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Russian diamond manufacturing - Escape from the past

01 october 2018

The Russian diamond cutting industry used to produce and is still producing impeccable samples of its business. Created in the first half of the 1960s by order of Soviet Prime Minister Alexey Kosygin, the diamond manufacturing industry - the future network of Kristall factories - was to solve the problem of using diamonds in consumer goods, which seemed to be a bourgeois relic a short time ago. Diamonds and jewelry were not on the list of priority needs of the Soviet man and were mainly exported in order to increase the country’s foreign exchange earnings. From the very first days of its existence, the brand of domestic diamond manufacturing symbolized the highest standards of quality. In many ways this was due to the peculiarities of the production process. Soviet diamond cutters, unlike their counterparts in other countries, were limited not by the yield ratio, but by the precise execution of a technical assignment, i.e. by the quality of cutting and polishing. Diamond cutters tried to provide ideal shapes for diamonds, often without regard for losses, which seemed inconceivable to their counterparts in Israel or Belgium.

However, the cost of diamonds sold made it impossible to compensate for losses in the industry caused by the unwillingness to use rough diamonds in a most efficient way. The costly economics of diamond manufacturing was based on an opinion that the country’s resources of high-quality rough were inexhaustible. As some experts said, diamonds were fed into the manufacturing flow, which resembled a "black hole". Long before 1991, domestic diamond cutting enterprises were unprofitable and subsidized. The fact that some of them have survived to this day is connected with local reasons and circumstances more than with the economic laws, which were merciless to many Israeli, Belgian, and earlier, American competitors. The high costs of labor and equipment did not contribute to their victory in natural selection, which was outright harsh to this segment of the "diamond pipeline" due to uneven distribution of margins in favor of mining and retail companies.

According to Bain, the profit margin in the diamond manufacturing segment dropped below 1-2% in 2017, while even in better times it did not exceed 5%, which is much lower than 27-28% in diamond mining and 9-11% in large-scale retail. Actually, polished prices do not follow the upward trend displayed by prices for rough, which is widely used in speculative trading, and diamond manufacturers lose their margins when it comes to sales due to the long processing cycle. Russian diamond manufacturers, unlike their less choosy Indian colleagues, are competitive in cutting relatively large diamonds - from 2 grainers upwards. The share of such rough in the production footprint of ALROSA stays flat at best and even goes down under the influence of low-grade diamond deposits being put into operation or due to the depletion or inactivity of rich diamond pipes (including Mir). Diamond manufacturing in Russia is rapidly declining - according to Smolensk-based Kristall, it decreased fivefold over the past ten years. Now Russia, one of the largest diamond-mining countries, is producing only 700,000 carats of polished diamonds.

Up to a certain point, the terms for Russian diamond cutters were more profitable than for their colleagues in diamond manufacturing companies outside Russia, thus causing their envy. They could receive larger diamonds of high colors and quality from ALROSA in the so-called ‘selected’ lots. It is highly profitable to produce polished goods from such stones even with Russian costs, which are mostly due to high wages (compared to India). Often, it was possible to have even greater premium by re-selling rough diamonds. Diamond manufacturers in Russia were often provoked to re-sell rough on a large scale – causing reasonable discontent of ALROSA – by the VAT levied on diamond sales inside the country. For some time, the diamond manufacturing industry enjoyed a hothouse environment due to its access to high-quality rough and resale operations. The practice of ‘selected’ diamond lots was ended in the 2010s dealing a significant blow to the Russian diamond manufacturing industry. However, another important privilege - the 6.5% export duty on diamonds - remained intact until September 2016.

Thanks to this export duty, the cost of rough from ALROSA for companies based in Russia was lower than for foreign companies, which allowed local businesses to be competitive in processing certain categories of rough diamonds. The cancellation of this export duty made the terms of trade equal and prices for Russia-based customers immediately went up by 6.5% (Kristall reported that in some cases the growth was 8-10%). In reality, these terms can even be unequal, because the cost of rough diamonds for Russian customers comprises the 18% of VAT. While exporting polished goods, diamond manufacturers receive their VAT refunds, but because of the long cycle of diamond manufacturing and delays in processing tax documents companies need to increase their working capital by the same 18%, attracting money from banks, which ultimately results in higher production costs.

Responding to the concerns of its Russian customers, ALROSA increased the amount of their payments for the purchased goods, which can be delayed, from 50% to 75% of the contract value in the course of six months. The domestic market received additional quotas for diamond assortments most effective in terms of processing. A source familiar with the situation admits that it was not easy for ALROSA to embrace this measure, because the company can sell large-size and colored diamonds bringing high returns after processing through tenders and auctions to gain additional premiums. In return, ALROSA obliged local buyers to cut not less than 50% of the purchased rough in Russia.

The government joined the efforts to rescue the domestic manufacturing industry - especially since even before the cancellation of the export duty, in mid-2014, Deputy Prime Minister Yury Trutnev, who oversees ALROSA, set the task to increase the added value of diamonds by processing them inside the country. The very idea of ​​increasing the added value of diamonds by way of subsidies to the diamond cutting sector going through a protracted crisis was debatable; rather, it looked like an operation to rescue the diamond manufacturing industry at the expense of ALROSA, which caused fierce resistance from the then president of the company, Fyodor Andreev, later forced to resign. Strategically, it is really disadvantageous for ALROSA if the diamond cutting sector will be weakened, as it is the major buyer of rough. But from the immediate perspective, the Russian diamond cutting industry is not a priority in this sense, since it accounts for no more than 10% of sales of the Russian diamond monopoly.

After the abandonment of several unviable projects, such as the establishment of a Territory of Priority Development (TPD) in Yakutia, which is outstanding by its high costs due to climatic conditions even among other Russian provinces, the optimal option was to create a diamond cutting cluster in Vladivostok. This is to be a zone of preferential tax and customs regulations, the residents of which receive additional quotas of rough diamonds from ALROSA for opening on-site processing facilities. The zone is oriented to foreign participants of the market, which is logical. After all, supporting the existing inefficient enterprises is not the only way to develop diamond processing within the country.

The purely Russian representatives in the diamond cutting industry include Smolensk-based Kristall, Yakutia-based EPL Diamond and Diamonds ALROSA (the Kristall network of factories located in Barnaul and Moscow). They all survive in different ways. Diamonds ALROSA is helped by the fact that, being a branch of ALROSA, they do not have to pay for rough. Small-size diamonds are being cut by ALROSA at the Barnaul factory, while in Moscow, where wages are much higher, the company is cutting and polishing only large and colored stones. The finished goods are exhibited and sold within diamond collections to produce a marketing impression. The sale of polished diamonds from the collections is accounted for in the financial results of Diamonds ALROSA, and the associated marketing costs are borne by the parent company.

EPL Diamond has diversified into jewelry retail and created a chain of stores throughout Russia with the support of the Yakutia authorities. Unlike Kristall, which is specializing in cutting and polishing diamonds from 1 carat and above in line with the Triple Excellent quality standard and keeping up with the novelties of the Italian style collections, EPL Diamond also offers polished goods affordable for a wide range of consumers, which allowed this company to become the most recognizable Russian brand. The fact that some diamonds of 0.1 carat and smaller in the EPL online store do not contain annotations to prove these are “Yakut diamonds" (unlike the larger ones sold under the general advertising slogan and the concept of pure "Yakut diamonds"), may be noted only by most sophisticated buyers.

Diamonds ALROSA’s sales are comparable with those of Kristall (about $ 100 million), but the company’s staff is more than 3 times smaller (550 people against 1800 people at Kristall). EPL Diamond produces $80 million worth of diamonds and employs about 300 people at its jewelry and diamond cutting factories. “Kristall has a professional team and excellent equipment adapted to their needs. Diamond cutters and polishers are some of the best. This is an old school, in the best sense of this concept. But the building and premises they occupy, their social functions, the museum and the veterans – all this is too much [in terms of costs]. The efficiency per one person of personnel and one unit of area at Kristall is very low. The Indians do not live like that. And even for the Indians diamond cutting is often just one of the activities that depends on the donor business," says a source familiar with the business of Kristall.

A few other small domestic companies belong to state-owned Almazyuvelirexport, through which 5% of diamonds produced in the country are sold for control purposes. The remaining stakeholders of the domestic market are the subsidiaries of Indian companies established in the Russian jurisdiction as an additional channel for access to rough. S. D. Daimond and DDK are Russia-based branches of KGK Group, while Aives is a daughter company of Excel Overseas.

After the cancellation of the export duty in Russia, it would be logical for Indian companies to think about transferring diamond manufacturing operations to Vladivostok. Nevertheless, two years after the discovery of the Vladivostok diamond cluster, the latter has only one resident - KGK. Investors are stopped by the necessity to cut the entire number of allocated quotas in Vladivostok, where it will take a lot of time and effort to create the necessary skill and knowledge, admits one of the organizers of the Vladivostok Diamond Center. "The requirement to process all the allocated rough on this site is not feasible in principle, as diamond lots you get are not entirely suitable for processing. At some point, Vladivostok attracted great interest, but later it turned out that there was no mechanism for implementing the promised benefits. Some were trying to get these benefits, but faced an insurmountable document flow," he says.

One of the industry veterans, Ruiz Diamonds, which used to supply diamonds to the Moscow Jewelry Factory (both owned by Lev Leviev), wound up its business shortly after the abolition of the export duty on diamonds. It is noteworthy that Israel-based LLD Diamonds remained on ALROSA's long-term client list, while Russia-based Ruiz did not wait for the VAT cancellation announced by the Ministry of Finance as a key measure in the ministry's "road map" to support the diamond cutting industry. The VAT cancellation process took quite a long time. The Ministry of Finance planned to submit the bill on cancellation in April-May 2018 and this mechanism can start operating no earlier than the fourth quarter, taking into account the quarterly VAT payment period. Additional complications for companies exporting their goods (primarily, for Kristall) arose due to the strengthening of the ruble in 2017.

In 2017, Kristall registered a loss on sales for the first time in at least 5 years (1.356 billion rubles against 420 million rubles a year earlier). The proceeds of the Smolensk enterprise decreased by 22%, to 9.22 billion rubles, its net loss increased from 208 million to 1.92 billion rubles. ALROSA was called to save Kristall. It is noteworthy that at that time even Deputy Prime Minister Yury Trutnev admitted the inexpediency of buying Kristall, but the new management of the company judged otherwise. ALROSA sees a synergy with Kristall “in terms of optimizing the assortment of rough and in diamond manufacturing costs. If Kristall joins ALROSA, our financial condition will allow us to optimize all the flows and see how to properly arrange the work... There is no task to simply assume obligations and losses... We naturally expect that this business [diamond cutting] can bring a small margin. In the world of diamond manufacturing the margin is very small, and to make a small margin in Russia one needs to make sufficiently great efforts,” Sergey Ivanov, CEO of ALROSA commented on the future deal. If you carefully read this quote, you can find anything except the main thing: explaining the reasons why such a transaction would be economically profitable in the current or medium term.

Before the issue of acquiring Kristall started to face ALROSA with all its implacability, the company analyzed what measures could be taken to improve the situation (and in particular to prevent this acquisition). A participant of this debate recalls that when discussing the prospects for the promotion of the Russian Cut brand, it was suggested that the quality standard set out in Soviet times was superfluous. "The cost of obtaining a diamond of excessive quality is unjustified. The stone becomes excessively good and it can only be appreciated by a very narrow client group. For unique stones - large, having high color and quality grades, such efforts are needed. But for the regular flow of diamonds having medium quality in terms of inclusions and color - probably not," says the source.

So, is it really necessary to have a diamond manufacturing industry in Russia in the existing form? For a long time, this sector, due to historical, social and other circumstances, enjoyed hothouse conditions. As soon as the regime became ordinary, the ship began to sink. Government support is also used by Indian diamond manufacturers, but this is by no means the only factor that ensures their survival and dominance. The mantra of Maxim Shkadov, CEO of Kristall about the need to maintain domestic diamond manufacturing in order to avoid excessive strengthening of India's position, which will soon be able to dictate its terms to diamond miners, looks convincing only at first glance. Firstly, the Indian industry is too fragmented and does not have unlimited cheap credit in order to be dangerous from the point of view of low-balling. Secondly, and this is the main point, the domestic diamond manufacturing even theoretically cannot be the backbone of ALROSA, as its role and importance on the market are much inferior to Indian diamond manufacturing.

And nevertheless, we are close to a positive answer to the question of the expediency of preserving the diamond manufacturing in Russia. Maybe not on such a scale and in such a form - as Sergey Ivanov pointed out speaking about the possibility to optimize part of Kristall’s operations. It's not just that a direct probe in the midstream allows for better understanding of pricing in the rough and polished markets.

ALROSA and other producers are basically satisfied with the current state of affairs, in which Indian diamond manufacturing dominates the low- and medium price segments. But if the state support in India is lost or weakened, the other diamond manufacturers will not cope with the bulk of rough in need of processing. The diamond cutting business will become prohibitively expensive having won some part of margins in the "diamond pipeline" from diamond miners. The resulting problem of personnel shortage in this case will have to be solved by someone. And, probably, it is better if it is solved by a stable and easily transformable division of a mining company and not by a diamond manufacture in the state of permanent financial crisis, which lives by the patterns of the past.

Our task does not include a detailed expert analysis of the financial condition of Russian diamond manufacturers - balance sheet data may not reflect the real financial flows. The profit accumulating centers of Russia-based subsidiaries owned by foreign diamantaires are probably outside the jurisdiction of the Russian Federation and the performance data of Russia-based limited liability companies are not so indicative in this sense. But the data on the companies conducting their main activity on the territory of Russia (like Kristall) with certain reservations can be considered quite eloquent.

Igor Leikin for Rough&Plished


SUPPLEMENT

Financial results of Russia-based diamond manufacturing companies-participants of ALROSA Alliance in 2017, thousand rubles

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* Unconsolidated balance sheet data. Kristall did not publish IFRS Report for 2017.
** Controlled by one parent company - Cyprus Hammarby Limited.
*** Former Barnaul-based Kristall.