Organizationally, the diamond industry in the USSR was characterized by a truly Spartan simplicity and logic. Mines, mining companies and processing plants were part of the association called Yakutalmaz. The discovery of primary diamond deposits in Yakutia facilitated the development of the diamond cutting industry within the Kristall System embracing seven factories, including those based in Smolensk, Moscow and Gomel. People in the Soviet Union could not be stable consumers of diamond jewelry, due to which only a small part of luxury goods was sold domestically through a network of retail stores belonging to Glavyuvelirtorg (Main Department of Jewelry Trade). Basically, the diamond-cutting industry was export-oriented, and rough and polished diamonds and diamond jewelry were sold overseas through Almazyuvelirexport, a state-owned trade association for exporting diamonds and jewelry. This example of divided business profiles can rightly be called classic for the “diamond pipeline,” with diamond mining, diamond manufacturing, jewelry production and retail functioning separately. The idea to integrate all of these specific activities into a conglomerate apparently never occurred to the People's Commissariat of Trade, the Ministry of Finance or the Council of Ministers of the USSR, which at different times made decisions on establishing or transforming this or that element in the production chain. The Russian government did not think about it either when it established the diamond mining company called “Almazy Rossii – Sakha” (later turned ALROSA) on the basis of Yakutalmaz in 1992. However, the prospect of vertical integration started to loom in dead earnest before the Russian diamond industry in 2014.
In the spring of this year, Deputy Prime Minister Yury Trutnev, appointed to oversee ALROSA, authorized the company to consider the development of the diamond cutting industry in Yakutia to increase production of high-level-processing goods. Besides ALROSA, Yakutia’s diamond cutting industry is to get state support - at the expense of public-private partnership and preferences. “We need to process the natural wealth of our country here, leaving a high added value in the territory of Russia,” Yury Trutnev said. Later he instructed the Ministry of the Russian Federation for the Development of the Far East, Yakutia’s authorities and ALROSA to explore the establishment of a diamond bourse in Khabarovsk. In the opinion of the Deputy Prime Minister, Khabarovsk would be able to compete with the world center of diamond trade in Antwerp and satiate the fast-growing Asian markets with diamonds manufactured in Yakutia due to its geographical location.
Let us leave aside for a while the issues regarding the slow-up in demand for luxury in the key Asian market, which is China, or the absence of conditions for the creation of a diamond hub in Khabarovsk. Instead, we shall focus on the long-suffering diamond-cutting industry in Yakutia. The task to increase the profitability of the diamond industry in Yakutia has been repeatedly formulated by the federal and local authorities, but it failed to be implemented. It was not only because, in the opinion of ALROSA, some manufacturers in Yakutia misused purchased rough to resell it, actually not being engaged in diamond manufacturing. Keep it in mind that margins in diamond cutting barely exceed 5%-8% in the best of times, whereas miners drive this index to 16%-20%, according to Bain. If a hypothetical diamond manufacturer in Yakutia does not bear the costs associated with mining and due to some non-market peculiarities of doing business gets access to high-quality rough, it is obvious that this manufacturer is not motivated “to leave a high added value in the territory of Russia.” Such a manufacturer is motivated to strike mutually beneficial deals abroad using the diamond cutting segment of its business in this situation only as a cover. Especially taking into account that the added value obtained from processing in Yakutia cannot be “high” a priori. Diamond manufacturing costs in Yakutia reach about $ 180 per carat, well above the $ 80 at which such costs are estimated at the Smolensk-based Kristall factory built in the 1960s, the largest “fragment” of the Soviet Kristall System. This is why Kristall in Smolensk located 10,000 km away from the diamond fields in Yakutia is the major diamond manufacturer in Russia and a major player in the international market, not diamond manufacturers in Yakutia. The option of subsidizing diamond cutting in Yakutia by the state or ALROSA does not seem to Kristall the most rational distribution of forces at all.
Therefore, in the wake of reports saying that Kristall is to be included in the privatization plan for 2014-16 Maxim Shkadov, CEO of the Smolensk-based manufacturer, dealt a “counterblow” – he proposed his own concept of how to rehabilitate the diamond-cutting industry to Deputy Prime Minister Yury Trutnev. However, it can be assumed that initially the main task of Maxim Shkadov and Smolensk Governor Alexei Ostrovsky was not the reform of the entire industry, but presenting Smolensk “as the only established integrated diamond processing complex, which needs to be developed and supported by the government” (this is a quote from Maxim Shkadov). “The ideas of creating such centers in Siberia, the Far East and Yakutia are very difficult to implement, if not to say that it would be wasted money. ... As a result, the Deputy Prime Minister admitted that Smolensk today is Russia's only center that forms around itself a diamond processing industry,” the head of Kristall said.
He proposed to create in Russia a vertically integrated framework combining all the three parts of the “diamond pipeline” - diamond mining, diamond manufacturing and diamond jewelry retail. “On the part of the state it would be logical to create a holding company linking all the chains - from diamond mining to manufacturing, jewelry making and jewelry retail. This makes sense, because the major margins in our industry are earned in the first and last links - in diamond mining and retail trade,” Maxim Shkadov explained.
In other words, the optimistic scenario for Kristall’s future is to merge with ALROSA and cost-efficient players in the retail section, which together will subsidize the low-margin diamond-cutting segment. The pessimistic scenario for Kristall is to be bought by unfair competitors in the course of privatization and then drift into leasing its premises. Maxim Shkadov explained, that the issue is serious because investment attractiveness of Kristall as a diamond manufacturing business is minimal and the only “healthy” investor for it can only be ALROSA. “In the current situation, private business will not invest here any money. The company depends on the supplier of raw material, and there can only be some sort of combination with a mining company,” the CEO of Kristall said.
The contour of this combination is integrating Kristall in the framework of ALROSA, whose rough accounts for 60% of purchases made by the Smolensk company, as it was later explained at Kristall.
One consequence of such a conglomerate would be the creation of a Russian jewelry brand able to compete with Tiffany, Harry Winston and Cartier, Maxim Shkadov believes. The head of Kristall addressed this initiative to the Ministry of Finance five years ago, but he failed to convince the Ministry or ALROSA. The relevance of having a jewelry brand is enhanced by the threat of mixing synthetic diamonds with those natural, causing fears among miners and sellers.
Having done justice to the globalism of Maxim Shkadov’s idea, let us make some conclusions. Firstly, as we have already said, this idea is pragmatic within the struggle against Yakutia’s diamond manufacturing for “a place in the sun.” Do not forget that the top management of the majority of state-owned companies – Kristall is no exception here - is not interested in privatizing their businesses for a diversity of reasons. Perhaps, the option promoted by Kristall’s CEO – merging with ALROSA and unnamed players of jewelry retail – is impossible from the outset because from the purely legal point of view it may be accomplished only if the Smolensk factory will be privatized. Maxim Shkadov implies that there is a possibility either to abandon the privatization of Kristall or to undertake a cumbersome process of consolidating all the diamond sector with the participation of ALROSA, a public company. In the first case, the top management of Kristall will have to deal with the problems of commercial viability, but they are already doing this in the course of several years, and the positive market situation in 2014 allows diamond manufacturers to “accumulate some fat” in case the negative scenario of 2012-2013 will be repeated. The third option is not necessary – Kristall’s top management, its shareholders and members of the Board of Directors will not permit the factory to be shut down and to convert its production facilities into shopping centers, Maxim Shkadov stressed. What does it take to derail an unfavorable project? Obviously, to launch your own project, even if blue-sky, but distracting attention and efforts and forcing the decision maker be carried away thinking in a different direction.
Interestingly, while talking to the press Maxim Shkadov was frank to acknowledge the complexity of his proposal saying that “to put it together (mining, manufacturing and retail) is very difficult, because each stage of the so-called “diamond pipeline” has its own specifics. It is difficult to switch over to another type of business in a single step. ... It is difficult to say what kind of benefits such a framework will give. There is a bunch of nuances.”
At the same time, the situation makes the head of Kristall not sit idly by, watching the preparations for the privatization of his company and subsidies earmarked for diamond cutters in Yakutia. He admits that the sector is facing a reform. “According to the information I have, we can only conclude that there are plans to reform the entire chain - from diamond mining to establishing a framework producing and selling jewelry,” Maxim Shkadov said. And this is perhaps the main conclusion to date.
Now let us ask another question: If the inconsistency of the vertical integration concept is recognized even by the industry players most interested in such changes, why is it needed at all? According to Sergey Goryainov of Rough&Polished, “the game to create a conglomerate may pursue the goal to solve the conflict over the chair occupied by the head of ALROSA.” According to state media, Deputy Prime Minister Yury Trutnev opposed the extension of the contract with the president of ALROSA, Fyodor Andreev, despite the positive assessment of the latter’s activity by the Supervisory Board of the company and the support rendered by the second largest shareholder, Yakutia. “If Yury Trutnev is interested in this concept (vertical integration), this raises many questions. Creating a new company by combining ALROSA and Kristall may be some tactical maneuver to remove the theme regarding the appointment of Fyodor Andreev,” Sergey Goryainov said.
However, the idea of combining both companies is considered by Sergey Goryainov as quite adequate. "This idea has a rational element. Creation of large holdings bringing together diamond manufacturing, marketing and jewelry retail means to follow the trend set by De Beers, which is developing its own jewelry brand, Forevermark. Since the competitor moves in the direction of vertical integration, it is logical to do the same,” Sergey Goryainov said.
Analysts from investment banks evaluating the idea in terms of ALROSA’s investment attractiveness have a different view. Vadim Astapovich of VTB Capital reminds that ALROSA adopted a strategy focusing it on mining. “It was a strategically correct decision, which permitted to maximize the company's value. The trend of recent years is that diamond producers get rid of manufacturing and retail - the example of Harry Winston, which focused on mining, is revealing,” the VTB Capital analyst said. The result of such a merger will be reduced earning capacity of the group. “There is no synergy there – Kristall for ALROSA is only one of its Sightholders, albeit large. Taking into account the perspective of lower domestic demand for diamonds manufactured by Kristall due to an unstable macroeconomic situation and simultaneous inflation of prices for rough diamonds, it is natural that Kristall is ready to join another state holding – but it is not to say that it will be economically feasible,” the VTB Capital analyst said.
“By and large, ALROSA does not need either manufacturing or retail - due to low margins of the first business and the lack of expertise in the second,” Denis Gabrielik of the Otkrytie Investment Bank agreed. “This merger is contrary to the strategy of ALROSA, which long before the IPO announced its intention to focus on the core business, disband non-core assets and refrain from developing manufacturing or jewelry segments,” the review of the investment bank concludes. “If ALROSA will have to invest into diamond manufacturing in Yakutia and into creating a diamond hub from scratch - these projects are unlikely to yield significant dividends and this will be perceived negatively by the market. ALROSA’s investors will see this as a departure from the strategy. This involves additional capex and the need to increase the number of employees. In addition, ALROSA will not get additional value from this merger,” the Otkrytie analyst noted. In his opinion, this potential transaction will turn negative for ALROSA, as the situation, in which the mining division will subsidize the diamond manufacturing business, will adversely affect the company's profitability.
The same view is held by the Citi analysts. “We believe that this news is negative for ALROSA, as it demonstrates an increasing desire to integrate the miner into diamond manufacturing and possibly in retail. Such a move is likely to reduce the ROI (return on investment) and will be negatively perceived by investors,” the report of the investment bank said.
With all the “pros” and “cons” regarding the vertical integration of the diamond industry, it should be recognized that it is too heavy a tool for solving the problem of unseating the head of ALROSA. It is most likely, that the functional means at the disposal of the Deputy Prime Minister of the Russian Government and Presidential Plenipotentiary Envoy to the Far Eastern Federal District make it possible to solve this problem - if it is really worth it – in a more linear manner. There remains a hope that a chosen decision will not lead to a change in ALROSA’s strategy, which was highly appreciated by the market before the IPO and still allows ALROSA to be traded at 25% above the offering price. In fact, the company’s being public and the associated investments, as well as the opportunity to follow a coherent strategy of concentrating on its core business and cutting off non-core assets appear to be one of the main differences between the modern ALROSA and Yakutalmaz of Soviet times.
Sergey Bondarenko for Rough&Polished
