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Shareholders held hostage by the diamond market

07 october 2019

The prolonged decline in ALROSA shares, which have lost almost 30% since the beginning of the year, was a surprise for most investors. The shares of the diamond mining company, which had a reputation as a stable money earner, started to lead an unpleasant ‘hit parade’ by the end of summer among those investors, who were opening short positions, as they were no longer waiting for a recovery and were trying to make money on the correction sending the company’s equities into a steep dive. By mid-August, its shares fell to 70 rubles, which is only 8% higher than the price at which the Federal Property Management Agency held an SPO in July 2016 (65 rubles).

Perhaps this is not a convincing answer to the then skeptics of privatization - since then, the company has reimbursed its shareholders about 25% in the form of dividends, and the average share price over the past year is still close to 84 rubles. But this case is “a very good example of what can happen to cyclic companies during cycle reversals.”* “It is illustrative how unexpectedly and quickly a company that was a cash cow yesterday can turn out to have a zero (or even negative) free cash flow,“ Tremasov says.

ALROSA's revenue for the six months of 2019 fell by almost a quarter due to lower sales – diamond manufacturers decreased diamond purchases due to their excess inventories and tighter access to credit in India. Diamond miners had to adjust prices (right now, it is known that their correction reached at least 5% since the beginning of the year) and make concessions to sightholders in order to maintain their interest in the business. This situation is quite standard and is a consequence of high sales in 2017-18, but this year also brought new challenges. The trade wars negatively affect the sale of jewelry goods, while demand for luxury is falling in China and jewelry brands, primarily in the key US market, are actively going online, because of which they do not need to keep significant inventories of finished products.

Market conditions remain weak. By August, ALROSA's sales dynamics deteriorated for four consecutive months, reaching its lowest level in July, 2019 from December 2016. The company's official forecast is very cautious: “Given the seasonality of the market, there are prerequisites for the restoration of demand for rough diamonds closer to the end of Q3 2019 on the eve of the Christmas sales period 2019-2020." In the opinion of the vast majority of experts, the pressure on ALROSA shares will not subside until demand in the diamond market recovers. The company could support stock quotes by announcing a buyback, but this option is not considered because of the miner’s reluctance to reduce its free float.

The announcement of dividends for the first half of the year – in the amount of 100% of the company’s free cash flow, as stipulated by its dividend policy - did not fundamentally change the situation. Due to the fall in financial indicators, dividends were 35% below the level of the first half of 2018, although then the company payed back to shareholders 70% of free cash flow, and now it is to pay 100%. The decline in sales and prices means that the financial results of the second half of the year will be weak, Aton writes in its review, therefore, interim dividends for the first half of the year may be the only dividends for the year if the market does not show a strong recovery in the 4th quarter. ALROSA’s cash flow in the second half of the year, taking into account the growth in working capital (due to an increase in inventories) will be zero or negative, says BCS GM.

The picture regarding ALROSA’s stock is certainly no exception to the industry. The DPA partners, Petra, Gem and Lucara have fallen in price over the past year by 73%, 37% and 44% respectively, Trans Hex - by 30%. Canada-based Mountain Province lost more than 50% and was threatened in August with delisting from Nasdaq due to its stock prices falling below the level of $ 1 necessary to maintain the lot on the stock exchange. Shares of such global jewelry chains like Signet and Tiffany fell by 37% and 79% respectively since the beginning of 2019, reflecting falling profits and disappointment of investors in the historically most remunerative segment of the diamond pipeline. If De Beers, the largest diamond miner by revenue were traded on the exchange, it would be difficult for its stock to avoid a two-digit slump. But what distinguishes ALROSA from De Beers and other industry partners is its inability to significantly adjust production indicators - that is, flexibly responding to market challenges, materialize the fundamental driver helping to maintain a high value of diamond mining companies, which is the legend of an imminent drop in production due to the depletion of profit-making diamond mines.

The accident at the Mir mine in 2017, which deprived the company of about 10% of annual production, forced ALROSA to accelerate projects to increase operational efficiency, i.e. to intensify production and processing, which meant, among other things, to actively involve ore segments with a rich diamond content in mining, increase extraction and exclude alluvial deposits. In addition, the company started to develop the Verkhne-Munskoye diamond field, which in the first half of the year yielded about 700,000 carats of diamonds. As a result, ALROSA increased production by 10% to 17.6 million carats in the first half of the year, thus fulfilling its target. Moving at the same pace, ALROSA announced in early August that it had exceeded its forecast for production in 2019 by 500,000 carats bringing its output to 38.5 million carats.

The growth in performance of ALROSA accounting for 27% of global diamond output is set off by the slowdown in global diamond production, VTB Capital noted in one of its reviews. According to the Kimberley Process, global diamond production decreased by 2% in 2018 amounting to 148 million carats. In the second quarter of 2019, when ALROSA's production grew contrary to the results of other major players in this market, the rate of decline slowed to 1% compared to the previous year. Other significant diamond producers reduced production amid negative market conditions - De Beers by 11% in the first half of the year to 15.6 million carats and Rio Tinto by 10% to 8.28 million carats. De Beers also lowered its annual forecast to 31 million carats from 31-33 million carats, explaining this with the intention to bring this performance indicator in line with the market situation.

The specifics of production in Yakutia are limiting ALROSA’ performance, explained Sergey Ivanov, the head of the company: “We do not have assets where we can simply stop production and put a lock on the door until better times.” Any decrease in production at the company’s key mining and processing divisions automatically leads to an increase in costs. A high share of fixed costs, especially in underground mines, does not allow ALROSA to reduce production by more than 5–7%, the head of the company said during a teleconference on August 22, 2019 when analysts reasonably asked him whether the company was going to reduce production next year if the current outlook will not materialize and market recovery will not happen. Such an option is possible, said Ivanov. “If the reduced production will make us more cost-effective, we can consider this issue,” he said.

In addition to the issue of cost optimization, ALROSA has another argument in favor of not reducing production. The company expects that the rough currently put in its stock will create a solid start for the company during the restoration of demand in the end-market of diamond jewelry. “The market is cyclical, so it is sometimes more profitable in one year to get a bit more diamonds and put the goods in a vault than to reduce production,” Ivanov said. There were moments in the history of the company when holding diamonds in stock and waiting for the improvement of the market situation, ALROSA sold significantly larger amounts of rough than it produced, he recalled.

Having no room for maneuver with production, ALROSA has to reduce sales. Over six months, the miner’s sales fell by 16% to 18.9 million carats, and the forecast for this year was adjusted from 38 million carats to 32-33 million carats. “Obviously, our goal now is not to maximize sales at all costs. We are not trying to sell at any cost. We take a responsible approach to the situation. Our task is to accelerate the market's return to normal mode, to help ensure that inventories in the midstream disperse faster. We focus on the medium and long term, and not on momentary solutions,” Yevgeny Agureev, head of ALROSA’s United Selling Organization (USO) told reporters.

According to ALROSA, the current situation is even more complicated compared with the situation in 2015, when diamond prices were corrected by 15% due to overstocking in the midstream. There are more negative factors at play, including the difficult financial situation of diamond manufacturers, problems with funding their working capital in India, structural changes in the retail sector and tensions in trade relations between the United States and China.

However, one comparison with past turbulences looks advantageous specifically for ALROSA, for the time being. The crisis of 2009 came when ALROSA was using an auction system of sales, which turned out to be completely dysfunctional in the face of a global drop in demand. Now about 70% of rough diamonds are sold by the company under long-term contracts. This mechanism allows its customers to maintain their purchasing power even in the most difficult times in the market. “ALROSA customers and De Beers customers faced a dilemma: either to buy high-quality rough from us, suppliers or to buy cheaper polished goods in the market,” Agureev explained, outlining the problem. So far, customers working under contracts can still afford to opt for suppliers. The absolute majority of sightholders fulfill their obligations within this relationship; the exception is only those whose business is dying, and the owners go on the run, like Nirav Modi. “Sales are going on and customers are buying, as the system of long-term agreements was created to ensure this stability,” Agureev said. At the same time, the priorities of customers have shifted towards smaller-size rough. “Some people buy because it is easier to maintain production using small rough. Starting up the production process from scratch will be more expensive,” he admitted.

ALROSA prefers to avoid a sharp correction of prices, Agureev emphasized. “We do not drop prices and we do not intend to reduce them by 5-10% at once. Such a correction could lead to a revaluation of polished inventories held by customer. Every month before a trading session, we analyze the incoming information and find a balance between the sale price and the supply volume,” said the USO head.

Reducing sales and avoiding a strong price correction, ALROSA behaves as a responsible market stakeholder. Another question is whether fatal mistakes were made in the first half of the last year, when the major diamond miners flooded the market with excessive supplies. In any case, ALROSA has sacrificed financial performance in the second half of this year for the sake of restoring the industry, Aton said. If the price over volume policy does not bear fruit, ALROSA has an airbag in the form of Gokhran. This government agency acquired almost all of ALROSA’s production during the crisis of 2009 and profitably - at least until recent events - sold it to the market. Gokhran operates within the framework of its annual budget quota (which is 10.5 billion rubles annually for 2019 and 2020) and over the past few years bought mainly gold. Of course, the quota can be increased - after all, the jobs of thousands of residents from Yakutia and the Arkhangelsk Province are at stake - and the strategy can be changed. In fact, the presence of Gokhran in today's conditions looks like a compensation to the company for its non-market birthmark, which does not allow ALROSA to make difficult decisions to reduce production.

But no Gohran will be able to compensate for the losses incurred by ALROSA shareholders, as it is out of its functions to pay them dividends for that difficult period when ALROSA restricts sales or does not sell rough to the market at all. Already next year, ALROSA may face a choice: to work for stock to improve the diamond market and stop paying dividends or keep selling contrary to the laws of the diamond market and paying dividends, but thus destroying the hopes of recovery. The strategy of maintaining a balance in the diamond market may come into conflict with the strategy of maximizing profit for shareholders. It is in their interest to receive the greatest possible dividends - and it is precisely these interests that are likely to be sacrificed for the stability of the diamond market. And in this sense, the initiators of the aforementioned privatization of 2016, and also of 2013, were paradoxically right. After all, the state gained shifting some of the risks inherent to the cyclical diamond business to stock market investors.

* Quote by Kirill Tremasov, an ex-director of the Macroeconomic Forecast Department at the Ministry of Economic Development and currently Head of Analytical Department at Loko-Invest.

Igor Leikin for Rough&Polished