The Issue: De Beers' Multifaceted Strategy Shift

Faced with such challenges as new sources of competition and suspicion about conflict diamonds, Gareth Penny had to rethink the basics

A diamond may be forever, as De Beers' famous advertising slogan contends, but is the same true of a business model? That was the question facing Gareth Penny, managing director of De Beers, in the late 19'90s, when the famed diamond cartel found itself beset by a series of events that ultimately forced it to examine and then retool its business strategy.

Since the company was founded in 1888, De Beers followed a strategy of supply control. In addition to mining its own diamonds, it bought diamonds from other producers and had what it called the "central selling organization," controlling some 90% of the world's diamonds. Its tight control over such a vast amount of supply enabled De Beers to keep prices high for a commodity that is neither particularly scarce nor useful. If a competitor offered diamonds on the market outside of De Beers' central selling organization, De Beers would simply flood the market with similar stones, thus eliminating any pricing power the competitor might offer.

By the end of the 1990s, the business model of controlling supply and managing how much of its inventory went to market at any time was no longer effective: New sources of diamonds were discovered in sufficient quantity that they could be sold competitively outside of De Beers' central selling organization. Demand for diamonds was dropping at a time when demand for other luxury goods was increasing. Brand-conscious consumers viewed the stones as anonymous commodities, and the precious stones, long marketed as an emblem of eternal love, became tainted by the phrase "blood diamonds" and came to symbolize the ill-gotten gains of rogue governments.

Sparking Demand

Many of the challenges that De Beers was facing—including the drop in demand and the taint of "blood diamonds"—beset the diamond industry overall, according to Penny. But as the largest player by far in the diamond business, those challenges were magnified for De Beers.

"By the end of the 1990s, that [supply-management] business model no longer worked for us," says Penny. "It wasn't economically feasible, it was legally challenged, and it was just something that needed to change."

De Beers shifted its strategy from managing supply to driving demand. Under its "Supplier of Choice" program, De Beers had the goals of stimulating diamond demand by 5% per year; improving the efficiency and margins of all De Beers operations, from mining to sales; and leveraging the De Beers brand by offering De Beers-branded jewelry directly to consumers.

For Penny, removing the taint of "blood diamonds" or "conflict diamonds," which the U.N. Security Council defined in 2001 as "diamonds that originate from areas controlled by forces or factions opposed to legitimate and internationally recognized governments or in contravention of the decisions of the Security Council" was perhaps the greatest challenge facing the industry and De Beers. While the company was now focused on driving demand rather than managing supply, there was the realization that questions or suspicions about diamonds' origins would have an impact on demand.

Certified as Clean

The response, spearheaded by De Beers and done in concert with governments and NGOs, was the Kimberley Process, an international government certification program that requires that governments certify that shipments of rough diamonds are free from blood diamonds. More than 70 governments are now signatory members of the Kimberley Process.

"The net result has been that something like 99.8% of all diamonds around the world now flow through this certificated system and are monitored to ensure that the way in which the business is being conducted is totally auditable, totally ethical, and that there is no funding that is flowing through to undesirable organizations anywhere in the world," says Penny. "I think the Kimberley Process offers itself as a role model for other industries, not only in natural resources but in other areas of the economy as well."

Penny is keen to have De Beers itself serve as a role model for other businesses. "We are an extractive industry—we take diamonds out of the ground, but how do we add value beyond the mining process in the countries from where those diamonds come?" he asks.

One answer is the Diamond Trading Co. Botswana, a joint venture between the government of Botswana and De Beers. The diamond-sorting facility, which opened in spring 2008 and is billed as the world's largest and most advanced, helps to ensure that a portion of Botswana's most important natural resource stays in the country longer.

With the relocation of its diamond-sorting facilities from London to Botswana, De Beers is creating more than 3,000 jobs—10% of all those employed in the manufacturing sector in the country. And Penny says the company has been encouraging its partners to move facilities to Botswana, with the result that 16 factories have been set up. "We're encouraged by the impact that this kind of "in-sourcing" is having," says Penny. "[Adding value] places us in a position where we are aligned with the needs of the country and where we're the partner of choice for the government. We think that it adds to our competitive advantage."

In its strategy that focuses on creating demand rather than controlling supply, De Beers faces some risk as it competes with its customers

De Beers is the largest player in the rough-diamond world, controlling some 50% of world supplies. The company has been in the hands of the Oppenheimer family for more than 80 years, and during that time has created a reputation for tough enforcement of cooperation and refusal to lower list prices.

Great companies are marked by their ability to create strategic advantage and retain it over time. De Beers long operated as a cartel that managed to maintain high prices despite an actual lack of scarcity of diamonds, but then a series of events conspired to drive De Beers' economic profits down:

• In 1991, the Soviet Union (the world's second-largest diamond producer by value) collapsed. The disintegration of communism made it difficult for De Beers to protect the agreement that the region sell its output through the cartel. As a result, the volume of Soviet diamonds sold outside the cartel increased throughout the '90s.

• In 1996, Australia's Argyle mine became the first major producer to terminate its contract with De Beers.

• Several rich diamond deposits were discovered in the Northwest Territories of Canada. Only a small fraction of this output is sold through the cartel.

• Diamonds became tainted by the term "blood diamonds," meaning that money made from the mining and selling of diamonds in some African countries helped finance war and war crimes.

• A taste shift among consumers toward branded luxury goods. The diamond value chain has promoted diamonds as a category. While stones were distinguished by quality, they were essentially commoditized.

• Alternative distributors came into prominence.

• Weakness in the economies of consuming regions.

The results: De Beers controlled a shrinking share of output in a shrinking market. Also, the emergence of a market outside the cartel increased the bargaining power of other suppliers and increased De Beers' cost of goods and sales. As De Beers competed with more production and demand softened, inventory—and invested capital—grew.

The resulting problems for De Beers helped to demonstrate the inherent instability of a cartel and forced it to rethink its business strategy. De Beers implemented a multipronged response:

• It employed the "Supplier of Choice" strategy;

• It was a key player in putting together the Kimberley Process;

• It remained focused on mining joint ventures;

• It worked to leverage the De Beers brand, in party by selling De Beers jewelry;

• It helped create and then meet emerging demand in emerging markets.

Some of the results are still unclear. While De Beers clearly hates blood diamonds and has all the right intentions with the Kimberley Process, it's hard to know how well the process actually works. Also, the Kimberley Process has made the distribution of diamonds more expensive, so returns are lower. And in selling jewelry at De Beers retail stores, De Beers is now competing with its customers—those stores that buy rough stones from De Beers.

It is the company's intention to benefit the countries in which it mines, as is seen by it corporate social responsibility projects, and the strategy of moving its sorting operations from London to Botswana, creating a downstream economic benefit for the country. But De Beers has to be careful not to allow such benefits to escalate costs too much.

Among the advantages that De Beers still has:

Access to capital, largely from close ties with governments and private investors;

Close ties with governments. These often result in regulations that favor De Beers—for example, determining who may transact in the sale of rough stones, tariffs affecting diamond transactions, how much output is mined out of government owned mines;

Expertise at managing downstream players, creating demand for diamonds, and in sorting and classifying diamonds.

Information about mining operations, inventories, sales, and demand for diamonds.

And there are various areas in which De Beers might find reprieve:

• It might improve the efficiency of its mining operation;

• Perhaps De Beers could earn excess returns by owning more of the high-end output—which could explain why De Beers is buying up mines. De Beers could leverage ownership of a high fraction of high-end output into control a broader market. That is, De Beers could bundle medium-quality stones with its high end stones.

• De Beers could parlay its formidable brand name into a great margin on each sale by convincing end customers they want a De Beers diamond (or any good bearing the De Beers brand) and all that goes with it ("blood-free", premium image , quality assurance, proprietary designs). This will require new skills and new partnerships.

However, it's very difficult to predict whether De Beers will retain sufficient bargaining power. The Supplier of Choice strategy entails many more additional costs in the diamond value chain—the costs of all the additional activities required to establish world-class brands are nontrivial, indeed.

Ultimately, De Beers becomes a diamond vertical (operating from exploration, to mining, to retail) and competes with a series of sight holders (say 50 globally) who may be as vertical or at least operate from cutting through retail. This is how De Beers is competing: selling firm X rough stones and then also competing with firm X in the market for retail jewelry. Any sight holder who is able to establish a powerful retail brand now has power in the jewelry market. And potent global brands potentially diminish De Beers' power both in rough sales and in retail sales.

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