Diamond miner braces for a sparkling makeover

Russia became the world’s leading diamond producer in 2009. And yet, Alrosa, Russia’s monopoly diamond mining company, owner of about a third of global diamond reserves and globally competitive with South Africa’s De Beers, is now facing serious problems.

The Russian government and Alrosa’s management made an important decision to restructure the financially troubled company into an open joint-stock company and hold an IPO for it. This required amending legislation in the Republic of Sakha (Yakutia), home to the diamond miner. After 6 October, this was all taken care of.

How it all began

On 13 June 1955, Soviet geologists searching for diamonds in Yakutia sent a radio message: “Smoking the peace pipe, excellent tobacco”. In this allegorical way they informed the country’s authorities about the discovery of the USSR’s biggest diamond deposit, the Mir kimberlite pipe (“mir” meaning “peace” in Russian).

Cold and unfriendly Yakutia, comparable to India in size, is Russia’s diamond treasure trove, holding the world’s largest diamond deposits in terms of both proven and probable reserves. At the same time, even Russians themselves see this vast area in East Siberia as inaccessible and mysterious: A six-hour flight from Moscow, impassable coniferous forest, permanent frost and temperatures below -50C (down to -70C in some areas) render this land even more mysterious.

Alrosa, one of the key players on the global jewelry market, is based here in the industrial centre of Mirny.

At the height of the former Soviet republics’ independency following the collapse of the Soviet Union, the Republic of Yakutia in 1992 restructured Yakutskalmaz union trust into Alrosa and put it under the control of the regional administration, local businessmen and the heads of the eight municipal districts where the diamond mines are located.

All revenue from diamond sales remained in Yakutia, generating 80% of the regional budget and seeing the local authorities spend it as they saw fit.

To make sure outsiders could not get a piece of the Alrosa pie, Yakutia’s local parliament issued a law in 2003 declaring that a closed joint-stock company was the only form of incorporation that fit national interests.

A few years ago, when it became clear that Yakutia’s government alone was unable to protect Alrosa against international companies, a high-profile campaign was carried out to nationalise the diamond producer. As a result, the Russian government gained control of Alrosa, with the Federal Agency for State Property Management controlling 51%, the government of Yakutia 32%, eight municipal administrations 8%, and another 9% held by individual and corporate shareholders.

This arrangement will soon be changed as the federal government has decided to make Alrosa a public company by selling a large stake to strategic investors. Once the the regions breadwinner, Alrosa will emerge as a successful market player with global ambitions. Now it has a real chance to catch up with De Beers.

Meanwhile, according to a government source, there have been proposals over the past two years to create a global cartel based on Alrosa, similar to OPEC. Producers, cutters and sellers of rough and cut diamonds are looking for a new global formula of success. African countries, especially Botswana and Namibia, where revenue from diamond sales make up the bulk of their state budgets, hope that Russia and Alrosa will organise a new diamond cartel.

The economic crisis

Alrosa’s independence from the federal government came to an end with the advent of the economic crisis, which hit the diamond market much earlier than financial markets, and perhaps with even more adverse effects. By 2008, the diamond market was obviously overheated, prices reached their peak levels, and demand began to drop. Some 10–15 years ago, when the market was entirely controlled by De Beers, and thus absolutely non-transparent, this trend could be concealed from the public eye.

Under pressure from the European and American antitrust agencies, De Beers had to ease its grip on the market by letting other players in. The market reacted immediately, with prices dropping 50-60% in 2008–2009.

Before 2001, De Beers had been buying almost all of Russia’s rough diamonds, including small ones. This meant stable sales for Mir and other mines in Yakutia. By 2009, however, De Beers’ share in Alrosa’s exports dropped to zero.

De Beers froze production and reduced supply at the end of 2008. The number of stones for sale was reduced by 50%, and several large mines saw their operations grind to a halt. Yet, this was not enough, and prices continued to fall.

Given the situation on the market, it seemed logical to support De Beers’ initiative to curb supply, but Alrosa went rogue: without stopping production, it halted sales altogether until prices would go up.
There was no other option. Alrosa is Yakutia’s economic bedrock, and stopping production would be politically and socially inadmissible. Alrosa is Yakutia’s biggest employer and responsible for much of the republic’s social infrastructure. As a result, not a single employee was dismissed, and not a single hospital was closed.

All this, however, inflated the company’s debts. “In the six months from December 2008 to June 2009, Alrosa’s debt grew by over $1.5 billion,” says the company’s public relations Director Andrei Polyakov. In May 2009, the company was facing serious difficulties paying interest on its loans. Alrosa’s management analysed the situation and came to the conclusion that the only way to avoid bankruptcy was to receive $1 billion in government support. Prime Minister Vladimir Putin made the decision himself: Gokhran, the State Precious Metal and Gems Repository, purchased $1 billion worth of Alrosa’s diamonds.

The company, which continued its mining operations, became the world’s largest producer with an increase in its global share from 22% to 29%, while De Beers, which suspended production, saw its share fall from 30% to 23%.

At the same time, the South African company, unlike Alrosa, continued to sell its products, thus incurring huge debts.

In the end, Yakutia’s authorities were forced to face the political music: the federal government demanded that the company, which had begun dropping hints about the state buying up another $1 billion worth of rough diamonds, go through restructuring.

The federal government offered a compromise that would entail Alrosa restructuring itself into an open joint-stock company, holding an IPO and finding an investment partner, all the while leaving the Yakutia and federal government’s stakes in the company untouched. Ideally, this would create an open market structure with the ambitions of a global diamond leader.

The problem was that few people in Yakutia wanted Alrosa to go public. It was not exactly easy to get the required legislation through local parliament, this being a highly unpopular move in the region. The federal authorities persuaded Yakutia residents that there is no need to have uneasy feelings about their stakes possibly being watered down as a result of the company’s IPO: an agreement will be signed with Alrosa’s key shareholders to guarantee that Yakutia will preserve its stake in the business.

Diamonds Kimberlite pipe Mir. Source: Reuters/Vostock

Prospects

Yakutia’s authorities recognise that Alrosa’s restructuring is a hot-button issue. “The company’s financial state no longer allows it to remain, much less grow, as a closed joint-stock company. Neither Russia nor Yakutia can afford to wait until the company’s production falls two/three-fold,” stressed Alexander Morozkin, first deputy speaker of Yakutia’s parliament.

Alrosa’s restructuring from a closed joint-stock company into an open joint-stock company will boost the company’s investment appeal, reduce its debt and enhance management efficiency, the company said in a statement.

Independent observers, however, offer more straightforward explanations, saying that Alrosa simply has no other choice. “Its debt burden is already too high, and the company needs more and more loans. For example, cash is needed for exploring and further developing new diamond deposits. If Alrosa does not find the money, this could impact production, since the company’s available deposits are close to exhaustion,” says Sergei Goryainov, an analyst at Rough & Polished.

The company has to “go underground” and build new mines. Its investment programme for 2011–2012 is worth less than $1 billion, Polyakov says. It is impossible to borrow that much, which means that the company will have to sell its stocks.

Agreements have already been reached with three investment banks that will join in the IPO, according to a source in the Finance Ministry. Alrosa hope to sell a 25% stake by Christmas, most likely, at auction, which is a transparent and comprehensible approach that could bring the largest amount of cash possible.

The strategic investor could expect to influence Alrosa’s sales policy, getting the best rough diamonds for the lowest price.

At least two groups of buyers are expected to fight for Alrosa’s shares: the Indians and Chinese. Indian diamond cutting firms, already among Alrosa’s biggest customers, have recently signed a memorandum to buy $490 million worth of diamonds annually, and might be willing to buy more. The Chinese, meanwhile, are actively purchasing African deposits, taking part in every tender under the sun. Therefore, it goes without saying that Alrosa, which holds the majority of global reserves, will attract their attention, too.

Another potential bidder is Kristall Smolensk, Russia’s largest diamond cutter and one of the key players on the global market for big diamonds.

This seems even more likely given that the price tag for a 25% stake will not exactly break the bank. Oleg Petropavlovsky, an analyst at BCS, puts the company’s assets at $4.5 billion, based on its financial results and debts, meaning that a 25% stake would fetch slightly over $1 billion. Alrosa and Finance Ministry officials refuse to give more accurate figures, while insisting that the company is an absolute leader in terms of proven reserves, even beating out De Beers, and that it is potentially worth more than any forecasts would predict.

New marketing strategy

Over the next five years Alrosa plans to increase output to 165-167 million carats a year (in 2009, production was down to 115 million carats), and later on hold that level steady. Such slow growth stems from Alrosa’s self-imposed restrictions on production due to the financial crisis, which in turn was caused by Alrosa’s old deposits having been exhausted and there not being enough new ones.
The company’s experts hope that, taken together, these factors will drive up market prices for rough diamonds by 55% by 2018.

Along with its IPO, Alrosa will also change its sales strategy to look more like De Beers’ by controlling its supply of rough diamonds and selling them to a small number of trusted customers.

The company currently uses three sales methods, including one-off sales on the spot market, auctions and tenders, and long-term contracts, the last of which is Alrosa’s preferred method. In accordance with its sales strategy through 2012, which was approved by the Supervisory Board in 2009, Alrosa will sell at least 70% of its rough diamonds through long-term contracts.

In 2010, Alrosa hopes to bring its share of such contract sales to 56% of revenue, up from 21% in 2009. By doing so the company hopes to protect itself against fluctuations in demand, says Mr Goryainov. “Before the economic crisis, Alrosa’s clients were not very reliable and there were no long-term contracts. The customers could disappear at any time,” he added.

The company is currently working to build a pool of loyal customers. In the spring of 2010 it signed a three-year agreement with India’s Rosy Blue, Diamond India Limited, and Ratilal Becharlal and Sons to supply rough diamonds. Alrosa is even considering plans to open an India-based office.

The company signed long-term contracts with fifteen Belgian companies this past summer worth about $500 million. Talks are underway with companies in China, Armenia, Belarus, and Israel.

We can only guess what other companies will make it onto Alrosa’s elite list of partners. Experts are critical of Alrosa’s sales system: “There is no competition; partners are selected by a special board that reviews incoming bids,” Goryainov says.

Export figures, nonetheless, bespeak significant progress in Russian diamond sales. Russia exported 12.452 million carats of diamonds in the first quarter of 2010, for a total of $765.779 million, against 6.649 million carats worth $414.836 million in the first quarter of 2008. Belgium and India were the largest buyers in January-March 2010, accounting for 66% and 17%, respectively. India will have a better result towards the end of 2010, with Alrosa planning to bring its exports total to India to $1 billion.

Source: www.alrosa.ru

Yakutia is Russia’s largest region and the world’s biggest administrative unit within a single country. The region is 3,103,200 kilometres in size and has a population of 950,000 people with an average per capita income of 18,000 roubles.

The region’s average wage is 24,000 roubles (around $800 a month), 25% above the nation-wide average. At the same time, the cost of living is a third higher than Russia’s average as most food products have to be brought in from afar, except for Yakutia’s traditional horse meat, venison and other northern delicacies.

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