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Exceptional Way of Fluorescent Severalmaz

22 september 2014

Last March, ALROSA commissioned the second phase of the concentrator at the Lomonosov Mine in the Arkhangelsk Region. Having cleared the second phase for operation, Severalmaz, which develops this diamond field, will be able to raise production to 5 million carats in 2021, thus bringing its contribution to ALROSA Group’s total output to about 10%. Currently, Severalmaz provides 2%. The Lomonosov Diamond Field embraces six kimberlite pipes, whose total resources are estimated at 126 million tons of ore containing 115.5 million carats under JORC, but so far Severalmaz is developing only one, which is Arkhangelskaya. Severalmaz plans to start mining diamonds at Karpinski-1 at the end of 2014.

Severalmaz is developing its mines at the expense of ALROSA, which provides funding for its "daughter" in the form of contributions to its registered capital. The next such installment – worth RUB 16 billion - has suddenly become a stumbling block between the management of ALROSA and its minority shareholders. The foreign investment funds, including Oppenheimer and Lazard, which acquired interest in ALROSA during its IPO, voted against additional issue of Severalmaz shares at ALROSA’s annual meeting of shareholders. This did not prevent the approval of the deal - judging by the outcome of the vote (pros exceeded 92% and cons were 7.5%) it was supported by the major shareholders of the company, the Federal Property Management Agency and Yakutia, as well as by Yakut uluses (municipalities). However, this outcome made people at least think about the reasons.

The more so that the analysis of the reports submitted by the funds suggests that this position was hardly "technical". Large investment funds owning shares in dozens of companies in various countries, often vote proceeding fr om the recommendations of agencies specializing in consulting minority shareholders, such as, for instance, Institutional Shareholder Services (ISS). However, at the annual meeting of ALROSA the funds holding stakes in the company voted differently on most issues, including the election to the Supervisory Board and related party transactions. The only issue on which the overseas shareholders were unanimous was the investments in Severalmaz. In order to understand why a purely technical matter – converting the subsidiary’s debt to the parent company - caused a negative reaction, it is necessary to recall the past of Severalmaz and analyze its earning capacity data.

The diamond deposit named after Mikhail Lomonosov was discovered in 1980. Despite the fact that the exploration and the feasibility study for the development of the field were performed by Yakutalmaz (the predecessor of ALROSA), the path Severalmaz had to walk to enter the framework of the Russian diamond monopoly was thorny. In 1997, Severalmaz got a major shareholder, which was another monopoly, De Beers controlling 80% of the world’s diamond sales. De Beers received a 27-percent interest in Severalmaz and an access to its technical documentation, which was used for its own survey and confirmed the estimates made by Yakutalmaz. However, the hopes cherished by the local authorities for investments fr om De Beers fell short of their expectations – in much the same way as the hopes of De Beers to gain control over the diamond operations in the Arkhangelsk Region (besides the Lomonosov Mine, De Beers put a claim in the nearby Grib Diamond Pipe). In this situation, De Beers found it inexpedient to develop the second diamond province in Russia, especially since the miner was deprived of the opportunity to conclude a PSA, while a high tax rate did not permit to achieve the desired profit margin. In 2000, the share owned by De Beers was bought by ALROSA, which launched a comprehensive program to construct a mining-and-processing integrated works, the second phase of which envisaged a diamond manufacturing operation at Zvezdochka, a company producing defense equipment in Severodvinsk. At that time, the entire project was estimated at $ 400 million.

Reality made adjustments to the amount of capital investment in the diamond field, the development of which was carried out based on the projected global shortage of rough diamonds - to date, total costs have exceeded the initial estimates twofold reaching $ 800 million. The first phase of Severalmaz’s mining division had a capacity of 1 million tons of ore and was commissioned in June 2005. Severalmaz started selling diamonds at auctions in 2008. Since the acquisition of the company in 2010, it has never reached a breakeven point, yielding a net loss of about RUB 1 billion a year, which was equivalent to the net income earned by ALROSA during the crisis period. Production costs at Severalmaz in 2009 was about $ 70 per carat, while diamond goods it produced were priced at no more than $ 50 per carat.

The goal to achieve a breakeven level at Severalmaz turned at the very least difficult not only for De Beers, which found itself in uncomfortable environment, but also for ALROSA. “We hope that in five years we’ll bring the project to a cost-effective level. But so far, we only invest, invest and invest,” Fyodor Andreev, the newly appointed head of ALROSA said in 2009. The company expected to turn Severalmaz a money earner as early as 2009, but the outbreak of the crisis undermined the economics of far less imperfect diamond projects. It is impossible to mothball Severalmaz – the mine will simply be flooded due to the existing geological conditions in the area.

However, there are no easy-to-develop diamond fields left at all, and after the players in the diamond market recovered fr om the crisis Severalmaz attracted the interest of one of them - this time, Rio Tinto. It was the company, which achieved the biggest progress compared to all the other contenders in wrapping up a possible deal with the then-Finance Minister Alexei Kudrin, who was in charge of ALROSA. It was planned that Rio will pay $ 250 million for 50% -1 share in Severalmaz and invest $ 135 million in further development of the company to make it reach its nameplate capacity of 2 million carats in 2015. Rio Tinto was to receive the right to sell diamonds extracted from the Lomonosov Mine pro rata to its stake in the company - by the way, until now ALROSA does not have this possibility with regard to rough produced by Angola’s Catoca.

However, the desire of ALROSA to attract a strategic investor to Severalmaz proved fleeting. On the background of post-crisis growth in prices in the diamond market in the first six months of 2011, ALROSA revised its plans. “Prices for diamonds mined by Severalmaz went up to $ 110 from $ 60 per carat. From being a loss-maker the project is turning into a cost-effective operation being our core business - this is not iron ore or gas. To sell the asset would be inappropriate. The company has the means to develop, although the project requires about $ 500 million of investments,” ALROSA’s spokesperson said in May 2011.

Speaking of investments, it should be mentioned that ALROSA channeled its major capital allocations (RUB 38 billion in 2014 with a similar outlook for 2015) into underground mines - primarily to build the Udachny underground mine launched last summer. However, the share of capital expenditures relating to Severalmaz in the overall capex of ALROSA is incommensurate with its two-percent share in the overall production of the parent miner, as it follows from ALROSA’s statement on reserves and resources according to JORC as of July 1, 2013, prepared by Micon. Severalmaz accounted for 15% of the total capex made by ALROSA in 2013 and for about 7% in 2014.

Severalmaz is extracting ore, which is not rich enough compared with other diamond fields developed by ALROSA in Western Yakutia. Currently, Severalmaz is operating the Arkhangelskaya Mine, wh ere ore has a diamond grade of about 0.5 carats per tonne. For comparison, in the second quarter of 2014 the Nyurba Mine’s diamond grade reached 2.26 ct/t, Internatsionalnaya showed 8.7 ct/t and Mir 3.5 ct/t. Severalmaz will reach kimberlite ore at the Arkhangelskata Mine with a diamond grade of 1 ct/t by 2016. Karpinski-1 will have this grade from the start and will reach its peak of about 1.7 ct/t in 2020.

The average price of diamonds produced by Severalmaz is also low compared to diamonds mined in Yakutia.

Average selling diamond prices of ALROSA mining divisions in H1 2014, $ per carat:


* Calculated by Interfax

Based on available data, it can be said that the surge in prices for rough produced by Severalmaz in the first half of 2011 was a one-off instance. Experts expressed an opinion that it had been achieved due to the sales of the most sought-for pinkish and greenish diamonds recovered by Severalmaz. The content of this kind of rough in the general diamond footprint mined by Severalmaz is insignificant and such stones appear to be a bonus from the Lomonosov Mine in much the same way as the unique pink diamonds at Argyle. In January-September of the same year of 2011, the average price of diamonds at Severalmaz was $ 80 per carat. In 2013, it decreased to $ 60 once again (without adjustment for currency fluctuations).

The average price of rough at Severalmaz was about $ 70 per carat against costs reaching $ 60 per carat in H1 2014, Ilya Ryaschin, First Vice President of ALROSA said in early September. “This explains why the company has not yet been operating at full capacity. It will be possible to speak of full-fledged business at Severalmaz in 2016. We have always said that this project was quite complex,” said the top manager.

Diamonds produced by Severalmaz are sold at 3% below the price list of Russia’s Ministry of Finance, a source familiar with ALROSA’s foreign-trade transactions said. As a result, the customs service clears the goods sold below the list price, but ALROSA has to pay export duties based on their 100-percent price. Severalmaz’s rough makes controversial the process of making up diamond boxes in which ALROSA sells its goods to customers. Recently, ALROSA got the right to mix rough diamonds from all of its mines, but diamonds from Severalmaz may shave the price of a box having such a mix.

Some of diamonds recovered by Severalmaz are fluorescent, and such stones get hazy and become milky being cut and polished, said a source familiar with the product range offered by ALROSA. “This cannot be seen in rough, so it is estimated as more expensive. But customers know that polished diamonds made from this rough will be hazy and offer lower prices,” the source said explaining the distinctive features of Arkhangelsk diamonds.

With proper marketing, the properties of these stones may not have a negative impact on their price, the source assured: “We need to teach clients to work with this sort of rough, so that they were not afraid of risks associated with polishing these stones and knew what kind of goods they will get from this rough. There is an opportunity to position this fluorescence in a special way and sell it as a feature, or use special processing methods to eliminate the ‘milky’ effect.”

It will probably take more than one year to market Arkhangelsk diamonds, but right now ALROSA is interested to avoid a situation wh ere investments in Severalmaz would decrease the attractiveness of its own shares for investors. This is especially true in an environment wh ere the lack of liquidity in the Russian market and lower attractiveness of Russian assets due to sanctions are increasing the importance of foreign capital in the company.

ALROSA explains the position of the funds by the fact that the shareholders have not received comprehensive information about the deal with Severalmaz. “Only brief materials were presented at the annual general meeting and they did not give a complete picture to the shareholders. I think if the materials had been prepared properly, the shareholders would have no reason to vote against,” Ilya Ryaschin said.

According to Sergey Goryainov of Rough&Polished, the decision of the investment funds was largely due to political tensions reducing the opportunities of ALROSA for fundraising, including from foreign banks. ALROSA has a large enough debt burden, though not critical (about $ 4.2 billion), he recalls. “Against this background, a large amount of capital expenditures necessary for continued functioning of Severalmaz was untimely in the eyes of Western funds," Sergey Goryainov said. According to him, theoretically ALROSA may postpone investments to expand production at Severalmaz and apparently ALROSA’s minority shareholders considered this an ideal way out.”

At the same time, Sergey Goryainov believes that “in the long term, these investments are justified.” The fact that at a particular historical moment the foreign funds consider it necessary to refrain from investing in the most troubled assets of ALROSA, does not exclude that the main driver behind the Arkhangelsk project - the lack of new diamond fields - remains in force. Karpinski-1 is one of the main diamond projects belonging to the “new generation,” as Bain noted in its report on the world diamond market last year, and Severalmaz as a whole is the largest diamond mine in Europe. This means that Severalmaz - especially if it solves the problem of marketing its rough - is doomed to take its rightful place in the portfolio of ALROSA’s assets. It is natural that players operating in the stock market do not like great capex, but they do not like the depletion of reserves experienced by mining companies even more, no matter how strong their positions in the market are, which is the case of ALROSA.

Igor Leikin for Rough&Polished