Can This Share Build Upon Its Market-Beating 900% Gains?

If you’d like to meet a market-beater, you probably would not stray too far-off with Sarine Technologies Ltd (SGX: U77).

Since its listing in April 2005, the Israel-based diamond-cutting equipment and technology provider has increased by close to 900% (893% to be precise!) in price. Meanwhile, Singapore’s market barometer, the Straits Times Index (SGX: ^STI), is up a relatively measly 48% to its current level of 3,227 points.

What’s next?

But, that is then and this is now. How can we tell if Sarine would continue to post such impressive share price growth in the future? A large part of the answer to the question resides in Sarine’s valuation.

Sarine Technologies PE ratio

Source: S&P Capital IQ

At Sarine’s current price of S$2.90, it carries a trailing PE ratio of 31, which is considerably higher than its average PE of just 9 going back all the way to April 2005. Sarine’s valuation also does not compare favourably with the SPDR STI ETF‘s  (SGX: ES3) PE of around 13. The SPDR STI ETF is an exchange-traded fund which mimics the Straits Times Index.

These valuation figures suggest that Sarine is actually pricey. But, we can’t get the full picture if we’re looking at Sarine’s PE ratio alone without considering the future of its business. As investor Ric Dillon puts it:

“On the behavioural-finance side, one of many inefficiencies comes from people anchoring on the past. People assume something is cheap, say, just because it hasn’t traded at such a low valuation for five or ten years. But that doesn’t matter, what matters is what will be [emphasis mine].”

So, it doesn’t matter if Sarine’s trailing PE ratio is near the highest it has ever been – the share might still be cheap if its corporate future warrants the optimism.

Expanding its frontiers

With Sarine, it’s interesting to note that the company has some powerful drivers for future growth. The company develops, manufactures, and sells precision technology products which help diamond manufacturers optimise and improve their processes when it comes to turning rough diamonds into polished gemstones.

For a large part of its history, Sarine’s customers were the diamond manufacturers and the company’s products were centred on that part of the entire diamond industry value chain. It also derived most of its revenue from one-off sales of its technology and equipment.

But, things started to change in 2009 with the introduction of the company’s Galaxy family of products and services.

The Galaxy suite of products helps diamond manufacturers evaluate and map inclusions (a type of clarity characteristic found within a diamond when the stone’s first formed in the earth) in rough diamonds more accurately, conveniently, and in a far shorter amount of time compared to traditional methods. The products are also charged on a per-use basis, giving rise to recurring revenue for Sarine.

Given that diamonds “without inclusions can be worth up to 10x more,” according to Sarine, the company’s Galaxy suite of products thus provides great value to diamond manufacturers. This has helped drive the adoption of Galaxy products amongst diamond manufacturers. Along the way, Sarine’s profit margins strengthened as recurring revenue from the Galaxy family of products provides higher margins.

Financial period Galaxy systems installed Recurring revenue as % of total revenue Gross margin
Year 2010 10% 64.3%
Year 2011 50 ~12.5% 66.2%
Year 2012 95 25% 68.1%
Year 2013 140 30% 71.5%
First half 2014 175 35% 71.7%

Source: Sarine Technologies’ filings

In addition to better technology and products for diamond manufacturers, Sarine has also recently started to make inroads into the retail and wholesale trading market within the diamond industry. This is a part of the industry’s value chain which Sarine has never had a presence before.

According to Sarine, the retail sales of diamond jewellery stood at US$74.5 billion in 2013. In contrast, rough diamond mining output, rough diamond sales, and rough diamond output, have a collective market value of ‘only’ US$52.3 billion. So, Sarine’s new ventures are indeed an area of promise should the company be able to capture even a fraction of the market value of diamond retail sales.

Sarine’s involvement in that part of the diamond industry value chain comes mainly in the form of its Sarine Light (it grades certain aesthetic parameters of diamonds) and Sarine Loupe (allows diamond traders to view a virtual image of a diamond as though they were seeing the stone in person) products.

Both products can add to Sarine’s recurring revenue base in the future with Sarine Light expected to provide “significant revenue contribution in 2015 and beyond.”

Foolish Bottom Line

There’s plenty of room for optimism when it comes to Sarine’s future given its growing profit margins and new market opportunities. But, there are also important risks to consider.

My colleague Sudhan had recently pointed to a potential rise in rough diamond prices, which can lead to a narrowing in the price gap between rough and polished stones.  This can affect the profit margins of diamond manufacturers, ultimately leading to lesser demand for Sarine’s technology and equipment.

On that note, my colleague Chin Hui Leong had also recently highlighted rough diamond supplier De Beers’ concern about a possible rise in rough diamond prices due to a dearth in supply.

Some other pertinent risks include the cyclicality of Sarine’s business. Diamonds are after all discretionary products and consumer demand is likely to be adversely affected in economic downturns. During the Great Financial Crisis of 2007-09, Sarine suffered with its revenue falling from US$37.1 million in 2007 to US$21.4 million in 2009. The company’s business model has since changed as mentioned above, so volatility might be dampened going forward. But, we can’t know for sure until a crisis hits again.

All told, investors would have to weigh the risks and rewards associated with Sarine in order to make an informed investing decision.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing owns shares in Sarine Technologies.