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27 September 2011

Predicts Global Synthetic Gem-Quality Diamond Market to be 7% of Total Polished Diamond Demand by 2015

The principals of synthetic diamond producer Apollo Diamond, scientist Robert Linares and his (ex-Wall Street banker) son Bryant Linares, have always maintained an air of mystery and secrecy around themselves and their venture. The first time I had the privilege of visiting their production facilities - in a hangar-type of building in the woods in the outskirts of Boston, Mass. - it had been preceded by a discussion about whether I should be blind-folded so that I wouldn't know exactly where the facilities were. I also needed to promise never to disclose how many production units I actually saw - and was kept a few meters away from the machines lest I would recognize some of their remarkable technological wonders. 

Apollo Diamond became the subject of cover stories in Newsweek and Wired Magazine well before the "cultured diamond" product actually succeeded in creating a serious presence in the diamond pipeline. Actually, it never did - at least not in a visible way.

A Puzzling Story

Now the baffling saga continues. Get used to a new name: Scio Diamond Technology Corporation. Scio is a Nevada Corporation that has just completed the purchase of all of Apollo's diamond-growing machines and Apollo's intellectual property. The puzzling aspect of this story is the price: there must be something behind it all...

According to the Asset Purchase Agreement, Scio bought the business for merely $2 million - to be precise: a cash payment of $1,000,000 and a $1,000,000 promissory note bearing interest at 4.00% annually and due and owing in full on September 1, 2012. Don't get the wrong idea: the re-born Apollo, now a publicly listed company through Scio, has a market capitalization of $58.5 million - and its share price has risen from $2.10 to $2.70 just in two-three days.  [See article below directly following this editorial: "From Dental Work to Scio - A 10-Year Journey."]

The Apollo website - through which one could buy some Apollo cultured diamond jewelry - is no more. Scio is in the process of moving the production facilities to Greenville, South Carolina. It plans to sell polished diamonds - thus, it is partnering with diamond manufacturers that already have considerable synthetic cutting and polishing experience. We conjecture that this task will primarily fall on a publicly listed Indian diamond company, which also operates from Dubai and Singapore.

This hasn't been confirmed yet. But Diamond Intelligence Briefs was able to obtain most details around the transaction and Scio business plans: its four-year projection calls for the production of 2,300 polished carats in the first year, gradually rising to 26,500 carats in its fourth year of operation.

Cultured Diamonds: Volume and Prices

In terms of rough diamond production, Scio's objective for its first year of operations is "to produce and deliver 860 rough diamond carats within twelve months of completion of the initial financing, yielding approximately 160 carats of polished white (D-I color) and 100 polished pink cultured diamonds for total sales of approximately $980,000." In its second full year of operation Scio's "sales goals are to produce and deliver 7,500 rough cultured diamond carats, yielding approximately 2,300 polished carats of white and pink cultured diamond gemstones for total sales of $9,000,000."

These figures are quite puzzling. The company expects to get $6,000,000 from retail sales and $3,000,000 from sales to the wholesale business - probably a 50-50 percent breakdown in terms of carats. This suggests, however, an average sales price of $3,900 per carat (in polished wholesale and retail sales combined), and a probable average of $2,700 p/c (in polished wholesale sales) to $5,200 p/c (in retail sales). Is that realistic?

On what pricing assumptions are these sales revenues based? According to Scio, experience has shown that white cultured diamond gemstones using the Apollo technology have been sold at price points between 10-30 percent lower than published prices for comparable mined diamonds.

"These price points are consistent with the findings of customer surveys wherein respondents indicated, among other things, that a 10-15% discount of near- colorless cultured diamonds (G-I) and a 25% discount of colorless cultured diamonds (D-F) would likely be necessary to match or exceed sales of equal quality mined diamonds," states Scio.

"However," says the company, "as borne out by the more recent consumer surveys, Scio anticipates it will eventually - perhaps sooner than later - offer cultured diamonds at price parity, if not at a premium to mined diamonds in some product categories." Pink stones, however, when marketed, will sell at substantial discounts to comparable natural stones.

Production Ranges

According to Scio, it has the demonstrated ability to produce single-crystal diamond gemstones of colorless, near-colorless and fancy- colored clarities in finished stones generally ranging in sizes from .25 carats to over 2 carats in colors ranging from D (colorless) to fancy colors and clarities of IF (internally flawless) to SI (slightly included). It will offer colorless and near colorless (collectively "white") cultured diamonds of D-H color and IF-SI clarities as well as fancy-color diamonds including high-quality pink, cognac and blue cultured diamonds.

Initially, Scio plans on delivering high-quality cultured diamond gemstones in the most concentrated categories (< 1.0 carat) of the diamond business. As the technology continues to progress, it anticipates that it will attain recurrent and renewable production of large (> 1.0 carat), high-quality cultured diamond gemstones.

The CVD technology produces small wafers in various forms. It has always been Diamond Intelligence Briefs' own understanding that a typical CVD-produced square form of a rough diamond wafer would produce 65 percent large stones and 35 percent smaller stones when measured in the resultant polished carat output.

However, if one counts by the number of stones, the ratio of large to small would probably be 1 to 3. Though Scio doesn't provide these kinds of details, we have reasons to assume that technologically it is not unreasonable to expect that - based on carats - some two-thirds of Scio's total output will be in goods in excess of 1 carat. Moneywise, it will therefore compete in a very small - but value-wise the highest - niche in the value chain.

Restructuring and Going Public

Nothing in the deal gives us the impression of an "arm's length" transaction - because if it was then prima facie it wouldn't make sense. It is basically a restructuring of Apollo, turning the company into a (debt-free?) Wall Street-listed technology company that will raise money through equity financing rather than taking on debts.

Apollo's diamond technology (i.e. the assets which were sold for merely $2 million) was developed over a ten-year period at a cost of approximately $40 million. Apollo had failed to penetrate the markets. According to Scio, "the Apollo Companies achieved [total] revenue of approximately $4.5 million through test market sales of cultured diamond gemstones, blades for diamond laser scalpels and research and development stage sales for diamond windows for advanced optics, and development of experimental high power devices."

Whether Apollo's lack of meaningful revenues point to a marketing failure or are due to technological challenges, we'll probably never know. However, Scio, in its first year of full production, envisions revenues of $9.1 million - that is double all the revenues ever earned by Apollo. This would suggest that the technology is certainly ready for a marketing take-off. Scio told its own shareholders that "the restructuring of Apollo was necessitated in large part by the financial crisis that began in late 2008, which adversely impacted the ability to secure needed financing and thereby execute strategic objectives."

In any event, the $2 million price tag to purchase the technology looks too low. If, indeed, $40 million was spent to develop that technology, one wonders whether these funds were loans to the Apollo companies. Nowhere in the purchase agreement (as far as we know) is there any mention of royalty payments to Apollo - hence there will be no cash flows there back to Apollo.

I assume that the Linares families hold - directly or indirectly - the lion's share of Scio.

According to Scio, "the core platform of intellectual property and diamond-growing capabilities will allow Scio Diamond to become a leading supplier of cultured diamond gemstones and subsequently CVD diamond substrates for high-tech applications leveraging the unprecedented electronic material capabilities of diamond." This spells it out: the non-gem diamond part of Apollo, the other industrial applications, etc., are part and parcel of the transaction. Scio will become more like Element Six of De Beers: a developer of a wide range of CVD-based products.

Scio People: Not From Diamonds

The principal shareholders - or, should I say, the "visible shareholders" - of Scio are two brilliant lawyer entrepreneurs and academicians: Edward S. Adams and Michael R. Monehan. Adams is the Chairman of Scio Diamonds. Adams and Monahan are partners in Adams Monahan, LLP., based in Minneapolis, Minesota. [For bios of both Adams and Monehan, see DIB 677: https://www.diamondintelligence.com/magazine/magazine.aspx?id=9880]

Adams Monahan (AM) is, according to its website, "a strategic agent for its clients - forming and growing new enterprise, driving and coordinating finance efforts and recognizing and protecting intellectual property assets. ... Working with entrepreneurs and the finance community requires comfort with the certainty of rules and the uncertainty of new business. AM lawyers have deep experience in this environment, working collaboratively with clients, colleagues and the community to drive results." Clearly - their own business model suggests that they work for clients - might these be the Linares families without the burden of the Apollo companies?

Another name for the diamond industry to get used to is Joseph ("Joe") D. Lancia. If De Beers can bring in a new CEO from the railroad and transportation industries, there is no reason why Scio shouldn't bring in Lancia, the ex-president and CEO of D&W Fine Pack, a manufacturer of disposable packaging products for the food industry. In Lancia's previous job, within a seven years' time span, revenues increased from $48 million to $106 million, while reducing the number of employees by 10 percent.

Commenting this week on the task at hand, Lancia, who was also an investment banker in the past, points to Scio's wide range of core assets "that can be immediately commercialized and exposed to the wide-open demand for cultured diamonds in today's market. I will look to drive revenue growth in existing market opportunities, and build commercial success by leveraging our equipment and patented technology into a range of new service areas and markets worldwide."

Familiar Faces

But then, the "old team" comes in again. Apparently, Lancia has already identified four ex-Apollo employees to join Scio. According to its business plan, Scio will initially have four employees and one or more part-time consultants. In the second year, it is anticipated that the company will employ up to ten full-time employees.

Apollo's Vice President, Patrick J. Doering, who was co-inventor of the technology, will serve as the Chief Technology Officer for Scio Diamonds. Moreover, Apollo founder and co-inventor of the technology Dr. Robert C. Linares will serve as a technology consultant.  This new company very much seems like Apollo - just under a different name and different umbrella.

The Business Plan: First Raising Money...

Scio will initially focus production on cultured diamond gemstones.  Just as Apollo had done before, Scio seeks to begin sales of cultured diamonds direct to consumers through a proprietary website as well as through one or more retail distribution relationships by December 1, 2011.

Scio is presently in the process of raising at least $5,000,000 to acquire the Diamond Technology, i.e. to actually pay the $2 million, and to relocate the business to and commence operations in Greenville, South Carolina.  Production of cultured diamonds is expected to commence in South Carolina within four months of relocation. Scio's five-year operating plan and budget is predicated on financing of $10,000,000. [If only $5,000,000 is raised now, Scio will seek an additional $5,000,000 to $7,000,000 of financing in approximately six to twelve months.] 

Operations plans are to set up a 20,000-plus, square-foot manufacturing facility in the Greenville area. The facility will be sufficient for at least 15 additional diamond growers and related equipment beyond those diamond growers acquired from the Apollo Companies.

The company has NOT disclosed how many growers were actually acquired from Apollo. As part of the initial plans, Scio needs to establish "an international marketing and distribution network for its cultured diamond gemstones."

The Future of Cultured Diamonds: $2 Billion by 2015

Scio claims that it will develop an additional market niche and that it is not going to compete with the demand for natural ("mined") diamonds. It also sees its product as a natural substitute to make up for the expected shortfall in natural diamond supply.

Scio tells its stakeholders that in contrast to the current supply-driven market model (owing to the quality vagaries of diamond mining), it will develop a demand-driven business model within the global $70 billion annual diamond-jewelry retail market.

It intends to address what Scio believes will initially be a $1.0 billion market and potentially a $10 billion market as acceptance of laboratory-created diamonds grows over time. Scio believes that the "cultured  market will be incremental to the existing market for earth mined gemstones, providing a gap in the supply shortfall as well as a quality equivalent and socially responsible alternative to mined diamond. As such, Scio Diamonds will not need to take market share from naturally occurring diamonds in order to realize market success."

Hiding the Nomenclature Challenge: Synthetics versus Cultured

Nowhere in all the stakeholder materials that Diamond Intelligence Briefs reviewed was there any reference to the nomenclature issue, specifically the Federal Trade Commission's (FTC) rules prohibiting the use of the words "cultured diamonds." As Scio's marketing targets the domestic U.S. consumer market as its principal sales destination, the FTC rules, which state that synthetic diamonds may only be described as synthetic, laboratory-grown, laboratory-created and [manufacturer-name]-created, are of great relevancy.

In a July 2008 decision, the FTC did not allow the use of the term "cultured," but agreed that the term might be used in advertising if the total context of the ad clearly indicates that the diamond is synthetic. It is therefore that the FTC decision concluded that the Commission staff will continue to evaluate advertising for "cultured diamonds" on a case-by-case basis "and recommend enforcement action when appropriate."

Scio did inform its shareholders that "laboratory technology activities are subject to various federal, state, foreign and local laws and regulations, which govern research, lab development, taxes, labor standards, occupational health, waste disposal, protection of the environment, mine safety, hazardous substances and several other matters." It did not make any reference to marketing and marketing nomenclature issues.

Consumers hold a distinctly different perception of "cultured diamonds" versus "synthetic diamonds." Let's face it: synthetic is not a consumer-friendly term.

"We believe," says Scio, "that we are in compliance in all material respects with applicable technology, health, safety and environmental statutes and the regulations promulgated by the State of California and the United States Federal Government."

Questions that we posed to the company were not yet answered at our press time, but Scio will become an ongoing story and there is always a next publication. The lack of disclosure of the existence of the FTC rules seems an omission that Scio needs to address at some point- before it actually gets into the market.


From Dental Work to Scio - A 10-Year Journey

The key to understanding 10 years of Apollo strategy may well be Edward Adams. In the year 2001, Adams became a director and shareholder in a company called Dental Resources Inc. It was a listed company that was actually looking to sell itself to other companies seeking a fast track to become a publicly listed company.

Apollo Diamond's efforts to go public started in 2001 when it entered into a quite similar agreement with Dental Resources to become a public company. The process was as follows: the family of Robert and Bryant Linares would acquire the shares in Dental Resources and then Dental Resources would go public.  So the price tag of the deal at that time was $500,000. The letter of intent was signed on June 26, 2001. Actually, all of the documents are hundreds of pages; it was a very elaborate scheme.

Then the 9/11 tragedy happened, and the international financial markets were in turmoil. On November 24, 2001, the dream of the Linares family to go public fell through. The contemplated transaction was cancelled. The only thing that remained permanent was Edward Adams. He remained the director of the shell company, which was involved in all kinds of other deals, including the development of casinos and leisure resorts. Until we reached 2004 [see box: Déjà vu].

In 2004 again, a merger agreement was made with the same company that, in the meantime, had changed its name to DTLL Inc. Different name, same entity. A letter of intent was signed, lawyers got into the act, only for it all to be cancelled five months later. No agreement was reached.

The continued focus of Apollo management on going public, in gaining access to having the company developed through raising equity, and seeing the value of their part of the holdings appreciate over time makes sense. It is a totally valid business strategy.  It explains many things. It mostly explains why creating a high media profile and name recognition was more important than marketing cultured diamonds.

The almost universal name recognition of Apollo was out of any proportion to its sales efforts and actually to its available production. As we mentioned in the previous article, they appeared in places like Newsweek and Wired Magazine and created a tremendously high media profile without being in the market. At some point, they didn't even have a marketing manager. With the benefit of hindsight, it seems they were not aiming at the diamond industry but at the investment community. They were aiming at that community for well over a decade.  

So now a deal similar to the 2001 and 2004 deals is on the table. The structure is in place. The risk that the family is taking is low because they secured their part of shares on July 31, 2011, in an asset purchase agreement with Krossbow Holding. So, when Krossbow Holding became Scio, the family was already in there.

The bottom line of this deal is that the decade-year-old dream of the family to go public has now been realized on the third try (at least as far as we know).Whether the public will buy the shares is something that is as uncertain as it was a decade ago.