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29 september 2014

The resignation of Fyodor Andreyev as President of ALROSA is negative for the company, but the fundamental conditions giving rise to investment attractiveness of the Russian diamond miner remain unchanged, according to reviews and comments coming fr om the majority of investment banks. The main thing is to follow the strategy focused on exploration, production and sale of diamonds. If the new head of ALROSA will confirm this strategy, the company may regain the 15-percent drop in market capitalization fr om the highs of 2014, largely due to the risks associated with state regulation.

The nervousness of investors in light of geopolitics and potential interference of government officials in the company's operation is understandable, but ALROSA’s main economic drivers look stable, Morgan Stanley notes in its review on the subject. Due to this the investment bank raised the price target for ALROSA shares by 20% driving it to RUB 60 per share (or by 5% in USD terms) last week. Morgan Stanley said that so far the ruble-weakening factor was not taken into account for share price estimates. While 90% of ALROSA’s revenue is denominated in dollars and 85% of the company’s costs is denominated in rubles, every time the ruble weakens by 1% towards the U.S. dollar this scales up the miner’s EBITDA by almost 2%. The picture is also influenced by a stable price movement in the diamond market in 2014 (demonstrating an 8-percent increase in prices for diamonds mined by ALROSA), as well as by a 7-percent reduction in the company’s production costs in the second quarter of 2014.

State control can, however, become a positive force for ALROSA - in case of an embargo on Russian diamond supplies to Europe and difficulties arising due to retargeting diamond exports ALROSA may once again get a helping hand from Gokhran, says Morgan Stanley. ALROSA’s financial standing will allow the company to outlast finance cost shocks caused by this rough going.

At the same time, the pro-active lobbying by Deputy Prime Minister Yury Trutnev in favor of a diamond-cutting cluster in Yakutia and the attempt to draw ALROSA into supporting this project make observers pay extra attention to assessing possible changes in the strategy of ALROSA. Now it is this issue, which is causing major concerns among investors, according to Morgan Stanley. ALROSA may take part in the above project by way of subsidizing it selling rough below market prices. In the opinion of Morgan Stanley, one million carats of gem-quality diamonds sold at a 20-percent discount are translated into 1.5% of the miner’s target EBITDA for 2015. If a Russian diamond-cutting center could consume 5 million carats at 50% off the market price, ALROSA’s EBITDA would have decreased by 18.6% in 2015. However, such amounts look excessive for the Russian diamond manufacturing, Morgan Stanley said, adding that Kristall of Smolensk, being the largest diamond manufacturer in Russia, bought only 172,000 carats of rough last year.

At the same time, ALROSA may use additional demand from the Yakut diamond-cutting cluster to unload part of its stock and reduce working capital, the investment bank said. However, it should be noted that this thesis is controversial, because ALROSA has no ready-to-sell stock, while the Russian diamond-cutting industry handles only high-quality rough, which accounts for about 10% of ALROSA’s annual mining footprint (about 3.5 - 4 million carats).

Discounts for rough sold to Russian manufacturers are analyzed by Citi in its review. The option offering 20% of gem-quality diamonds produced by ALROSA to Russian manufacturers at 10% off under the program to support the national diamond manufacturing industry is viewed by Citi as one of the components of a negative scenario for ALROSA. The other components of this scenario laid out by the investment bank include additional RUB 3 billion in operating expenses in 2015 due to higher taxes and social liabilities in Yakutia; a 10-percent increase in capex in the coming year reflecting growing costs in mining; a 5-percent drop in global rough prices in 2015 and dividend payments going down to 25% from 35% of the miner’s net profit.

This scenario anticipates a 10-percent decline in ALROSA’s EBITDA and a 34-percent decrease in its free cash flow in 2015 compared with the current forecast of Citi (RUB 89.59 billion and RUB 36.554 billion, respectively). In this case, ALROSA’s stock will fall to RUB 32.0 per share. This is 14% lower than its closing price last Friday on September 26 at the Moscow Stock Exchange. According to Citi, the company’s current target price is RUB 35.0 per share. Citi stressed that such a scenario, involving a combination of five negative factors for ALROSA, is hypothetical and does not reflect the basic expectations with regard to the Russian diamond miner. Citi has not changed its forecast and target price for ALROSA.

Regarding the creation of a diamond-cutting center in Yakutia, Citi estimates its total costs at $ 200-250 million and its manufacturing capacity at 6 million carats per year (about 16% of ALROSA’s total sales). The investment bank considers this project ineffective. Most Russian diamond manufacturers will operate at a loss on the background of the high costs involving wages and “general inefficiency” if they continue to buy rough diamonds from ALROSA on an equal footing with foreign customers. This is the main reason for the risk in case ALROSA will be involved in cross subsidizing the diamond-cutting industry, which will be manifested in discounts for Yakut diamond manufacturers within the program pursuing the aim of creating a Russian diamond cluster, Citi said.

ALROSA commented on the concerns expressed by investment banks, recalling that the application of discounts is contrary to the rules of diamond sales agreed with the Federal Antimonopoly Service of the Russian Federation.

The BCS Bank considers the recent publication of ALROSA’s explicit plans for the development of its diamond-cutting unit (Brillianty ALROSA) exactly in the context of protection against possible plans to amalgamate all the Russian diamond manufacturers under the auspices of the diamond miner. Last Thursday, ALROSA announced that it was mulling to attract the world's major jewelry manufacturers as strategic partners in the production of polished diamonds. The company’s diamond manufacturing operations are expected to be merged on the basis of the Kristall factory in Barnaul, wh ere manufacturing costs are comparable with those in India reaching about $ 40-50 per carat. In Moscow, wh ere manufacturing costs are around $ 150 per carat, ALROSA will focus on processing very large and colored diamonds meant for sale through international auction houses as part of the miner’s marketing program. BCS believes that the published details of consolidating the cutting and polishing arm of ALROSA and the intention to attract a strategic investor appear to point to the company’s decision to spin off this business from the mining group. The bank also notes that this process is positive for investment attractiveness of the company. Oleg Petropavlovsky, a BCS analyst, says that in the context of the administrative pressure on ALROSA explained by the need to support the Russian diamond manufacturing, the separation of this segment from ALROSA and inviting an international investor into it will protect the company's profit margin. De-consolidation of diamond manufacturing will allow ALROSA to eliminate the low-margin segment (5-10% EBITDA margin), the size of which is not that large since the sale of polished diamonds account only for about 3% of total revenues.

Societe Generale analyst Sergey Donskoy also believes that it is not worth for ALROSA to turn its strategy towards developing diamond manufacturing in Russia. The worldwide practice shows that there is no real synergy between diamond mining and diamond manufacturing for these are too different competencies and approaches to business.

ALROSA should get rid of non-core assets reducing induced investments and invest instead in mining, the analyst believes. According to Sergei Filchenkov of Metropol, investors are unlikely to be pleased if the company would have to divert resources to the cutting and polishing business.

Revisiting the consequences brought about by the change of CEO at ALROSA, Sberbank CIB notes that the issue will become clear in the near future, after the appointment of a new president. “The advent to this position of a person who does not have significant experience in corporate governance will be considered by the market as an unfavorable factor for the credit profile of the company,” Sberbank CIB says in its review. Fyodor Andreev “has a reputation of a capable and technocratic general manager, who turned the company overburdened with debts and following very dubious financial policies into a transparent setup listed on the stock exchange and having a comfortable repayment schedule of short-term debt,” the investment bank says.

Sberbank CIB emphasized that there was no evidence to suggest that the high level of state support, which is a characteristic feature of this company, may weaken after the change at the top of ALROSA.

The resignation of Fyodor Andreev is a negative factor for ALROSA, but perhaps this has been already included in the estimate of its shares, which were falling after the release of information about the resignation, VTB Capital said. Until the situation with the new head of the company is not clarified, ALROSA’s stock will be traded on a limited scale. Fundamentally, ALROSA - with its EV/EBITDA for 2015 estimated as 4.4x by consensus - is still underestimated, the investment bank said.

"On the one hand, the resignation of the company’s president may be somewhat negatively perceived by the market as there is uncertainty about the future strategy of the miner. However, if ALROSA will be headed by someone from the existing management, the current policy of the company, in particular pursuing the sale of non-core assets, can be continued,” Promsvyazbank says in its analysis. “On the other hand, with the departure of Fyodor Andreev the conflict with Deputy Prime Minister Yury Trutnev who is supervising the diamond industry and who was opposed to the extension of the employment contract with Fyodor Andreev, is likely to be eliminated, which should facilitate decision-making in the government with respect to the company.”

The resignation of Fyodor Andreev is negative for ALROSA, as it can lead to failures in the operational management of the company and induce the possibility of changing its strategy, according to a review by the Otkrytie Bank. In addition, Fyodor Andreev enjoyed the support of minority shareholders and that of the Federal Property Management Agency. In the opinion of Otkrytie, the possibility that Olga Dergunova currently heading the Federal Property Management Agency will take up the presidency of ALROSA will be a positive news for the miner.

Igor Leikin for Rough&Polished