Sarine Technologies - DBS Research 2022-05-19: Growing Trade Revenues To Lift Margins

SARINE TECHNOLOGIES LTD (SGX:U77)

Sarine Technologies - Growing Trade Revenues To Lift Margins

Sarine Technologies's 1Q22 revenue of US$15.6m was in line while net profit at US$3.4m was higher than expected on robust gross margins of 71.8%.
Trade revenues continued to gain traction, reaching 11.6% of overall revenues in 1Q22.

Upgrade Sarine Technologies to HOLD with higher target price of S$0.50 from $0.45 previously.

Sarine Technologies (SGX:U77)'s 1Q22 revenue forms 27% of our full year forecasts for FY22. 1Q22’s revenue is 9.9% lower compared to 1Q21 due to the exceptionally strong first quarter last year.
Net profit of US$3.4 million was higher than expected on robust gross margins of 71.8%. The higher-than-expected gross margins can be attributed to the increasing proportion of trade revenues as well as the sale of higher end galaxy machines. In 1Q22, Sarine Technologies delivered 17 Galaxy-family systems comprising one Galaxy Ultra, five Galaxy models, two Meteor and nine Meteorites.

Russian rough diamonds continued to flow into the pipeline in the first quarter. The utilization rates of Sarine Technologies’s inclusion mapping systems did not differ significantly compared to late 2021, recording 100,000 stones daily on average. This indicates that midstream polishing activities were generally not too affected by the Russia-Ukraine crisis.

Trade revenues consist of revenue from the Sarine Profile, the Sarine Diamond Journey, and digital tenders. Sarine Technologies’s traceability and grading solutions has gained acceptance by luxury brands such as Maison Boucheron. In April, we continue to see adoption from the Aura Blockchain Consortium and Bonas Group. Keep a lookout on more customer acquisitions that could drive trade revenues.

We are adopting a cautious stance given that the Russia-Ukraine crisis is still ongoing. While Sarine Technologies’s business was not materially affected in 1Q22, we note that the stricter sanctions on Alrosa were enacted in April.
The US has placed Alrosa on the Specially Designated Nationals list, which bans Alrosa from trading with Americans and kicks it out of the US banking system. Alrosa has cancelled its last sale in April and reports indicate that they are unlikely to sell large volumes in May given the sanctions.
At the same time, US demand for Russian diamonds has declined. Firms such as Tiffany and Co and Signet have stopped purchasing diamonds mined in Russia. If the Russia-Ukraine crisis persists, the flow of Russian rough diamonds could be impacted, which could lead to a weaker outlook.

Given that the US government has placed Alrosa on the Office of Foreign Assets Control (OFAC) list of banned entities and some US companies have ceased their purchases of Russian mined diamonds, manufacturers are starting to separate goods to serve different markets. It is expected that Russian supply will shift towards China, although demand may be hampered by the resurgence of COVID-19 cases and lockdowns.

India’s cut and polished exports are a good indicator of manufacturing and production activity of diamond manufacturers. An increase in midstream diamond manufacturing activity translates to higher recurrent revenue from diamond scanning.

Scanning data from Sarine Technologies has shown less polishing activity partially due to the summer vacation in India which resulted in a slowdown in business operations of manufacturers. Another possible reason for manufacturing slowdown could be the expected decline in inventories of rough, possibly constraining diamond manufacturing activity, at least until a more robust bifurcation of Russian supply.
While US retail sales have remained stable, we are also keeping a close watch on the impact of rising interest rates and inflation.

Given that the polished and diamond prices are impacted by a myriad of factors, it is challenging to predict the difference in rough and polished prices. Nonetheless, apart from the price of small rough diamonds that have risen 20% since the beginning of March, the overall market price of diamonds is lower than their February highs.
Manufacturers who purchase rough diamonds now are poised to enjoy better margins compared to the same period in February. Historically, better midstream manufacturer margins have translated to higher capital equipment sales for Sarine.

According to our channel checks, the Russian-Ukraine crisis has accelerated interest in traceability solutions by 1-2 years as companies avoid Russian mined diamonds. As at 1Q22, trade revenues have inched up to 11.6% of overall revenues (vs 8% in FY21 and 11% in 2H21).
A growing trade segment will positively impact gross margins as the cost of providing these services is much lower compared to capital equipment sales.

Since our last report, Sarine's share price has corrected to near our previous target price on normalization of top and bottom lines. Our revenue assumptions remain unchanged, but we have revised our margin assumptions upwards on acceleration in the trade services segment in light of the Russia-Ukraine crisis.
We have increased our margin assumptions to 70.0%/70.5%/71.0% from 68%/69%/70% for FY22/FY23/FY24. Our EPS is revised upwards to US$0.0279 and US$0.0299 by 26.4% and 22.2% for FY22/FY23 respectively.
Our target price of S$0.50 for Sarine Technologies is based on the average of
1. 12.5x (20% discount to historical mean) and
2. peer average of 14x.
We have taken a 20% discount to the historical average P/E to reflect the ongoing macroeconomic and geopolitical headwinds and risks. We have assumed an exchange rate of 1.36 (US$/S$).
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Sachin MITTAL DBS Group Research | Singapore Research Team DBS Research | https://www.dbs.com/insightsdirect/ 2022-05-19

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