The Investor Day is an annual event, during which an investment community has an opportunity to get acquainted with detailed operating results produced by an issuer of interest, inquire outlooks and ask questions directly to the company’s management. It should be noted that this refers to large and public companies. Only a corporation matching these two qualities will be in demand by investors and properly covered by analysts. In Russia, such companies have not yet moved into the category of “rapidly vanishing species,” but after a series of delistings (Polyus Gold, Uralkali) the public status, implying common management and disclosure standards, is becoming ever more valuable. No wonder that during the “ALROSA Investor Day 2016” analysts were vividly interested in the diamond miner’s privatization prospects, which are shrouded in the mist of uncertainties, providing a not so pleasant news background exactly from the point of view of publicity.
In addition, during its Investor Day ALROSA presented a moderately optimistic forecast for the situation in the diamond market and pleased the audience with a prospect for higher dividends. Once again, the company confirmed the permanence of its strategy to refrain from businesses unrelated to diamond mining and dispose of non-core assets. On the other hand, the current market wariness generated new targets for capital investments.
LONG-TERM FORECASTS
From the presentation of ALROSA it follows that fundamental diamond market indicators remain strong, despite a drop to 23% (down 1 percentage point) in demand and in the share of jewelry and watches in the total luxury market (estimated at $ 302 billion). According to ALROSA, global demand for diamond jewelry will grow by 2-4% in 2016-2025 on the backdrop of smooth increase in demand in the United States and more significant growth by 4-6% in Asia. The diamond market in 2016-2019 will be balanced, the company said. Diamond demand growth during this period is possible at the level of 0-2% per year. But this growth, according to ALROSA, will be driven by sales of diamond inventories accumulated in 2015. Starting from 2019, ALROSA expects an increase in demand - up to 2-4% per year, which, combined with a low (1-2%) increase in production and depletion of diamond stocks, will lead to shortages in the market.
For its part, the Otkrytie Bank considers this outlook not quite realistic. Firstly, there are more than 15 new projects (besides those developed by ALROSA) that can replace the depleting deposits, which will result in a 2-3 percent increase in the global diamond production in this period, the investment bank said in a review. Secondly, in the opinion of Otkrytie 3-4 years will not be enough to sell the diamond stocks accumulated in 2015. “For example, ALROSA has currently a diamond stock exceeding 22 million carats, while the normal level is 10.7 million carats, i.e. the company has 12-15 million carats in excess,” Otkrytie said. If ALROSA alone will sell additionally 2-3 million carats from its stock in the coming 6-7 years, this will be enough to meet the growing demand. Thirdly, Otkrytie has doubts over the forecast demand growth of 4-6% in Asia (especially in view of the current situation in China), which is supposed to be the main driver of the global diamond market. “In general, we believe that the diamond market will be in a small surplus in the next 5-7 years, and the stocks held by major producers will inhibit the growth of prices for diamonds,” Otkrytie opines in its review.
POSITIVE START TO THE YEAR
If long-term forecasts can be the subject of discussions between ALROSA and investors, their assessment of the situation at the beginning of the year is almost unanimous. The data coming in the first three months indicated that the diamond market stabilized – the midstream now appears in a much better position than in 2015, as the policy of mining companies (regarding prices and lower supplies) was instrumental to higher margins earned by diamond manufacturers and diamantaires. ALROSA’s sales and revenues in the first three months of 2016 exceeded the miner’s outlook, as well as the comparable results of the previous year, when the company raked in about $ 1.1 billion, Andrey Zharkov, President of ALROSA said. He expressed a hope that market demand in the second half of 2016 would be stable and would not be subject to correction as in the previous year, when sales fell by 30%. Meanwhile, the company takes “a cautious view of this year,” Andrey Zharkov said.
The decline in sales in the second half of last year resulted in piling up ALROSA’s inventory and now the company considers its main purpose to avoid growing it further this year. The first steps in this direction were made in January and February, said the president of ALROSA; due to successful sales in the first two months of 2016 the company decreased its inventory, which reached 22 million carats (estimated at $ 2.5 billion by ALROSA). The market, however, has not quite believed in the reality of this task. According to Otkrytie, there is a risk that the inventory held by ALROSA will increase this year, if the miner will not decide to cut production. Deutsche Bank forecasts that ALROSA’s inventory will add another 6 million carats in 2016.
“PLAN B”
The possibility that ALROSA may reduce production was initially voiced by the company’s First Vice President Ilya Ryaschin late last year. It was viewed as a response to a situation where demand for rough could fail to bounce back to a “normal level.” The decision was to be taken based on the results achieved in the first quarter of this year, which means that Plan B is still possible. ALROSA is mulling two mining scenarios in 2016 involving diamond production in the range of 34 to 39 million carats, Andrei Zharkov said during the Investor Day. To reduce output, the company may suspend mining operations on alluvial diamond fields (the largest of which are Almazy Anabara and Nizhne-Lenskoye), Igor Sobolev, First Vice President and Executive Director said.
The decision to cut production may only be welcomed, Otkrytie said in its review, but there is one negative factor: ALROSA's alluvial operations mainly yield better quality diamonds compared with those mined underground. In addition, diamonds extracted on placers do not need crushing, grinding or dressing since they have already been processed in a natural way. Thus, if ALROSA will reduce its alluvial mining, this will affect its inventory and have a negative impact on average diamond prices and margins, the investment bank pointed out. Meanwhile, according to ALROSA's presentation, it is its alluvial mining operations, where the company incurs the highest costs (2,477 rubles per carat), exceeding the costs not only of open-pit mining (1,879 rubles per carat), but also those of underground mines (2,431 rubles per carat).
A few days later, ALROSA mitigated the effect produced by the loud statement made during the Investor Day, noting that Plan B does not involve a production cut to 34 million carats, but to 37 million carats. Andrey Zharkov, speaking at a meeting of ALROSA's active functionaries, said that “possible cuts in production will not affect the company's employees and that its management does not intend to introduce downtime at the company’s operations, while production will be reduced due to personnel taking their scheduled leaves.” Nevertheless, the basic message remains the same - the company’s actual output will depend on global diamond demand.
DIVIDENDS
The first positive news for the shareholders of ALROSA came in mid-March, when Andrei Zharkov announced that the company may drive its payments to 50% of its net profit under IFRS instead of the 35% under its dividend policy. In this case, ALROSA will pay 2.2 rubles per share to its stockholders (a total of about RUB 16 billion). The miner’s generosity is due to the stricter requirements set by the government for dividend payments carried out by state-owned companies - in April, Prime Minister Dmitry Medvedev signed a decree, which had been debated for quite a while and now says that such companies are expected to pay the greater of the two amounts - 50% of their net profit under RAS or under IFRS – “in order to mobilize revenues to fill the federal budget.”
But tying dividend payments to net profit will not eliminate the problem of exchange rate differences - at least as long as the ruble exchange rate remains volatile. Ninety percent of ALROSA’s revenue and twenty percent of its costs are denominated in US dollars, as it follows from the presentation, and a 10-ruble change in the dollar exchange rate results in a 25-percent change in the company's EBITDA.
Providing a positive impact on revenues and EBITDA, the devaluation of the ruble often has a negative impact on net profit. In 2014, ALROSA posted a net loss due to the revaluation of its foreign currency debt, and was allowed by the Federal Property Management Agency to pay dividends at the level of 2013 (1.47 rubles per share or RUB 10.826 billion in total). Right now the Federal Property Management Agency is considering to tie the total amount of dividends to be paid to the company’s free cash flow, rather than to its net profit, which is influenced by non-cash items, said Igor Kulichik, Vice President and Chief Financial Officer of ALROSA. Switching to dividend payments based on cash flow may be possible after the company will post its 2016 results, he said.
CAPEX
If the dividend-related package promising an increase in incomes was positively embraced by investors, the miner’s new capex benchmark struck a warning note. ALROSA increased its estimate of capital investments in 2016 to RUB 38.9 billion, according to its presentation. Previously, the company said that capex would be at the level of last year, when it reached RUB 34.2 billion.
The diamond miner’s total volume of capital investments will grow by 20% (or by RUB 15.6 billion) in 2016-2018 compared with the previous estimates, according to a review of Deutsche Bank. Of these, RUB 8 billion will be spent for the construction of a railway branch to Verkhne-Munskoye to be later reimbursed by the state. The remaining RUB 7.6 billion may be related to exchange differences, according to Deutsche Bank.
In the view of Renaissance Capital, ALROSA’s capex growth is explained not only by the devaluation of the ruble, as only 10% of its capex is denominated in U.S. dollars. “We believe that this reflects the structural risk of further pressure on the cash flow in the long term,” the review said.
PRIVATIZATION
The Investor Day participants, of course, could not ignore the theme of privatization, which could become a major corporate event for ALROSA in 2016. Terms and methods of privatization are to be chosen by the government, but the position of the company’s management in this regard is important, if only because it sheds some light on the current stage of discussions. Even more so, in the context of rumors, which are disturbing the market from time to time, about various combinations that are not ideal in terms of growth in shareholder value of ALROSA - such as the rumor about a possible merger with Polyus Gold. The market does not welcome a strategic investor in this company either, which means that the entire stock to be floated (10.9% or even 18.9%) can be sold to a sole proprietor, because in this case ALROSA may face a shareholder conflict hanging over it like the Sword of Damocles. On the other hand, it would be not at all logical for the state to support a company having a powerful ‘anchor investor’ frequently mentioned on the Forbes list, like Suleiman Kerimov or Viktor Vekselberg.
The management team of ALROSA believes the best option to privatize the company’s stock will be to put it up for sale to a wide range of investors, said Andrei Zharkov on the Investor Day, answering the question, which privatization option was most likely - public offering or selling to a strategic investor. This position is supported by the investment community, according to the company’s president. Otkrytie viewed this statement as a positive aspect. Deutsche Bank is skeptical about the prospects of privatization itself. According to the latest comments coming from officials, the government, too, prefers public sale on the Moscow Stock Exchange, although the final decision will be made based on the recommendation of the transaction organizer, which is Sberbank CIB. If the course for higher publicity prevails, we can be sure in the first place that the “ALROSA Investor Day 2017” will be held and, secondly, that its agenda will be focused on regular issues, like prices, market demand, plans, repayment of debts and disposal of non-core assets, but not on some struggle between ALROSA’s shareholders, though giving a thrill to journalists, but not very useful for the company's market capitalization - like that, which was tearing apart Norilsk Nickel in 2008-2012.
Sergey Bondarenko for Rough&Polished
