Graff Diamonds IPO

Graff Diamonds kicks off $1 billion IPO in lacklustre market

Graff Diamonds is looking to sell about 30% of its share capital at 18 to 24 times this year's earnings.
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Just a few of the diamonds from Graff's $667 million jewel inventory
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<div style="text-align: left;"> Just a few of the diamonds from Graff's $667 million jewel inventory </div>

Despite challenging market conditions that have seen the Hang Seng Index lose 11% during the past two-and-a-half weeks, Graff Diamonds will start the institutional bookbuilding for its $1 billion Hong Kong initial public offering today.

According to sources, the company is looking to sell $850 million worth of new shares, while the wife of founder and chairman Laurence Graff is selling a further $150 million. In view of the tough market, the deal will be offered at a lower-than-previously intended valuation of 18 to 24 times this year’s earnings. Together with the company’s unique business model as an integrated producer and retailer of quality diamonds to the world’s ultra-rich, Graff will be hoping that this is enough to attract investors and give its IPO the same kind of sparkle that its diamonds have.

At the bottom end of the range, Graff is coming at a decent discount to the fair value estimates of 22 to 30 times this year’s earnings that several syndicate analysts have put forward, and it is also offered at a discount to Prada — the only other international luxury brand that is listed in Hong Kong. The two businesses are obviously quite different, but both are seeing a lot of growth opportunities in Asia as its population is getting wealthier and have a lot of scope to increase their penetration in the region through new store openings. Prada is currently trading at about 22 times, while other luxury brands such as watch and jewellery maker Compagnie Financiere Richemont, Tiffany and Harry Winston Diamond are quoted at even lower multiples.

The top of the price range, though, does look quite ambitious, but if the market sentiment were to improve during the bookbuilding — the deal isn’t scheduled to price until after the US market closes on May 31 — it gives the issuer the flexibility to move up the price.

The valuation range translates into a price range of HK$25 to HK$37 per share. Graff is offering a fixed deal size in dollar terms so the number of shares will depend on the final price. Based on the price range, the number will range from 210 million to 311 million shares. According to a source, this will translate into 29% of the company at the mid-point of the range and 33%, if a $150 million greenshoe is exercised in full. The shoe will be made up of shares sold be Laurence Graff himself and could increase the final deal size to $1.15 billion.

This suggests Graff will have an approximate market value of between $2.8 billion and $4.1 billion at the time of listing.

According to sources, the company hasn’t signed up any cornerstone investors, as the difficult market conditions makes investors reluctant to commit to a lock-up. They also weren’t too keen to accept the top-end valuation of 24 times forward earnings — cornerstones commit to buy shares at the final IPO price and therefore have to be prepared to pay the maximum price — and lowering the top end to accommodate potential cornerstones would have reduced the flexibility if the market sentiment changes.

However, sources said there were indications from potential anchor investors, which is giving the bookrunners visibility of as much as 40% of the order book at launch. Anchors don’t have to commit to a lock-up and are also able to limit their orders at a certain price, giving them more certainty in terms of what they have to pay. For the purpose of supporting the order book, anchors can be as useful as cornerstones, although a key drawback is that other investors don’t know who the anchors are.

Some people argue that a company like Graff that sells primarily to ultra-high-net worth individuals is less affected by economic downturns, simply because these people have the means to continue to spend. And as a result it should be better placed to ride out challenging markets like the one we are currently in. However, the numbers show that Graff’s sales dropped by 29% during the financial crisis in 2009 and that the company was the hardest hit among the major hard luxury names, followed by Harry Winston and Bulgari. This suggests that Graff is not immune to a slowdown.

Other key risks include the fact that it relies on a relatively small number of individuals for a significant portion of its revenues. In the past three years, its top 20 customers have accounted for 42% to 44% of the total revenues. And one single customer accounted for between 12% and 15.8% of the revenue in each of those three years.

Except for actual mining, Graff is active across the diamond value chain — from the sourcing, cutting and polishing of the stones to the design, manufacturing and retail distribution. It is recognised in particular for its expertise when it comes to rare and very expensive diamonds and is known for paying top prices for high-quality diamonds at auctions as well as for its superior cutting and polishing capabilities.

Since the company was started by Laurence Graff in 1960, it has built what analysts describe as an “impressive” inventory of diamonds and finished jewellery that, according to a draft prospectus, had a book value of $667 million at the end of March this year. The inventory includes 708 white diamonds that each weighs more than three carats and 71 yellow diamonds that each weighs more than seven carats, most of which are contained in approximately 6,000 pieces of jewellery and 800 watches.

This inventory is one of the key things that sets Graff apart from the competition, analysts say, noting that it would be very difficult — not to mention expensive — for other companies to replicate. The inventory gives Graff the ability to offer its customers unique large pieces on demand.

The growth story, however, is largely centred on the building of the Graff brand in “new” markets such as Asia and the planned store expansion. The company currently has 18 directly operated stores and 13 stores operated by franchise partners. This year it will open another five directly operated stores, all of which will be in Asia (in Hong Kong, Shanghai, Macau, Hangzhou and Tokyo) with another five to follow in 2013 in Asia and in major European cities where it still doesn’t have a presence, such as Paris and Milan. It is also considering additional expansion opportunities, both through additional directly operated stores and franchise stores.

In 2011, Asia accounted for 19% of the company’s retail sales, although one syndicate analyst report estimates the sale to Asian customers to be somewhat higher at 25% to 30% as many customers buy Graff diamonds when they travel to Europe.

In the first quarter this year, the company’s revenues in Asia more than doubled to $36.1 million from $16.8 million in the same period a year earlier due to higher sales volumes, and exceeded the revenues generated in the US ($33.7 million), the company said in a draft prospectus published on the Hong Kong stock exchange website on Friday.

Overall, revenues increased by 24.9% to $204 million in the first quarter, setting the company off to a good start to the year. However, analysts note that since a large proportion of the company’s retail sales comes from items priced at more than $1 million – 47% in 2011 – sales can be lumpy and it is difficult to draw conclusions for the full-year results by extrapolating revenues in one single quarter. In the past three years, Graff has been able to sell at least one item priced above $10 million and missing out on such a sale could swing retail sales by 10% to 20%, one syndicate analyst estimates. Graff said in the prospectus that it sold no item at a price above $10 million in the first quarter.

Forecasting is also made difficult by the fact that there is little information about the purchasing cost of diamonds – a key number for calculating gross margins.

The  syndicate analyst report projects adjusted net profit (excluding one-off items) to expand at a compound annual growth rate of 27.6% in 2011 to 2014, driven by sustained sales growth, gross margin improvements and some operating leverage as the scale of its sales grows. For 2012 it projects a net profit of $145 million.

In 2011, revenues increased by 22.5% to $755.6 million, while net profit grew by 14.7% to $120.1 million.

Part of the IPO proceeds will likely go towards the store expansion, although the company will also use some of the money for an internal reorganisation that will strengthen its grip on the supply chain by removing a middle man. Until now, Graff has bought many of its diamonds from DiamondWorks, a company wholly-owned by Laurence Graff, but in the future it will source directly from suppliers, allowing it to capture any appreciation in the value of the stones before they are eventually sold to retail investors.

Last year, 35.4% of the polished diamonds used by the Graff’s retail division were supplied by DiamondWorks, 33.6% were supplied by the company’s own procurement and polishing division and 31% by other independent sources. The company buys the majority of its rough diamonds from Diamond Trading, which is a subsidiary of mining company De Beers. It also buys rough diamonds on the open market and through other suppliers and tenders.

As part of the reorganisation plan, Graff will buy 73 diamonds with a combined weight of 1,250 carats (one carat is equal to 0.2 gram) that are currently consigned to the company by DiamondWorks. The cost of this acquisition will amount to about $227 million and will increase the book value of Graff’s inventory to about $894 million.

The company will also buy the part of Safdico International (also known as the South African Diamond Corp) that it doesn’t already own in order to secure the diamond supply for its manufacturing and retail activities, to facilitate increased supply chain integration and to eliminate minority interests, which should allow it to capture more profit. Safdico is the holding company of Graff’s procurement and polishing division. The cost of this acquisition will be $60 million in cash, of which $50 million will go to a company owned by Laurence Graff, and $40 million in Graff shares split between the other two sellers, Brian Gutkin and Jonas Kneller. The company will also repay $96 million of outstanding loans to Laurence Graff, Gutkin, Kneller and third parties.

Graff will also buy the Graff Diamonds store in Monaco from Laurence and Francois Graff for $200 million, while Laurence Graff will buy a luxury winery estate in Stellenboch in South Africa, as well as other real estate and aviation interests from Graff for about $110 million, removing non-core assets from the listed company. He will also buy certain paintings for $8.2 million.

Credit Suisse, Deutsche Bank, Goldman Sachs and Morgan Stanley are joint global coordinators and bookrunners, while HSBC is a joint bookrunner. The listing is scheduled for June 8.

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