For the 2008 fiscal year Alrosa, the largest Russian diamond producer,  reported a loss of more than RUR 32.5 billion. The shortfall is blamed on the international economic crisis and the devaluation of the Russian currency. The company’s profit for the year stood at RUR 16 billion.

Alrosa’s indebtedness increased in 2008 nearly twofold – from RUR 60 billion to RUR 115.5 billion.

While experts are not ready to say that Alrosa’s prospects for the next several years are brilliant, the company’s position on the market will be a sustainable one as the largest diamond-consuming countries recover from the effects of the economic downturn.

Losses

The earnings statements issued by Alrosa indicate that the causes for the decrease of profits include the drop of FX forward values, the negative exchange rate differences on dollar loans and anticipated disbursements in forward contracts.

Forward contract between Alrosa and several banks were made three years ago for purposes of hedging foreign exchange risks when Russian currency strengthened. Alrosa entered into agreements to sell American dollars to banks at an exchange rate of RUR 26.56 – 26.84 to a dollar. The loss resulting from Alrosa’s adherence to these contracts for the past fiscal year was more than RUR 25 billion.

According to the vice president for relations with corporate clients of JP Morgan Russia Mr. Albert Sagirian, the results Alrosa reported were expected. The rising cost of procuring financing and assuming the obligations under foreign exchange contracts exacerbated the situation.

The losses from the company’s operations in 2008 came to RUR 14.01 billion. In 2007, the company had a profit of almost RUR 24.5 billion. Alrosa’s EBITDA in 2008 was RUR -5.2 billion. Just one year before, in 2007, the EBITDA indicator was RUR 33 billion.

Despite losses from other sectors of its operations, Alrosa managed to preserve the positive trends in its sales. In 2009, revenues from sales were RUR 91.08 billion, a figure that slightly surpassed the results of 90.73 billion in 2007. The sale of diamonds was virtually stopped in the last two months of 2008.

The sales of diamonds standing at RUR 78.24 billion amounted to 86 percent of net revenues – roughly 2 percent down compared to the results for 2007. The revenue from exports decreased dramatically by 18 percent, leveling off at 38.9 billion. A major contributing factor for the decline in export activity is the drop in sales to De Beers. 

In early 2008 analysts predicted a surging demand for cut and uncut diamonds. Prices for diamonds were also supposed to have gone up throughout the year. The forecast remained valid for the first nine months of the year – until the economic downturn finally reached the diamonds industry. As demand dropped, the market became saturated and financing procurement proved to be extremely difficult. The prices on rough diamonds decreased, prompting the largest mining companies to cut sales and lower production. 

As Sergei Goryainov, an analyst with Rough&Polished, commented, at the onset of the crisis, Alrosa was just to the point of establishing firm relationships with its long-term clients. Most of the company’s clients bought on a deal-by-deal basis, and the purchase of even a large consignment of diamonds did not mean that the same client would return to Alrosa to make additional orders in the future. Clients were generally not interested in buying diamonds for end-consumer processing. The increase in price before the economic collapse lead to the involvement of brokers and greater opportunities for speculation in the business. 

When the economic crisis broke out, these one-time customers disappeared, leaving Alrosa without long-term  contracts and steady orders.

The substantial decrease in revenues notwithstanding, Alrosa decided to proceed with its capex plan, whose cost was estimated at RUR 18.25 billion. Spending on exploratory operations rose to RUR 4.52 billion in 2008, compared to RUR 4.14 billion a year earlier.

Most of the capex funding was allocated for converting Alrosa’s open pit mines into deep mines. The company is now engaged in the construction of three deep mines that cost USD 1 billion each. One of the mines at the Mir diamond pipe has been completed in the summer of 2009.

Indebtedness

Alrosa took out substantial loans for implementing its capex program. The overall indebtedness of the company increased from RUR 59.86 billion to

RUR 115.55 billion, largely as a consequence of capex. Short-term debt began to reflect negatively on the liquidity of Alrosa, especially in the fourth quarter of 2008, when the flow of cash from sales dried up. Negative liquidity in 2008 was RUR 37.56 billion.   

The debt problem became more pressing in the final months of 2008, when Alrosa intensified its work on constructing deep mines. Deep mine construction at that time no longer could be postponed because the process had already passed the point of no return from a technological standpoint. The need for ensuring the accessibility of new deposits was also a major factor in deciding to continue with the project – especially in view of the depletion of near-surface resources. 

VTB is Alrosa’s main lending institution. In 2008, the company also used the services of the Bank of Moscow, Alfa-Bank, and Mezhprombank. Alrosa has explored the option of selling diamonds to the state as a method repaying the loans. The company has entered into negotiations with the State Precious Metals and Gemstones Repository (Gokhran) that was interested in procurements. According to Interfax, Gokhran agreed to buy USD 1.5 billion worth of rough diamonds from Alrosa in 2009 and the same amount in 2010.

Gokhran has already bought RUR 12 billion of diamonds from Alrosa in the current year, an amount that includes RUR 3.69 billion for the purchase of diamonds initially authorized in the state budgets for the 2008, 2009, and 2010 fiscal years. The sale of these diamonds took place in early 2009. The budget of Gokhran has since been revised to authorize the purchase of an additional order of diamonds for the total amount of RUR 8.4 billion (including the payment of a value added tax in the amount of RUR 1.3 billion). This lot of diamonds was sold to the state in June.   

Industry experts note that Alrosa’s situation will remain stable if the state purchases USD 3 billion of diamonds from the company within the next two years. While profits cannot be expected to reach astronomical heights, the company will have enough money to operate and pay off its debts.

One other way for Alrosa to remove the burden of its indebtedness is to sell assets that are not essential for operating purposes. Recently, Alrosa approached VTB for discussions about the sale of the company’s hydrocarbon assets to the bank at the price of USD 620 million. The result of these negotiations was positive for the company. 

Alrosa was involved in talks for the sale of Urengoi Gas Company and Geotransgaz. Among Alrosa’s other hydrocarbons assets are Irelyakhneft and Sakhaneftegaz based in Yakutia. The latter enterprise was placed under court supervision at the end of 2008.

Analysts predict that this year the disposition of non-core assets and the improvement of market conditions will allow the company to demonstrate better financial results.

View going forward

Alrosa proceeded with its investment program in the first half of 2009, but diamond sales were virtually frozen, with the exception of state acquisitions. The company ended quarter I with a loss of RUR 12 billion, a marked decline from a profit of RUR 112.6 in quarter II, 2008. While the final numbers for the first two quarters of the year have not yet been released, analysts say that the results of the second quarter did not differ much from those of the first. 

The company rebounded in July, making several large long-term contracts and selling USD 150 million worth of rough diamonds. The company’s new clients include the Kristall factory based in Smolensk and the diamond-cutting plants in Yakutia. Alrosa also began to take part in auctions to sell its gems more than 10.8 carats in size. The first auction of this kind took place in Moscow in July and brought a USD 13 million profit to the company.

Alrosa still intends to sell USD 2.6 billion worth of diamonds before the end of the year. Some analysts, however, believe that the positive trends seen in July will not sustain themselves indefinitely. The diamond sector has been affected much more profoundly than other commodity markets. Also, the summer months have traditionally seen greater activity in the diamond industry.

While clear signs of recovery have now come to light, it would not be sensible to rely on overly optimistic forecasts. The forecast of the demand for rough diamonds should be based on the forecast of the demand for cut diamonds. Basing the estimates on the need for finished product is key to going past the speculative trends that once pervaded the industry. At this stage the demand for finished diamonds has been assessed as stagnant at best.

Analysts think that Alrosa will choose a careful sales policy and not allow its prices to fall. Backed up by Gokhran’s orders, Alrosa will strive to find real long-term buyers that are end consumers of rough diamonds.   

The head of Morgan Stanley’s Russian investment banking division Yan Tavrovsky commented that the improvement of the economic climate in the West will definitely help Alrosa, since Western countries were large consumers of the company’s diamonds.

Alrosa’s shareholders are also excited about the designation of Mr. Fyodor Andreyev as the new president. Mr. Andreyev enjoys broad support of the stockholders. According to Yan Tavrovsky, Alrosa has a reputation for honoring its commitments, and there are no grounds to believe that this business approach will change in the future.