Sarine Technologies Ltd - CIMB Research 2018-02-05: Sell-off Overdone; Restoring Its Lost Shine

Sarine Technologies Ltd - CIMB Research 2018-02-05: Sell-off Overdone; Restoring Its Lost Shine SARINE TECHNOLOGIES LTD U77.SI

Sarine Technologies Ltd - Sell-off Overdone; Restoring Its Lost Shine

  • Sarine Technologies trades at 15.9x CY18F P/E, 14% below its historical 9-year average of 19.1x.
  • Improved diamond prices in mid-stream value chain point to better sales outlook for Sarine.
  • It plans to enter the diamond grading market with the opening of two labs in 2018.
  • In Jan 2018, the company launched the Meteorite system to capture sales from the under-0.35 carat stone segment.
  • We upgrade to ADD from Hold in light of a more positive business outlook. Our new Target Price is lower at S$1.56, based on 17.2x CY19F P/E, with a transfer of analyst coverage.

Polished diamond market looking for recovery 

  • We think a lower rough/polished diamond price spread will restore manufacturers’ profitability, eventually leading to better revenue for Sarine Technologies as the bulk of its business is still heavily dependent on mid-stream manufacturing activities. 
  • Media reports in India cited robust demand from domestic and international jewellery manufacturers as the reason polished prices rose 3-4% over the last two weeks of Jan 2018 after the rough/polished diamond price spread continued to improve in 2HCY17.

Opening two diamond grading labs in 1H18F 

  • In Jan 2018, Sarine announced plans to open its first diamond grading lab in Israel in Feb 2018 and a second lab in India in May 2018. 
  • The new labs will offer a more compelling value proposition as they will employ automated artificial intelligence-based technology in the diamond grading domain, which has been plagued by concerns over accuracy, consistency and security. It is aiming to capture significant share (10%+) of the diamond 4C certification market (worth c.US$500m p.a. according to management) in five years.

New Meteorite system to extend market reach 

  • It launched the Meteorite system in Jan 2018, designed to capture the largely-untapped segment of very small (under 0.35 carat) rough diamond stones. 
  • Management believes the addressable market size for this segment is 50m stones p.a., which translates into market value of US$25m based on its proposed charge of US$0.50 per stone scanned.

Gaining traction in tackling illicit competition 

  • We expect sales that have been eroded by illicit competition to gradually recover and margins to be lifted on lower legal costs from 2H18F. 
  • Apart from pursuing legal action against illicit competitors in India that have reportedly eroded sales in 9M17, the group is gaining positive traction in its efforts to discourage customers from using illicit services that infringe on Sarine’s patented technology.

Major shareholder increasing its stake signals confidence 

  • Chilean-based fund Axxion SA (AXXO CI, Not Rated), now Sarine’s biggest shareholder, increased its stake from 8.7% to 9.18% (1.68m shares at S$1.15 per share) over the last two weeks of Jan 2018. Axxion previously held a 0.14% stake in Sarine before Mondrian Investment (Unlisted, previously the largest shareholder) disposed of its entire 8.6% stake on 30 Nov 2017. 
  • We believe this signals confidence in Sarine’s overall business outlook and suggests the current valuation offers an attractive risk/reward profile.

Upgrade to ADD with a lower Target Price of S$1.56

  • We think the sell-off over the past 12 months (40% decline in Sarine Tech's share price) is overdone and its current valuation of 15.9x CY18F P/E is attractive in light of the strong earnings growth outlook amid improving diamond market dynamics. 
  • We transfer analyst coverage and introduce new FY18-19F earnings forecasts and project net profit growth of 123% in FY18F and 38% in FY19F. Our Target Price is based on 17.2x CY19F P/E (at a 10% discount to its historical 9-year average). 
  • A key risk is global economic downturn.

Industry outlook 

Recap of Sarine’s recent financial performance 

  • Sarine reported a 60% y-o-y decline in 9M17 net profit to US$5.2m, citing a combination of issues that weighed down its operating profit. 
  • Key issues included: 
    1. Excess inventories of polished diamonds in mid-stream value chain, which drove diamond manufacturers to slow down production and hold off on capital expenditure, coinciding with poor rough diamond sales. This was exacerbated by prolonged closure of factories in India due to the Diwali festival that took place earlier than usual; 
    2. Infringement on Sarine’s patented technologies by illicit competitors. This mainly relates to the internal inclusion mapping technology (Solaris/Meteor systems) and rough diamond planning services. Sarine’s sales were eroded in 2017 by diamond manufacturers using illegal equipment and services; 
    3. Higher operating expenses, i.e. legal costs. This was the result of increased activities to enforce Sarine’s intellectual property (IP) protection and discourage manufacturers from using services from illicit competitors. Higher staff expenses were also incurred in US$ dollar terms as the US$ weakened against the local currency in Israel in 2017.

Outlook for mid-stream diamond market turning positive 

  • Sarine’s topline is sensitive to the price spread between rough and polished diamonds. When rough diamond prices increase faster than polished diamond prices, manufacturers’ margins are squeezed, leading to a slowdown in manufacturing that negatively affects Sarine as the majority of its sales (c.98% of 9M17 sales) still come from the mid-stream diamond market.
  • With reference to the Zimnisky Global Rough Diamond Index as at 27 Jan 2018 and the IDEX polished diamond price index as at end-Jan 2018, the rough/polished price spread seemingly tightened over the past six months (rough diamond prices: down 3.9%; polished diamond prices: marginally down 0.15%), which suggests a more positive manufacturing outlook for the midstream value chain ahead, in our view. 
  • We believe end-consumer demand for diamonds in the downstream should be well supported by continued economic growth in the US, which remains the biggest importer of diamonds globally, as well as the growing middle classes in China and India. We believe sales will improve for Sarine from here on after incurring losses in 3Q17.

Growth drivers 

New growth leg from c.US$500m diamond grading market 

  • Back in 2008, IDEX estimated 80% of all polished diamonds by value came with a certificate issued by a diamond grading lab and certified diamonds generally fetched price premiums over uncertified diamonds. Led by the Gemological Institute of America (GIA), the diamond grading market is seeing the entry of new competitors – notably the International Institute of Diamond Grading & Research [IIDGR, a subsidiary of De Beers PLC (Unlisted)] and Sarine, which claims to possess superior and automated technological solutions that offer more accurate and consistent grading.
  • We believe Sarine could gain faster market penetration in the diamond grading market compared to the retail business with Sarine Profile, as evidenced by IIDGR securing partnerships with established jewellery retailers, such as Soo Kee Group (SK SP, Not Rated) in Singapore, I-PRIMO (Unlisted) in Japan, Luk Fook Jewellery (590 HK, Not Rated) in Hong Kong, for its diamond grading services despite being relatively new in the market. 
  • With plans to open two new labs this year, we believe Sarine’s diamond certification business will drive earnings growth further.

Valuation & Recommendation 

Handsome dividend payout 

  • Sarine’s dividend policy provides for the distribution of 2.0 UScts on a semiannual basis and the company has generally paid out over 50% of EPS in the past ten years. 
  • We project DPS of 4.0 UScts for both FY17-18F, which translates into 5.0% dividend yield.

Upgrade to ADD with target price of S$1.56 

  • We upgrade our recommendation from Hold to ADD in view of a recovery in diamond manufacturing activities and Sarine’s current compelling valuation of 15.9x CY18F P/E (14.3x CY18F ex-cash P/E) after the sell-off over the past 12 months that pushed Sarine Technologies' share price down by more than 40%. 
  • Our target price is based on 17.2x CY19F P/E, representing a conservative 10% discount to Sarine’s historical 9-year average of 19.1x. 
  • Potential key catalysts for the stock are rapid growth in the diamond grading segment and strong recovery in manufacturing activities in the diamond market.
  • Sarine has no direct peer comparable in its dominant market – scanning/processing diamond equipment. While Sarine now trades above the global diamond sector average of 12.3x CY18F P/E, we think its higher multiple is justified in view of its strong earnings growth potential from its shift towards the polished diamond technology space, high recurring revenue stream and sizeable profit margins.

Colin TAN CIMB Research | 2018-02-05
CIMB Research SGX Stock Analyst Report ADD Upgrade HOLD 1.56 Down 1.960