alrosa 2013 review

www.diamondshades.com/diamondreport publication 1

Companies Diamond Industry Series

Equity Communications

Alrosa 2013 Review

(excluding Catoca)

July 25, 2013

Table of Contents

Production Page 2

Revenue Page 6

Diamond Reserves Page 9

Shareholder Value 0

Disposal of Assets Page 11



Overview

Alrosa is the world's largest natural

diamonds producer by volume. Alrosa

accounts for 98 percent of all rough

diamonds produced in the Russian

Federation. The company’s share of

current global diamond output is 25

percent.

Alrosa has been consistently predictable

in recent years. It has outlined goals for

the period 2010-2020 that it is

resolutely pursuing. It seeks to:

1. Grow production to at least 40

million carats

2. More than double sales revenue

3. Boost its diamond reserves

4. Diversify its shareholding and

grow value by 30-50 percent

5. Sell its non-core assets and

reduce debt obligations

We review progress to 2013 and also

look towards the future.

Figure 1: Alrosa Alrosa

Main Office

Russia

Mining Operations

Russia

Angola 32.8%

Exploration Pipeline

Russia

Angola

Zimbabwe



1. Production

Figure 2: Alrosa diamond production

Source: Company Reports, Equity Communications

Figure 3: Alrosa diamond production 2


Alrosa has maintained a steady level of production in recent years. This is helped by the fact that the

company has the ability to sell diamonds to the state in periods of weak market conditions. Contribution

from individual assets varies from year to year, influenced by maintenance work and the transition to

underground mines for key assets. For example, in 2012, transition of open-pit operations to

underground mining at Udachniy pipe resulted in further production decline which was offset by the

processing of higher grade ores at the Jubilee pipe.



To increase production to 40 million carats per year from its current assets, Alrosa will need to make

substantial capital investments of up to US$4.5 billion by 2020.

Figure 4: Alrosa Capital Expenditure


Mine developments

Aikhal underground - Completed. 500 000 tonnes of ore per year. 2.5 million carats at capacity

Udachniy underground - Early stage. 1.5 million tonnes of ore targeted for 2014

Mir underground - Medium Stage. 1 million tonnes of ore targeted for 2012

Severalmaz open pit - Medium Stage. Additional 2.5 million tonnes processing capacity by 2015

We have previously stated that Alrosa’s production plans for its mines are tarnished by the fact that the

company has historically always faced engineering and geological challenges in the development of its

mines. It is highly probable that Alrosa will continue to face setbacks as it takes its important assets

underground. For instance, water drainage design for the Mir underground project has been proven too

optimistic. A new design is in the works.



In 2013, Alrosa completed the acquisition of alluvial diamond mining company Nizhne-Lenskoe for

US$216.9 million. The company has estimated diamond reserves of 26.4 million carats with existing and

expected mineral resources sufficient to maintain diamond mining for no less than 14 years, according to

Alrosa. Nizhne-Lenskoe immediately adds at least 1.5 million carats to Alrosa's annual production,

enough to offset any potential production problems at assets undergoing transition and maintenance

work.

In the longer term, this acquisition will add at least 1.7 million carats to Alrosa group’s annual

production volume of gem quality diamonds.

By our estimates, at least 40 percent of Alrosa's output will be from underground mines by 2020. We

carry forward our view from last year that current market conditions allow Alrosa to generate sufficient

cashflow to cover capital expenditure requirements while servicing its debt. However, any worsening of

the diamond market could limit the company's ability to invest, thereby delaying project execution and

production replacement.



2. Revenue

Figure 5: Alrosa Diamond Sales Alrosa Diamond Sales

2007 2008 2009 2010 2011 2012 2013F

Revenue 3,125,680,000 3,145,140,000 2,088,140,000 3,333,800,000 4,260,550,000 4,450,128,000 4,825,000,000 Carats Sold 35,600,000 34,600,000 26,200,000 39,500,000 32,900,000 33,200,000 36,000,000

US$/ct $87.80 $90.90 $79.70 $84.40 $129.50 $134.04 $134.02

Source: Company Reports

Based on our global supply and demand projections for rough diamonds, it is quite improbable that Alrosa

will double its annual revenue to more than US$10 billion by 2020. Nevertheless, revenue has more than

doubled since 2009 to US$4.8 billion in 2012.

Figure 6: Alrosa Quarterly Diamond Sales

Source: Company Reports, Equity Communications Figure 7: Alrosa Gem Diamond Prices




Figure 8: Alrosa Price Index


Alrosa's revenue is steadily growing for two chief reasons:

In slow markets the company can sell production to Gokhran

Alrosa is using its monopolistic position to enter into beneficial long-term supply contracts with

selected clients.

The reality of rough diamond markets is that there are far too many rough diamond processors competing to

enter into far too few supply contracts with major diamond producers. Indeed, long-term supply contracts

are the holy-grail for processors of rough diamonds because being awarded one tremendously boosts

competitive advantage in diamond markets.

For the above reason, major diamond producers have achieved significant market strength. We believe long-

term contracts enhance price fixing capabilities of producers, with rough diamond prices now structured to

rise over time.

Alrosa is aggressively adopting De Beers' contract system model, now preferring to enter into long-term

supply with vertically integrated companies in the diamond pipeline. Such companies are attractive because

their businesses are less susceptible to volatile market conditions. Furthermore, these companies have

shown a willingness to pay premium prices for rough diamonds if doing so guarantees stable supply. For

instance, Alrosa has entered into a US$60 million per year supply agreement with Tiffany and Co.



The elimination of as many middlemen as possible is also a strategy that Alrosa is pursuing to boost its

sales. The belief is that middlemen create parallel distribution channels that compete with producers.

Alrosa has now expanded its sales activities in Israel for auctions of rough diamonds larger than 10.8

carats. The company also signed an agreement with the Shanghai Diamond Exchange (SDE) to sell its

rough and polished diamonds at the Shanghai diamond bourse.

We believe the drive by the major producers to eliminate middlemen will actually lead to more

middlemen in the secondary markets. In reality, no producer has the ability to provide all the diamonds

required by a vertically integrated manufacturer in the right quantities.

Alrosa should be able to raise the average selling price of its diamonds by up to 50 percent by 2020. We

anticipate increased production and higher grade ore from mines that are transitioning to underground

operations. Furthermore, the company can count on its strong market position to force through price

increases to a higher level.



3. Diamond Reserves

Alrosa`s diamond reserves and resources are preliminarily estimated at the level of 1.6 billion tonnes of

ore with 1.3 billion carats of diamonds.

In 2012 Alrosa announced the results of an audit of its mineral reserves and resources according to

Australasian Joint Ore Reserves Committee (JORC) mineral resource classifications. The audit covered

all major deposits of Alrosa, which represent about 70 percent of the company’s Russian mineral resource

base (based on the Russian resource classification).

Figure 9: Alrosa Reserve Statement

Alrosa's JORC Reserves and Resources 2011

Category Tonnes (000s)

Grade (ct/t)

Carats (000s)

Reserves

Proven 5569 1.69 9393

Probable 474063 1.31 621162

Sub Total 479632 1.31 630555

Resources

Measured 5569 1.69 9393

Indicated 493790 1.31 646513

Inferred 237715 1.31 311616 Total JORC Resources inclusive of Reserves 737034 1.31 967522

Source: Company Reports

Alrosa has traditionally been rather casual about finding new deposits for diamonds, with no real effort to

add to its significant resource base. Alrosa’s current mineral base of around 1.3 billion carats of

diamonds should be sufficient to cover four decades of production. Nevertheless, Alrosa is planning to

spend US$10 million to US$20 million annually on diamond prospecting in Angola.

We get the impression that Alrosa is satisfied with the depth of its diamond resource but would like to

add to its reserves of high quality diamonds.



4. Unlocking Shareholder Value

Alrosa's market value is estimated at US$7 billion to US$8 billion. We believe the company is undervalued

given the quantity and quality of its mineral base, as well as the company's prominent position in a captive

market.

Up to 92 percent of Alrosa's shareholding is in the hands of federal and state governments. Stakeholders have

long recognized the need to diversify the company's shareholding for purposes of unlocking shareholder value.

As a result, Alrosa spent the last three years preparing for an Initial Public Offer (IPO) that was to result in 20-

25 percent of the company being opened up to new investors.

According to early reports in 2013, it appears that both the regional government and federal government

shareholders have each agreed to give up 7 percent shareholding in an initial 14 percent IPO proposed for the

last quarter of 2013.

Alrosa's IPO has been coming for several years now. The company's shareholders have faithfully failed to reach

common ground on how best to go about the proposed IPO. In our view, the implicit message from the Russian

authorities seems to be that they prefer to remain with absolute control of the world's largest diamond miner by

volume. Therefore, further delay is possible since the terms of privatization have not yet been clearly defined

by the Russian government.



5. Disposal of Non-Core Assets

Alrosa's total debt is estimated at US$4.1 billion in 2013. US $1.1 billion of short-term debt is to be paid in

2013. We reiterate our view that the current market environment allows Alrosa to generate sufficient cash

flows to cover capital expenditure requirements while servicing its debt. However, any worsening of the

diamond market could limit its ability to invest, thereby delaying project execution and production

replacement.

Alrosa is currently negotiating the sale of gas assets it repurchased in 2012 at a cost of $1.2 billion. Indications

are that Rosneft will purchase these assets. Alrosa intends to use proceeds from the gas asset sales to refinance

its short-term debt.

Progression of the Diamond Market

Our expectations for the diamond market in the short-to-medium term are less aggressive. In the next three

years, we believe annual world production of rough diamonds will receive a boost of 10 to 15 million carats in

mainly lower quality diamonds as the Argyle underground mine also expands to full production. We already

anticipate increased production from Zimbabwe after four new companies were awarded mining licences for

different areas of the Marange concession, doubling the number of companies mining diamonds in Chiadzwa.

What this means is that diamond prices will likely rise at a slower pace than had been anticipated just two

years ago. Add to this the fact that emerging diamond markets are not growing quickly enough to replace

diminishing demand in developed diamond markets.

For in-depth analysis of Alrosa in the context of the global diamond industry, please visit the 2013 Diamond

Report Section of the Diamond Shades website.

http://www.diamondshades.com/diamondreport





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© Copyright 2013, Equity Communications Private Limited, ALL RIGHTS RESERVED.

This publication is part of the Diamond Industry Series, a series of diamond industry reports produced by Equity Communications ahead of the 2013 Diamond Report. Equity Communication’s Diamond Report provides detailed analysis of trends in the diamond industry value chain in 2012-2013, from the production end to the retail end. It is in its third edition.

About Authors

Tinashe Takafuma is Head of Research at Equity Communications. You may contact him by email at: [email protected]. Gerald Manyengavana is a Research Analyst at Equity Communications. You may contact him by email at: [email protected];

For Further Contact

If you would like to discuss this report, please contact either of the above. To find the latest Equity Communications content and register to receive notifications on new diamond industry reports and luxury goods sector reports, please visit www.diamondshades.com

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About Authors

Alrosa 2013 Review is based on research by the Diamond Industry Research Team at Equity Communications:

Tinashe Takafuma, Gerald Manyengavana, Romeo Takafuma and Fred Divine.

Supervision was provided by Tinashe Takafuma, Head of Research at Equity Communications. You may contact him by email at: [email protected]

For Further Contact

If you would like to discuss this report, please contact either of the above. To find the latest Equity Communications content and register to receive notifications on new diamond industry reports and luxury goods sector reports, please visit www.diamondshades.com


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