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ALROSA: crisis and diversification

20 july 2020

The diamond industry has already suffered heavy losses due to the pandemic. In fact, today rough diamond sales are suspended globally, and so far, the time limits for this pause are unclear. The possible ‘second wave’ of COVID-19 threatens with new losses, which may result in aggressive measures to save the diamond mining companies, the most capital-intensive part of the ‘diamond pipeline’. Against this background, the old discussion about the diversification of ALROSA’s products is particularly urgent, which, from the point of view of some participants, can be considered as a real anti-crisis measure to hedge the risks due to the current problems facing the rough and polished diamond industry.

As far as is known, this opinion is shared by vice-premier Yury Trutnev who instructed to develop proposals for  ALROSA’s participation in the development of precious and rare metals deposits. Vyacheslav Shtyrov, state adviser to the Republic of Sakha (Yakutia) insists on the ALROSA’s participation in the hydrocarbon production. At the same time, Sergey Ivanov, the current executive of ALROSA, is very skeptical about the idea of ​​diversifying the Company.

In our opinion, the only cause of the systemic crisis of any raw material company is the depletion of the mineral resources supporting its activities. Other reasons including the competition in the raw material market, financial problems of the companies processing raw materials, the problems in the final product distribution market are secondary, they require prompt actions and are temporary as previous experience shows.

From this point of view, applying the term ‘crisis’ to the current state of ALROSA is absolutely wrong, hence the emergency measures - including changing the line of business - are not required.

ALROSA has diamond reserves in the amount of 1.0 bn carats on its balance sheet, these are the raw minerals of industrial categories approved by the State Committee for Mineral Reserves of the RF. The Company has a ‘comfortable’ loan debt burden, high operational profitability and, most importantly, can count on the state support in the form of purchasing a part of marketable products by Gokhran. A combination of factors shows that ALROSA has obvious competitive advantages in the industry. The Company's management has a wide range of tools for making decisions during this difficult period, and minimizing losses depends on the management personnel’s proficiency.  

Supporters of the ALROSA diversification, as a rule, avoid assessing the impact of this process on the town-forming role - if not the geopolitical one - of the Company in the country’s Far East. However, this factor is crucial.

The transition of the state economy from the planned regulation principles to the market economy in the early 1990s was not accompanied by complete privatization of the industrial sector. As a result, in various spheres of production, companies were set up with the participation of government agencies - both federal and municipal ones.

As of the beginning of 2019, 59,300 enterprises of various organizational forms were registered in Russia that are indicated as the ‘public sector of the economy’ category in the statistical reports. The general list of the public sector enterprises includes the companies playing a town-forming role, both of the regional and supra-regional levels. Of course, ALROSA is among them.

By the volume of goods and services produced at the level of 250-300 bn roubles per year, ALROSA is inferior to the leaders of the state sector represented by Gazprom, Rosneft, Rosvooruzhenie (Russian State Arms Export Company), and many others. However, taking into account its town-forming role, ALROSA is among the leaders in Russia.

The Company's total deductions into budgetary and extra-budgetary funds of the Republic of Sakha (Yakutia) amount to 50% of the cumulative business volume. However, the area of this entity of the Federation makes 20% of the total area of the country. ALROSA supports and fully develops the infrastructure network in the areas where it operates, from the transportation network to the energy supply facilities. The development of the public sector in the areas where ALROSA’s enterprises are located is adequate to the state of the Company. This applies equally to the work of service firms including trade, supply, personal services, housing and utilities sector.

The ALROSA's production activities are ensured by a significant consumption of material resources. These are fuels and lubricants, metal, construction materials, gas, electricity. In total, the Company’s activities determine the development of the productive forces and production relations not only on a regional, but on a broader scale taking into account that ALROSA provides partner companies located outside Yakutia with work orders.

Of course, changing the line of business of the Company will upset the balance of the production relations in the region and beyond.

Any large-scale diversification, especially the one oriented towards new capital-intensive projects involving the production of solid minerals and (or) hydrocarbons will inevitably affect the ALROSA's dividend yield.

Receiving dividends and the investments in the development are oppositely directed, since the source is the same - the profit from the company’s activities. Attention should be paid to the indicators of the investment and dividend policy of the ALROSA Supervisory Board for the period from 2012 through 2019 (the data is taken from the annual reports).

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The data indicates that since 2016, there have been fundamental changes in the investment and dividend policy: prior to 2016, the funds exceeding the dividends by 4.0 times were allocated for the investments, and from 2016, the dividends began to exceed the investments by 2.0 times against the background of the decreased investments in absolute terms.

There is no doubt that the shortage of raw materials in 2030-2040 will increase, which will necessarily raise the question of its partial compensation at the expense of the deposits that are in reserve. There are many previously discovered deposits that are on the balance sheet of ALROSA and its subsidiaries; the results of their ‘Investment Feasibility Studies’ show a negative cash flow. This group of deposits is sometimes referred to as ‘low margin deposits’. Some blocks of mined deposits are also included in this category, such as pit reserves and rough diamonds reserves located below the boundaries of design mine workings.

Obviously, the investments in the development of this category of reserves and their subsequent mining will reduce the total margin indicator of the integrated project that can be called the ‘ALROSA Group Project’. This resulted in a decrease in the high level of dividend yield in 2016-2019. From the strategic point of view, the shareholders have a difficult choice - to maintain a high level of dividends in the short term while keeping on reducing the capital investments in the raw material sector, or to increase the capital investments to the detriment of the dividend yield in order to get the geological reserves of raw materials prepared for long term mining. The second option is certainly preferred from the point of view of the development of the productive forces and production relations in the region and beyond taking into account the town-forming mission of the Company.

Sergey Mityukhin and Sergey Goryainov