your sales even one year ahead, because you can only work with what they give you, and they decide.”31

27 “Diamonds Get Their Sparkle Back,” New Zealand, February 26, 2007. 28 Danielle Cadieux, “DeBeers and the Global Diamond Industry,” Ivey Case Study No. 9B05M040, 2005. 29 Debora L. Spar, “Continuity and Change in the International Diamond Market,” Journal of Economic Perspectives, Volume 20, Number 3, Summer 2006. 30 Nicholas Stein, “The DeBeers Story: A New Cut On An Old Monopoly,” Fortune, February 19, 2001. 31 Vanessa Friedman, “The New Rocks on the Block,” Financial Times, May 10, 2006.

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A Boston-based diamond wholesaler, however, had proven that branding diamonds could work, especially since the market was shifting to a demand-driven model. In 1997, the wholesaler, who sourced his raw stones from DeBeers sightholders and others, began selling a branded diamond called Hearts on Fire which was differentiated by its cut. Marketed as “the world’s most perfectly cut diamond,” the diamonds were cut by hand in Antwerp, Belgium in a pattern known as “hearts and arrows.” When viewed under magnification, each diamond revealed a symmetrical ring of hearts and eight pointed arrows.32 The brand produced $40 million in sales each year. In 1999, DeBeers entered into the brand world by marketing a limited-edition (20,000 stones) Millennium diamond, engraved with the company’s logo and the year 2000. The Millennuim diamond’s campaign came with a tag line of, “Show her you'll love her for the next thousand years.”

DeBeers’s brand positioning was accompanied by attempts to widen its customer base. A number of non-wedding advertisement campaigns were launched including the “Celebrate Her” campaign, which urged men to show their love for their significant other by buying her a three-stone diamond ring. The campaigns’ advertisement pictured a middle-aged man on bended knee asking, “Will you marry me again?” There was the “Women of the World Raise Your Right Hand” campaign, which encouraged women to indulge in a diamond ring to be worn on their right hand as an expression of personal style.33 In addition to new messages enticing consumers to buy diamonds for purposes other than engagements, in 2001, DeBeers entered into a joint venture with LVMH to open up a series of retail stores. Diamond jewelry was sold under the DeBeers name. By early 2007, DeBeers had 22 stores spanning the United States (3), Europe (4), the Middle East (1), and Asia (14).

From Public to Private

At the same time the new strategy was being rolled out, DeBeers delisted from the Johannesburg Stock Exchange where it had traded since 1893. Purchased by a consortium that included the Oppenheimer family, Anglo American plc, and Debswana Diamond Co. (Pty) Ltd, DeBeers became the world’s largest private diamond mining company. The privatization, which cost $17.6 billion (a 31% premium)34, left DeBeers heavily in debt. Ironically, the terrorist attacks in the United States on September 11, 2001 helped alleviate the company’s debt. As DeBeers’s Chairman Nicky Oppenheimer explained, “Sentiment changed dramatically after September 11, though we did not realize it at the time. There was a swing back to traditional values such as family and all the sorts of things that diamond jewelry plays into.”35

One of DeBeers’s first major media grabbing acts as a private company came in 2004 when it pleaded guilty to charges of price-fixing of industrial diamonds and agreed to pay a $10 million fine. Settling the 10-year old charges meant that DeBeers executives could visit and conduct business in the United

32 Greg Gatlin, “Branding Becomes Gen of an Idea,” Boston Herald, February 11, 2001. 33 Danielle Cadieux, “DeBeers and the Global Diamond Industry,” Ivey Case Study No. 9B05M040, 2005. 34 David McKay, “A Private Life: Oppenheimer at 60,” miningmx.com, July 4, 2005. 35 Brendan Ryan, “Nicky Oppenheimer, Private Treasure,” Financial Mail, August 30, 2002.

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