Second Quarter And/ Or Half Yearly Results 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
The Group reported improved sequential results with Q2 2017 revenues of US$ 18.2 million, profit from operations of US$ 4.2 million, and net profit of US$ 3.2 million, as compared to revenues of US$ 16.3 million, profit from operations of US$ 3.2 million, and net profit of US$ 2.5 million in Q1 2017. The sequential improvement in operating results was primarily due to the mix of GalaxyTM family systems delivered, nearly half of which were of various GalaxyTM models (see below), as well as due to increased recurring revenues.
On a year-over-year basis the Group's results were down, with Q2 20 I 7 revenues of US$ 18.2 million, profit from operations of US$ 4.2 million, and net profit of US$ 3.2 million, as compared to revenues in Q2 2016 of US$ 20.9 million, profit from operations of US$ 6.7 million and net profit of US$ 6.0 million. The Group realised in H1 2017 revenues of US$ 34.4 million, profit from operations of US$ 7.3 million, and net profit of US$ 5.7 million, as compared to revenues in H1 2016 of US$ 36.4 million, profit from operations of US$ 10.4 million, and net profit of US$ 9.0 million.
The year-over-year results were primarily impacted by lower sales, mainly due to the illicit competition in India and higher operating expenses. The lower than anticipated sales are primarily due to the sale offewer inclusion mapping systems for smaller stones (mainly MeteorTMsystems, but also Solarises TM), as is apparent from the unusual mix of inclusion mapping systems, as detailed below. Research and Development expenses remained high, as we were bringing to fruition our new Clarity and Colour grading technologies, as reported on 30 July 20 17, and adding significant capabilities to our AdvisorTM planning software, as detailed in section 10 (e.g., integrating light performance results with planning). The latter is a crucial facet in opening a significant technological gap with the illicit competition in India, as, due to more effective IP protection in later versions, they are limited to the use of our planning software from two generations back. We expect R&D expenses to start coming down in H2, as, among other issues, outsourcing related to the Clarity technology refinement drops off substantially. Sales and Marketing expenses, are being closely controlled, with very minimal expansion of our staff tightly coupled with growth in Sarine ProfileTMrollout. General and Administrative expenses are higher as we are aggressively fighting our IP infringements, as detailed in section 10. We expect these expenses will decrease, as our efforts bear fruit. Operating expenses were further impacted by an approximate 8% decline of the US$ versus the NIS in Israel, where most of our compensation expenses, especially in R&D, are incurred.
With deliveries in Q2 2017 of 16 GalaxyTM family systems to customers, comprising 6 MeteorTM systems, 3 SolarisTM systems, 3 GalaxyTM systems, 3 GalaxyTM Ultra systems and a GalaxyTM XL system shipped to the Botswana service centre, the Group had an installed base of 332 GalaxyTM family systems as of June 30, 2017. Overall recurring revenues for H1 2017 (including GalaxyTM-related, Quazer™ services, polished diamond related ("Trade") services, annual maintenance contracts, spare parts, etc.) represented approximately 41 % of our overall revenue.
Overall Trade revenues from our polished diamond line of products and services, the Sarine ProfiIe™ and its various components (Sarine LightTM, Sarine LoupeTM, Sarine ConnectTM, etc.), represented about 2% of our overall revenue for H1 2017, but we continue to expect to improve this ratio as the year unfolds, as new retail chains and independents continue to buy in to the paradigm (see Section 10 for more details), existing customers continue to expand their programs, and the number of stones processed increases. Previous years' experience has shown that the second half of the year, with retailers in the West preparing for the holidays buying season (and Valentine's Day) and those in the East preparing for the same holidays as well as for the Chinese New Year, typically sees twice as many stones scanned as in the first half of the year.
Balance Sheet and Cash Flow Highlights
As at June 30, 2017, cash and cash equivalents and short-term investments (bank deposits) ("Cash Balances") decreased to US$ 37.1 million as compared to US$ 38.0 million as of December 31, 2016. The decrease in Cash Balances was primarily due to the US$ 8.8 million final dividend paid in Q2 2017 for 20 16 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.
Revenues for Q2 2017 increased to US$ 18.2 million as compared to revenues of US$ 16.3 million in Q 1 2017, but decreased as compared to US$ 20.9 million in Q2 2016. Revenues for H1 2017 decreased to US$ 34.4 million as compared to US$ 36.4 million in H1 2016. The increase in revenues in most geographies on a sequential basis was primarily due to increased diamond manufacturing equipment sales and increased recurring revenues. The illicit competition based on the infringement of our patent for the GalaxyTM family of systems and the copyright of our older versions of the Advisor ™ planning software (as discussed in detail in Section 10), has negatively impacted the Group's results in India sequentially and is the primary cause for the year-over-year decrease in revenues, due to lower capital equipment sales (recurring revenues are flat).
Cost of sales and gross profit
Cost of sales for Q2 2017 increased to US$ 5.7 million as compared to US$ 5.2 million for Ql 2017, but decreased as compared to US$ 6.4 million in Q2 2016, with gross profit margin of 68% in Q2 2017 virtually flat with Q1 2017 and down slightly from 69% in Q2 2016. Cost of sales for H1 2017 decreased to US$ 10.9 million as compared to US$ 11.5 million for H1 2016, with gross profit margins of 68% in both H1 2017 and H1 2016. The sequential increase in the cost of sales was due primarily to higher sales volumes in Q2 2017 as compared to Q1 2017. The decrease in cost of sales on a year-over-basis was primarily due to lower sales volumes in Q2 2017 and H1 2017 versus the comparable periods in 2016.
Research and development expenses
Research and development expenses for Q2 2017 of US$ 3.1 million were virtually flat as compared to US$ 3.0 million in Ql 2017, and increased as compared to US$ 2.7 million in Q2 2016. Research and development expenses for H1 2017 increased to US$ 6.1 million as compared to US$ 5.3 million in H1 2016. The increase in research and development on year-over-year basis was primarily due to higher employee-related and outsourcing expenses. The increase in employee related expenses was significantly impacted by the approximate 8% decline of the US$ versus the NIS in Israel. The Group continues to focus its research and development expenditures on the development of future growth products and services, as expanded upon in Section 10.
Sales and marketing expenses
Sales and marketing expenses for Q2 2017 increased minimally to US$ 3.7 million as compared to US$ 3.5 million in Q1 2017, and was virtually flat with US$ 3.7 million in Q2 2016. Sales and marketing expenses for H1 2017 increased to US$ 7.2 million as compared to US$ 6.8 million in H1 2016. It should be noted that a much larger proportion of sales and marketing expenses are not incurred in Israel, and were hence not impacted by the aforementioned US dollar devaluation against the NIS, as were the research and development expenses. The insignificant increase in sales and marketing expenses on a sequential basis was primarily due to higher sales-commissions ex-India. The increase in sales and marketing expenses on a year-over-year basis was due to increased marketing, advertising and business development expenses as well as increased sales expenses in the Asia Pacific region, with the minimal expansion of our staff in line with the aggressive and growingly successful rollout of our polished diamond sales supporting (the Sarine ProfileTM) offerings.
General and administrative expenses
General and administrative expenses for Q2 2017 increased to US$ 1.5 million as compared to US$ 1.4 million in Q1 2017, and as compared to US$ 1.3 million in Q2 2016. General and administrative expenses for H1 2017 increased to US$ 2.8 million as compared to US$ 2.4 million in H1 2016. The increases in general and administrative expenses on a sequential and year-over-year bases were primarily due to higher third-party professional fees, mainly related to IP protection (primarily, but not solely, in India;(see Section 10).
Profit from operations
Profit from operations for Q2 2017 increased to US$ 4.2 million as compared to US$ 3.2 million in Q1 2017, but decreased as compared to US$ 6.7 million in Q2 2016. Profit from operations for H1 2017 decreased to US$ 7.3 million as compared to US$ 10.4 million in H1 2016. The sequential increase in profit from operations was due to higher revenues, offset somewhat by increased operating expenses. The decrease in profit from operations on a year-over-year basis was primarily due to lower sales volume and higher operating expenses, all as detailed above.
Net finance (expense) income
Net finance income for Q2 2017 was US$ 72,000 as compared to an expense of US$ 19,000 in Ql 2017, and income of US$ 208,000 in Q2 2016. Net finance income for H1 2017 was US$ 53,000 as compared to US$ 354,000 in H1 2016. The decline in net finance income on a year-over-year basis was primarily due to lower exchange rate income associated with NIS account balances.
Income tax expense
The Group recorded an income tax expense of US$ 1.0 million for Q2 2017 as compared to an expense of US$ 0.7 million for Q1 2017 and an expense of US$ 0.9 million in Q2 2016. The Group recorded an income tax expense of US$ l.7 million for H1 2017 as compared to an expense of US$ l.8 million for H1 2016. The quarterly increase in income tax expense on a sequential and year-over-year bases was primarily due to a US$ OJ million revaluation in deferred tax assets in accordance with official formalisation ofIsrael tax guidelines related to export oriented companies. The semi-annual decrease in tax expenses was primarily due to lower pre-tax profitability, as discussed above.
Profit for the period
Net profit for Q2 2017 increased to US$ 3.2 million as compared to US$ 2.5 million in Q1 2017 and decreased as compared to US$ 6.0 million in Q2 2016. Net profit for H1 2017 decreased to US$ 5.7 million as compared to US$ 9.0 million in H1 2016. The increase in net profit on a sequential basis was primarily due to higher revenues, offset somewhat by increased operating expenses. The decrease in net profit on a year-over-yearbasis was primarily due to lower sales and higher operating expenses, as detailed above.
We expect the following industry trends to continue influencing our business:
- Fundamental global economic indicators continue to be overall positive, though geopolitical uncertainties
in North Korea, Syria and Europe (Brexit) persist.
- In alI significant retail diamond markets, save for the domestic market in India, end consumer demand
remains robust. In the second most important market, China, general and retailer-specific indicators
continue to show consumer demand for luxury items, in general, and diamond jewellery specifically,
expanding after a two plus year hiatus.
- De Beers' and other major producers' sales of rough diamonds in the second quarter of 2017 were lower
than in the first quarter, with prices showing minimal increase. The reduced quantities of the sights in the
second quarter were absorbed for the most part in the industry midstream, though not all of Alrosa's offered
goods in the second week of July were taken, as there are growing concerns amongst manufacturers of
overstocking and excessive rough pricing. The July sight was at the high end of our expectations, at a
reported $570M, with rough prices flat and all boxes being taken up. This relatively low quantity for a
July sight shows prudence both from producers and manufacturers, as midstream inventories of polished
stones have increased significantly, and polished stone prices have eroded commensurate with the
additional goods available for sale. Expectations are that inventory levels will come down as wholesale
holiday-season buying commences towards the end of the summer and into the fall.
- The trends noted above, no negative macroeconomics, continued consumer demand for polished diamonds
in almost all major markets and renewed demand in China, should lead to continued normal industry
activity in the second half of 2017, assuming polished inventory levels are, indeed, reduced by wholesale
- In Q2 2017 we delivered 16 inclusion mapping systems, comprising 6 MeteorTM systems, 3 SolarisTM
systems, 3 GalaxyTM systems, 3 GalaxyTM Ultra systems and a GalaxyTM XL system shipped to the
Botawana service centre. The unusual mix of systems delivered this quarter is indicative of the illicit
competition in the Indian market (see below) which is primarily affecting sales of our systems for smaller
stones, with which their patent/copyright infringing activities more directly compete. We expect these
illicit competitive conditions to prevail in Q3, in accordance with the timelines set by the High Court in
Ahmedabad for the upcoming court hearings, as discussed below. The Group had an installed base of 332
inclusion mapping systems as of30 June 2017. We note that Sarine's installed base of inclusion mapping
systems are currently processing record numbers of stones, with around 33,000 rough stones of all sizes
being processed daily (note that these numbers include stones processed by all installed machines, also
those bought on a one-time basis without ongoing usage fees).
- Sales programs utilising Sarine ProfileTM by retailers primarily in the Asia Pacific (APAC) region and
North America continue to expand. Programs with retailers in the U.S. are also gaining momentum, albeit
slower than those in the AP AC region due to various factors, as discussed in our past announcements (e.g.,
the average quality of stones sold, corporate culture, etc.). In the APAC region we have enjoyed continued
geographic expansion this quarter, including commencing services in Thailand with the Aurora Group, as
announced on 16 June 2017, and in South Korea with the Golden Dew retail chain. We have concluded
plans for launches with additional major chains in APAC (Hong Kong and China, primarily) with actual
in-store operations scheduled for the beginning of 2018, due to the scope and operational complexity of
the planned programs. Due to the continued successes in the AP AC region, we are doubling our sales staff,
with the addition of two additional sales persons in China. We continue to expect doubling the number of
stones scanned for the Sarine ProfileTM in 2017, as compared to those scanned in 2016, and, based on
previous experience, we expect the second half of the year to show a doubling of the revenues realised in
the first six months of 2017. However, due to the long lead-times we are seeing between the signing on to
the ProfileTM paradigm to the actual programs' launches (mostly due to operational complexities stemming
from their scope, as mentioned above), we lower our expectation of the ProfileTM's contribution to overall
Group sales to 3 - 4 % of revenues this year.
- Our new technologies for the automated, objective and consistent grading of a polished diamond's Clarity
and Colour grades remain on track for commercialisation in Q3 2017, with the formal launch scheduled for
mid-September. The technologies' ability to correctly match the average grading opinion of a reference
group of multiple human gemmologists and the actual polished stone's gemmological lab report, when
available, within a grade's accuracy, exceeds 97% for Clarity and 99% for Colour. These error rates of3%
and I % respectively are in comparison to the current error rates of manual grading, which we have found
to be in excess of 7% for Clarity and 3.5% for non-fluorescent Colour (Colour grading of fluorescent
diamonds is substantially worse), based on statistical analyses of the manual grading group (note: typically,
10% of Clarity grade results are contested). We expect to further improve both these error rates to less than
I %, as the self-teaching algorithms improve over time. These technologies address the US$SOO milJion
annual 4Cs grading market, which currently generates an estimated 7 milJion reports a year for stones
typically a fifth of a carat and up, at prices ranging from US$50 to US$IOO a carat. We believe that by
introducing a cost-effective, consistent and reliable automated solution, the addressable market can be
expanded down to polished diamonds of a tenth of a carat and up, effectively increasing the total
addressable market value by 50% to US$ 750 million annually. We wiII commercialise these technologies,
either in conjunction with our Sarine ProfileTM or independently, and charge on a per carat basis, as is the
- The AIlegroTM system's planning optimisation algorithms and shaping/polishing hardware are still
undergoing re-evaluation, as previously disclosed.
- As announced on 29 June 2017, we recently filed lawsuits for patent and copyright infringement against
Diyora & Bhanderi Corporation and a number of its related entities (hereinafter collectively, "D&B") in
Surat, India. The lawsuits claim that D&B have copied Sarine's patented GalaxyTM inclusion mapping
products for the internal scanning and inclusion mapping of rough diamonds, and are using pirated and
manipulated versions of Sarine's proprietary and copyrighted AdvisorTM software program for the
purposes of adapting the resultant imagery for use in rough diamond planning. In addition to Sarine's own
investigation into this matter prior to the filing of the lawsuits, and as mentioned in the above referenced
announcement, the High Court in Ahmedabad appointed commissioners to carry out on-site inspections
of the defendants' premises and activities and to report back to the courts with their findings. The
commissioners carried out these inspections, which lasted for close to 10 hours, and thereafter filed their
respective detailed reports with the court. We are now awaiting the hearing(s) wherein the courts will rule
on Sarine's requests for preliminary injunctive relief against the defendants based on those findings.
- Primarily, we claimed before the court in India, based on our extensive investigations, that:
- D&B are operating a rough diamond scanning operation that utilises the same technology and processes as Sarine's patented family of inclusion mapping systems and copyrighted AdvisorTM rough planning software program. Diamonds that were submitted by Sarine's investigators to D&B for scanning and analysis, and the digital reports provided by D&B with respect to those scans, as well as other subsequent tests performed on the stones, clearly show that the patented processes are being duplicated. Furthermore, expert analyses of the digital files containing the scanning reports demonstrate that the software being used by D&B to produce such files is an illegally modified version of Sarine's proprietary AdvisorTM program, which, we believe, could not have been done without illegally breaching our software.
- D&B, of course, are disputing the aforesaid stand taken by us. They claim that their systems do not infringe Sarine's patented and copyrighted technologies. Sarine is awaiting the release by the court of the commissioners' reports, at which time we wiIJ be able to relate more extensively to the exact evidence that was found during those inspections. It is expected that in addition to the evidence already available to us, the local commissioners' reports wiII substantiate our claims before the court and more clearly show what we already know and further suspect.
- Based upon information obtained through various sources, we understand that a substantial number of duplicated GalaxyTM systems are installed at D&B's facilities, along with multiple pirated and illegally manipulated copies of the AdvisorTM software program. It is, however, unclear how many of the installed systems are already operational or are simply warehoused for future use. Furthermore, we have indicative information that the duplicated machines operate with throughput significantly less than that of the GalaxyTM. Thus, the scope of the illicit operations is not, as yet, clear.
- In addition to the legal processes we have initiated and which continue vis-a-vis the appropriate courts in India, we have also addressed these Intellectual Property (rp) issues with various arms of the Israeli government, specifically, the Ministry of Economy and Industry and the Ministry of Science and Technology. These will be addressing these issues through the appropriate diplomatic channels. Furthermore, we are also involving international diamond industry organs and law-enforcement agencies to increase awareness of and help fight this and other IP infringements (e.g., see announcement of23 July 2017 on arrests in Israel of suspected would-be IP thieves). Lastly, we are leveraging our market position and the release of innovations to the planning process (Advisor™ 7.0) and other facets of the diamond manufacturing and wholesale/retail sales processes, to incentivise and reward our loyal customers.
We will focus our research and development initiatives on the following objectives:
- Polished diamond oriented systems:
We will continue to enhance our Sarine ProfileTM:
- Introduction of yet another imagery format in true 360 degrees, specifically designed to enhance the ability to showcase special modified cuts, which are more and more the mainstay of special retail branded programs. This function will allow the retailer and the consumer to interactively and engagingly examine the unique faceting of these unique shapes. It should be noted that for modified shapes, as well as for labgrown diamonds, the stone's quality of faceting and light performance characteristics (see bullet below) are becoming an integral part of the stone's grading, essentially on a par with the 4Cs.
- In order to support a growing trend of producers' wishing to brand their rough stones, we will enhance the Sarine Profile™ in order to effectively present the rough-topolish (aka "chain of custody") story. This will include the importation of the rough stone external imaging, inclusion mapping imaging and the AdvisorTM planning imagery into the Sarine ProfileTM. We will leverage our dominant market share in inclusion mapping and planning to seamlessly enable this integration.
- Enhancement of our support of jewellery pieces, in addition to loose polished diamonds. As retail businesses display set jewellery by far more often than loose stones, this will significantly broaden the appeal and applicability of Sarine ProfileTM.
- Enhancement of our support of retailers' generic marketing material, images, video, text, etc., on the overall chain, store and program levels, so as to present the retailer's positioning message more effectively.
- Continued development of special integrative processes, involving retailers, suppliers and Sarine for enhancing the Sarine LightTM grading results of unique modified shapes of polished diamonds. By teaching the AdvisorTM unique proprietary recipes for these stones' optimal polishing, we can improve polishing results significantly, thus enhancing these stones market appeal (especially in the AP AC region). Initial results on three programs, which have opted for this service, have shown tangible improvements in these stones' light performance grades, with a much higher proportion of Ultimate grades derived. In one case study, the proportion of Ultimate *** graded stones, which command a significant premium at the retail outlet, doubled from only 15% to 30%, and continuing work is aimed at pushing this percentage to fully half of production,
- Continuation of the refinement of the Clarity and Colour grading capabilities currently in testing, having evaluated 10,000 polished stones for Clarity and 5,000 for Colour. Complete our end-toend technological solution for the 4Cs grading for launch in Q3, as planned, including process management, data security, etc.
- Initial assessment of available technologies and possible enhancements to the solutions for the
authentication of a polished diamond being of natural source and untreated, especially as
applicable to the high-speed screening of very small polished diamonds (so called "melee").
- We will continue to enhance our Sarine ProfileTM:
- Manufacturing products:
- AdvisorTM - following our June release (announced 19 June 2017) of our newest and most-capableever AdvisorTM 7.0 rough planning software, with significant new value-added features, including light performance simulation and evaluation, we are continuing to enhance this industry-leading package with additional unique functionality. The next capability slated for release later this year is the support of a stress (tension) display and analysis package, which will enable planners to take into consideration physical complexities within the rough diamond, when planning its optimal cutting solutions.
- AxiomTM- We will release the third generation of our standard-setting AxiomTM system for the ultra-accurate (better than I 0 micron accuracy) measurement of a polished diamond's proportions. The new system will provide for unmatched accuracy in the measurement of all 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 simulations of these diamonds' light performance, hearts and arrows, and photo-realistic qualities, we will provide a far better means to show and tell their quality.