Full Year Financial Statement And Dividend Announcement 2017
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Consolidated Statements of Comprehensive Income for the (US$'000):
Statement of Financial Position as at (US$'000):
* No par value
Review of Performance
For the year ended December 31, 2017, the Group reported revenues of US$ 58.6 million, profit from operations of US$ 9.4 million, and net profit of US$ 5.8 million, as compared to revenues of US$ 72.5 million, profit from operations of US$ 21.2 million, and net profit of US$ 18.0 million for the year ended December 31, 2016. The Group reported revenues in Q4 2017 of US$ 12.9 million, profit from operations of US$ 2.1 million and net profit of US$ 0.6 million, as compared to revenues of US$ 18.9 million, profit from operations of US$ 6.3 million and net profit of US$ 5.0 million reported in Q4 2016, and as compared to revenues in Q3 2017 of US$ 11.3 million, loss from operations of US$ 11,000, and a net loss of US$ 0.5 million.
The decrease in overall revenues year-over-year and the consequential decline in Group profitability stemmed primarily from higher than normal surplus inventories of polished diamonds, which built up in the mid-stream in the third quarter of 2017 and continued through mid-December in the fourth quarter, driving manufacturers to slow production and hold off on capital expenditures. In addition, the ongoing illicit operations of parties infringing our intellectual property (IP) further affected our sales of capital equipment but not our recurring revenues (a record number of 10 million stones were scanned in 2017). The illicit competition has had two types of effect on our sales – a) delayed decision-making, as potential customers await the resolution of pending legal actions, as detailed in section 10, prior to purchasing any new equipment, and b) actual sales made by the infringing party. Indications are that the latter are primarily in systems or services for smaller stones, mostly sub-carat in size. The year-over-year results for FY2017 versus FY2016 were primarily impacted by lower capital equipment sales, in general, and Galaxy family equipment sales, in particular, and by higher General and Administrative expenses, as we are aggressively fighting IP infringements, as detailed in section 10. Group operating expenses were further increased in FY2017 by an approximate 10% decline of the US$ versus the NIS in Israel, where most of our compensation expenses, especially in R&D, are incurred.
The sequential increase in revenues and return to profitability in Q4 2017 was primarily due to a gradual improvement in sentiment in the Indian diamond manufacturing industry, towards the very end of the year, as surplus inventories declined during the holiday season. It was also partly due to lower operating expenses, mainly related to the reversal in Q4 2017 of most of the accrued incentive-based compensation, which had been accrued earlier during the year, following the overall weak FY2017 results.
With deliveries in Q4 2017 of 11 Galaxy® family systems to customers, comprising 6 Galaxy® systems (five of which were outside India) and 5 MeteorTM systems, the Group had an installed base of 345 Galaxy® family systems as of December 31, 2017. Overall recurring revenues for 2017 (including Galaxy®-related, Quazer® services, polished diamond related ("Trade") services, annual maintenance contracts, spare parts, etc.) represented just under half of our overall revenue. Overall polished diamond retail-related revenues, currently from the Sarine Profile™ and its various components (Sarine Light™, Sarine Loupe™, Sarine Connect™, etc.), represented 2% of our overall revenue for FY2017.
Balance Sheet and Cash Flow Highlights
As at December 31, 2017, cash and cash equivalents and short-term investments (bank deposits)("Cash Balances") decreased to US$ 29.1 million as compared to US$ 38.0 million as of December 31, 2016. The decrease in Cash Balances was primarily due to the payment of US$ 15.8 million in dividends in 2017 (US$ 8.8 million final dividend paid in Q2 2017 for 2016 and the US$ 7.0 million interim 2017 dividend paid in September 2017), the repurchase of US$ 0.6 million of Sarine shares in the open market, and due to expenditures associated with Group’s completed new facilities in Surat India, offset by the Group’s operating results and lower inventory levels and payables.
The Group reported revenues for the year ended December 31, 2017 of US$ 58.6 million, as compared to revenues of US$ 72.5 million for the year ended December 31, 2016. The Group reported revenues in Q4 2017 of US$ 12.9 million, as compared to revenues of US$ 18.9 million in Q4 2016, and as compared to revenues in Q3 2017 of US$ 11.3 million.
The decrease in revenues on a year-over-year basis, mainly in India, was primarily due to lower capital equipment sales as a result of above average overstocking of inventory levels in the midstream, and the illicit competition in India, from the infringement of our patent for the Galaxy® family of systems and the copyright of our Advisor® planning software. It is notable that though substantially fewer rough diamonds were sold into the midstream, particularly in the second half of the year, recurring revenues are flat, which indicates that we have not been impaired by the infringing parties' activities as pertaining to our scanning of larger stones. On a quarterly sequential basis, the increase in revenue was primarily due to higher diamond manufacturing equipment sales, especially Galaxy® family systems offset somewhat by lower recurring revenues, which resulted, characteristically in Q4, from the Diwali holiday in India.
Cost of sales and gross profit
Cost of sales for the year ended December 31, 2017 decreased to US$ 19.3 million, versus US$ 22.2 million for the year ended December 31, 2016, with gross profit margins of 67% in FY2017 versus 69% in FY2016. Cost of sales in Q4 2017 decreased to US$ 4.5 million, as compared to US$ 5.3 million in Q4 2016, with a gross profit margin of 65% in Q4 2017 versus 72% in Q4 2016. The decrease in cost of sales on a year-over-year basis, and the decline of the gross profit margin was primarily due to significantly lower sales volumes in 2017. On a sequential basis, cost of sales increased in Q4 2017 to US$ 4.5 million, as compared to US$ 3.9 million in Q3 2017, with a gross profit margin of 65% in Q4 2017 versus 66% in Q3 2017. The increase in cost of sales on a sequential basis was primarily due to higher sales volumes. The modest decline in gross profit margin, was primarily due to product mix.
Research and development expenses
Research and development expenses for the year ended December 31, 2017, Q4 2017 and the comparable periods are shown in the table below. The Group has capitalised, beginning Q3 2017 (in compliance with IFRS), costs associated with the development of the Sarine ClarityTM and Sarine ColorTM systems, resulting in lower reported expenses in FY2017, as compared to the comparable periods in FY2016. These systems are planned to be in actual revenue-generating commercial use in Q1 2018, as we commence grading polished diamonds’ 4C's in our Sarine Technology Lab in February.
Research and development costs for the year ended December 31, 2017 of US$ 11.3 million increased versus US$ 10.8 million in FY2016 primarily due to higher employee-related expenses. The increase in employee related expenses was primarily due to the approximate 10% decline of the US$ versus the NIS in Israel. Research and development costs in Q4 2017 of US$ 2.4 million decreased as compared to US$ 2.7 million in Q4 2016 and as compared to US$ 2.8 million in Q3 2017, as we started reducing outsourcing expenses relating to the development of the Sarine ClarityTM and Sarine ColorTM systems and was also due to the reversal in Q4 2017 of accrued incentive-based compensation, which had been accrued earlier during the year. The Group continues to focus its research and development expenditures on the development of future growth products and services.
Sales and marketing expenses
Sales and marketing expenses for the year ended December 31, 2017 were US$ 13.6 million, virtually flat as compared to FY 2016, with increased marketing, advertising and business development expenses, offset by significantly lower incentive-based compensation. Sales and marketing expenses for Q4 2017 of US$ 3.0 million decreased as compared to US$ 3.5 million in Q4 2016 and US$ 3.4 million in Q3 2017. The decrease in sales and marketing expenses in Q4 2017 was primarily due to the reversal in Q4 2017 of incentive-based compensation, due to the weaker than expected sales figures in 2017.
General and administrative expenses
General and administrative expenses for the year ended December 31, 2017 of US$ 5.8 million increased versus US$ 4.7 million for FY2016. General and administrative expenses for Q4 2017 increased to US$ 1.4 million as compared to US$ 1.1 million in Q4 2016, and decreased as compared to US$ 1.6 million in Q3 2017. The year-over year increase in general and administrative expenses in FY2017 versus the comparable periods in FY2016 were primarily due to higher third-party professional fees, mainly related to IP protection actions (primarily, but not solely, in India; see section 10), offset somewhat by lower incentive based compensation accruals in 2017. The sequential decrease in general and administrative expenses in Q4 2017 as compared to Q3 2017 was primarily due to lower third-party professional fees, mainly related to a hiatus in many of our court-related IP protection activities during the Diwali holiday in India, as well as the reversal in Q4 2017 of accrued incentive-based compensation.
Profit from operations
Profit from operations for the year ended December 31, 2017 was US$ 9.4 million as compared to US$ 21.2 million for the year ended December 31, 2016. Profit from operations for Q4 2017 was US$ 2.1 million as compared to US$ 6.3 million in Q4 2016 and a loss from operations of US$ 11,000 in Q3 2017. The decrease in profit from operations in FY2017 on a year-over-year basis was primarily due to decreased capital equipment sales, as compared to FY2016 as detailed above. The sequential increase in profit from operations in Q4 2017 as compared to Q3 2017 was primarily due to increased revenues from capital equipment sales and due to lower operating expenses, as detailed above.
Net finance income
Net finance income for the year ended December 31, 2017 was US$ 17,000 versus income of US$ 0.8 million for the comparable period in 2016. Net finance expense for Q4 2017 was US$ 89,000, as compared to an expense of US$ 2,000 in Q4 2016 and net finance income of US$ 53,000 in Q3 2017. The decrease in net finance income for the year ended December 31, 2017, as compared to the comparable period in 2016, was due to exchange rate difference expenses in 2017, as compared to income in 2016, the recognition of an interest charge of US$ 0.1 million in 2017 and Q4 2017, related to prior period tax assessments settled in Israel, and the recognition of net finance income in 2016 of US$ 0.4 million relating to prior period tax assessments under dispute in India.
Income tax expense
The Group recorded an income tax expense of US$ 3.7 million for the year ended December 31, 2017, versus an expense of US$ 4.0 million for the year ended December 31, 2016. For Q4 2017, the Group recorded an income tax expense of US$ 1.4 million, as compared to an expense of US$ 1.3 million in Q4 2016 and an expense of US$ 0.6 million in Q3 2017. The minor decrease in income tax expenses in FY2017 as compared to FY2016 was primarily due to lower pre-tax profitability, as discussed above, offset by a write down of US$ 1.4 million (over 35% of the total yearly tax expense) of certain deferred and other tax assets. The increase in income tax expenses in Q4 2017 was due to the write down in Q4 2017 of US$ 1.0 million of certain deferred and other tax assets.
Profit for the period
For the year ended December 31, 2017, net profit decreased to US$ 5.8 million versus US$ 18.0 million for the year ended December 31, 2016. Net profit for Q4 2017 of US$ 0.6 million decreased as compared to US$ 5.0 million in Q4 2016, but improved sequentially from a net loss of US$ 0.5 million in Q3 2017. The decrease in net profit on a year-over-year basis was primarily due to significantly lower capital equipment sales, as detailed above. The sequential increase in net profit in Q4 2017 as compared to Q3 2017 was primarily due to increased revenuesfrom capital equipment sales and due to lower operating expenses, as detailed above, offset by higher income tax expenses (including write down), also as discussed above.
We expect the following industry trends to continue influencing our business:
- Fundamental global economic indicators continue to be overall positive.
- Courtesy of the 16th edition of Bain & Company’s annual global luxury study (October 2017):
- Global personal luxury items (including accessories, apparel, jewellery and watches) retail volume exceeded US$ 325 billion in 2017 with real growth of some 5% year over year, and is projected to continue growing at 4-5% annually for the next three years. Sales in 2017 were boosted by the return of Chinese buying at home, as well as abroad, notably also with renewed spending in Hong Kong and Macau. Chinese consumers are the single largest market for personal luxury goods (32%), followed closely by North America (31%+). For diamond jewellery, North America is still the single largest market with some 40% of global sales, followed by China. Holiday season retail sales in the U.S. in 2017 grew overall by some 4.9%, with jewellery sales exceeding average with 5.8% growth year over year.
- Online sales of luxury items grew an impressive 24% in 2017, led by accessories and apparel, though online sales of jewellery and watches also rose. The U.S. market accounted for nearly half of all global online sales – some US$ 28.5 billion. Brands are establishing an online presence more and more, with 31% of their sales now online. Still, forecasts project that even in 2025, online sales will only account for 25% of luxury item sales, with 75% remaining in stores. Federica Levato, a Bain partner and co-author of the study, opined “The growth of the online channel is remarkable, boosted by the ‘millennial state of mind’ that has permeated the luxury industry. But this doesn’t mean stores have lost their purpose – brands need to reinvent them to create an on-going engagement with customers that transcends channels.”
- As polished inventory levels built up significantly commencing the third quarter of 2017, De Beers' sales of rough diamonds in the fourth quarter of 2017 declined significantly, reaching an unusually low level of US$ 376 million in October, US$ 466 million in November and US$ 455 million in December. Similarly, Alrosa's (primary Russian producer) sales also declined significantly in Q4 2017. Notably, the sales figures for both DeBeers and Alrosa for 2017 show that production declined more than sales, indicating continued selling off of stockpiles accumulated in 2015, and prices per carat also declined, as midstream demand softened and was more inclined towards lower-end goods. The first sight of 2018 was a more robust US$ 665 million, but still lower than the comparable sight in 2017 (US$ 729 million). Rough prices were flat. We believe this indicates a measured return to more normal midstream activity.
- Midstream industry activity up until the very end of the fourth quarter continued to be muted, due to the excessive inventory build-up of polished diamonds. As expected, inventory levels were reduced by year-end holiday season sales, which were significantly stronger than in the preceding year (up 5.8% in the key U.S. market). Looking forward to at least the first half of 2018, midstream industry sentiment is positive, driven by evident shortages of specific categories of polished diamonds, and the consequential price increases, coming off the year-end holiday season, and bolstered by expectations for robust Chinese New Year and Valentine's Day spending.
- Sales programs utilising Sarine Profile™ by retailers in the Asia Pacific (APAC) region, primarily in China and Japan, but also in ASEAN countries, continue to expand. Of note is the launch with Chinese retailer JAFF, a chain of some 200 outlets, a brand belonging to King One, which comprises in total over 1,000 stores. Also of note is the launch with Chinese retailer JASS, a smaller chain of very high-end luxury jewellery. Both of these launches are scheduled for immediately after the upcoming Chinese New Year. Following a very successful trade show in January in Japan, ten new or expanded programs are being initiated, and additional retailers are adopting Sarine Profile™, including Bijoupiko with over 40 stores, Kawasumi with over 30 stores and Vanilla, a high-end retailer with two mega-stores in Hiroshima and Fukuyama. Our target for 2018 is to double the number of stones scanned.
- We have, as announced 22 February 2018, enhanced the Sarine Profile™ with a new feature, the Sarine Diamond Journey™, which graphically documents and depicts the stone’s transition from a unique rough stone to a one-of-a-kind polished gem. Leveraging on our extensive presence in the diamond industry's midstream, having scanned over ten million stones in 2017 for inclusion mapping and having planned many tens of millions of rough stones (some 40 million stones using our latest Advisor® family 7.0 software alone), we have launched a new captivating visualisation paradigm for showing the consumer the entire process that his/her unique diamond underwent. The rough stone can be shown as mined, as modelled and scanned, as planned, and as cut and polished at various stages, culminating in its final polished magnificence, creating an engaging personalised experience. This new capability provides the consumer with insight as to the painstaking craftsmanship that went into creating his/her unique jewel. It may, depending on data provided, also verify for the consumer where their rough stone was mined and reinforce their confidence in the responsible sourcing and manufacture of their diamond. Finally, as multiple stages of the stone's journey from the mine to their possession are documented, it may, in the future, be leveraged to create a secure chain of events for authentication record purposes.
- We formally opened our new Sarine Technology Lab on 18 February 2018, enabled by our automated, consistent and objective AI-based Clarity and Color grading of polished diamonds. Along with our industry-leading technology for Cut and Symmetry grading, as well as technology acquired for the authentication of the graded polished diamonds, we can now provide the first-ever technology-driven 4Cs diamond reports. Significant midstream and downstream players have expressed interest in this unique offering.
- We are now able to provide a unique packaged service tailored to each retailer's needs, comprising the baseline Sarine Profile™ with its various levels of imagery, hearts and arrows analysis, Cut 2D/3D proportions graphics, laser inscription viewing, etc. and various add-ons – our unique AI-based 4Cs grading report (including authentication of the polished stone), our Sarine Light™ light performance grading and our Sarine Diamond Journey™, as described in 10f. Our forte is that only we have the capability to package all the above informative features as one report. The fees for these services will range from US$ 30 per carat for stones of one carat (between .90 – 1.2 carats; prices for smaller or larger stones vary according to industry norms) to US$128 a carat, based on actual content. The guiding
principle is that the customer pays less and gets more – e.g., the customer pays the current industry norm as for standalone 4Cs reports from the established gemmological labs, but gets the added-value content provided by the Sarine Profile™ and light performance grading or the Sarine Diamond Journey™. Based on the value proposition created by the very cost-effectively priced packages, all provided by Sarine under one roof, we believe we can double the number of stones scanned in 2017 and triple the revenues generated therefrom, as the average selling price should increase by some 60%.
- We continue to see the illicit competition affecting sales of our inclusion mapping systems, particularly so for the systems for smaller stones. We expect the illicit competition to continue for at least another two quarters, though we have significant indications the industry is continually forsaking the use of the illicit technology. We delivered 11 systems in Q4, notably 6 of the Galaxy® model (five ex-India) and the rest of the Meteor™ model, bringing our installed base to 345 as of year-end 2017. Notably, we have not experienced a drop in the number of stones being processed by our installed base of inclusion mapping systems. On the contrary, 2017 was a record year in which we scanned over 10 million stones. On the backdrop of the significantly reduced DeBeers sights, we believe this is indicative that we are not losing significant existing business and are expanding our customer base, illicit competition notwithstanding. Notably, as DeBeers sights are now increasing, also, we are seeing a commensurate increase in our scanning activities, with new scanning records being set.
- The patent and copyright enforcement activities we are pursuing are:
- In the Indian judicial system, we are pursuing parallel lawsuits for patent infringement and copyright (software) infringement. In both actions we have requested interim injunctions to put an immediate halt to the infringing activities, pending the trials and final outcome of the matters. In the patent case, we are in the midst of the hearings related to this request. Concerning the copyright suit, the High Court of Gujarat overturned the decision of the lower court to deny our request for an interim injunction and ordered the lower court to reconsider the matter using specific criteria based on actual comparison of the software versions. The lower court is now hearing arguments by the parties on how that is to be done and by whom. On another related issue, we have filed a lawsuit against a customer who had purchased a Galaxy® system and who unlawfully and purposely manipulated the reporting of the sizes (carat weights) of the stones processed by their system in order to reduce the use fees owed the Group.
- U.S Enforcement – We have alerted major diamond importers and dealers that their supply of polished diamonds from India may contain goods that infringe Sarine’s U.S. patents and copyrights, which, if not abated, could lead, under U.S. law, to the banning of importation of said infringing goods. We have encountered a spirit of cooperation from key U.S. retailers, and at the request of some retailers we are preparing additional information regarding the infringements. The supply chain inquiries submitted by some of the leading retailers have notably increased the pressure on the infringing parties in India.
- Technological – The newest Advisor® 7.0 has many enhanced features:
- Comparative testing between Advisor® 7.0 and older versions (those which have been hacked by the illicit competition) shows the polished stones planned using the newer software have a significant tangible added value in actual dollar terms.
- Advisor® 7.0 also has functionality specifically aimed at enabling the manufacturer to better meet today's retail trends for branding - optimising modified cuts, light performance enhancement, etc.
- Technological (cont.) – We have launched the revolutionary DiaExpert® Edge for the significantly refined modelling of a rough diamond’s concave surfaces, as announced January 8th, which only interfaces with our Advisor® 7.0, thereby also adding incentive to migrate to the latest release.
- Commercial (Midstream) – We have launched our new Meteorite™, system, as announced January 21st, which is the most cost-effective system for scanning very small rough diamonds, under 0.35 carats in weight. The Meteorite™ specifically competes with the illicit competition on their main turf, as our analyses show that most of their scanning activities are of very small rough stones. We have already realised sales of this newest addition to our family of inclusion mapping systems.
- Commercial (Downstream) – We are leveraging our new relationships with major retailers launching Sarine Profile™-enhanced programs, to initiate same only with suppliers who have migrated to Advisor® 7.0. This too creates a strong commercial incentive to migrate, which precludes the use of infringing technologies (see above).
- Polished diamond oriented systems:
- We will continue to enhance our Sarine Profile™ :
- Personalisation of the Sarine Profile™ by the diamond's consumer buyer, allowing the creation / importation of text, imagery, music and video (e.g., the proposal), as a means of personifying his / her message to the ultimate recipient of the purchased jewel.
- Enhancement of our support of jewellery pieces, in addition to loose polished diamonds. As retail businesses display set jewellery more often than loose stones, this will significantly broaden the appeal and applicability of Sarine Profile™.
- Further refinement of the Sarine Clarity™ and Sarine Color™ AI-based grading capabilities, to achieve broader relevance to additional shapes and sizes of polished diamonds and even better accuracy and consistency.
- We will continue to enhance our Sarine Profile™ :
- Manufacturing products:
- DiaExpert® Edge - Further refine the newly launched DiaExpert® Edge for more accurate rough stone modelling.
- Galaxy® Tension Mapping – We are extending our Galaxy® capabilities not only for inclusion detection but also for tension/stress detection and modelling. Understanding the location, structure and magnitude of the stress inside a rough stone is key for reducing the potential damage that can occur in a stone during laser sawing and other manufacturing processes. We are proceeding with large scale testing and expect to commence beta-installations of this feature in the second half of 2018.
- Axiom™ – We will release the third generation of our standard-setting Axiom™ system for the ultra-accurate (better than 10 micron accuracy) measurement of a polished diamond’s proportions. The new system will provide for unmatched accuracy in the measurement of fancy shaped diamonds, including special modified branded shapes. This ability will enable the Sarine Profile™ to support far more accurate renditions of fancy and special shapes, including the more accurate analysis of their quality. As these diamonds typically do not get a Cut grade from gem labs, by empowering much better analyses of these diamonds, the Sarine Technology Lab will provide a far better means to document their quality.