In the current crisis environment, in which every rough diamond carat supplied to the market may be one carat too many, Russia’s Alrosa is perceived to be acting responsibly and admirably by taking itself “out of the market” and, instead, selling its current output to the federal government’s Gokhran precious stones and metals depository. Some time ago, Alrosa President Sergei Vybornov was quoted in a Russian press report as “expecting that the Gokhran will be a reliable source of at least $2.4 billion revenue in 2009.”

That remarkable statement is either a “solid fact” or merely “wishful thinking.” Together with Vybornov, one would hope that the Russian federal government’s desire to keep Alrosa afloat is absolute. The truth is, we simply don’t know. This week, Vybornov gave a different estimate: "We would like them [Gokhran] to buy up to 50 percent of our annual production this year." Vybornov also wants to start selling to private individuals in the Middle East who would buy the diamonds as an investment.

In 2008, the Alrosa Group produced some $2.36 billion worth of rough, and it plans to maintain this level of production in 2009. The Vybornov remarks imply that the Russian government is willing to buy between six months and a full year’s worth of output. This is all music to the ears of the international diamond community.

Alrosa will add to market and price stability, and, for as long it has a guaranteed buyer for its output, the world’s second largest diamond producer will also be perceived as being financially strong. The industry needs strong suppliers that can resist the pressures to which weaker players are exposed: the pressure to sell goods at any price since they need cash to survive.

The Russian federal government’s willingness to purchase the Alrosa output is fundamentally comparable to a government bailout. However, the situation is far more complex than the scenario in which a European or U.S. government injects trillions of dollars into its banking systems or actually nationalize banks or become the buyer of last resort of Alrosa’s diamond output.

Russia’s Federal Government and the Republic of Sakha

Just as Botswana is heavily dependent on diamond income, so is Russia’s Republic of Sakha (Yakutia), which is home to Alrosa and its mines. During previous diamond industry crises (in the late 1990s), this diamond republic of some one million people experienced severe budget problems and was hardly solvent. Its people suffered. Sahka’s governmental budget (of some $2.5 billion annually) depends largely on transfers from the Russian federal government and on the resource income such as the 40 percent direct Sakha government share in Alrosa, in addition to tax and other benefits directly supplied by Alrosa.

The Russian government has signed a power-sharing treaty with the Republic, and the degree of control over diamonds and the sharing of marketing rights and sales revenue have been points of contention between Yakuts and Moscow for many years. To complicate matters further, in recent months, Russia’s federal government has assumed control of 50.9 percent of the shares of Alrosa, which is partly the result of a complex political deal connected to former president (and now premier) Vladimir Putin’s support of the election and subsequent re-election of Republic of Sakha President Vyacheslav Anatolyevich Shtyrov.

Gradually, we have witnessed Putin's consistent policy of consolidation of “vertical power,” i.e. control over the ownership and distribution of diamond resources being wrested from the Republic's authority. So far, Putin has been successful – but will the present 50.9 percent of federal government control be enough?

The federal controls are, naturally, a potent political issue in the Republic of Sakha. There are many politicians and entrepreneurs within the Sakha national elite that opposed the loss of the Republic’s control over Alrosa, which produces well over 95 percent of all diamonds in Russia. They see it as “an end to all of its autonomy.” It is, however, a fact of life.

Gokhran Support – a Political Imperative

The Russian government bailout of Alrosa and the purchase of all its unsold diamond production should not be blindly interpreted as merely an act of “responsibility” to maintain international diamond price stability. It is foremost related to domestic policies – and to ensuring the solvency (and fiscal integrity) of the Republic of Sakha. The federal government, having assumed control over Sakha’s most important assets, must also show that it accepts the responsibility that comes with the controls. This works fine for the people of Sakha as well as for the international diamond community.

Will it last – or is it limited to the six months or one year as noted by Vybornov? There are too many seemingly inexplicable elements in the relationship between the commercially autonomous Alrosa and its federal and regional shareholders. Alrosa is burdened by debt. While on the one hand the Russian government ensures a regular and steady revenue flow through buying the company’s diamond output, on the other hand, Alrosa seems to be struggling to find money to keep it afloat.

In the next few days, Alrosa plans to raise some $50 to $100 million on Europe’s financial markets through the issuance of zero-coupon bonds (maturing in six months) at an expected (annualized) yield of 14 percent or more. At this price level, these bonds qualify to be viewed as “junk bonds,” well below investment grade. Standard & Poor’s recently downgraded Alrosa to a BB- rating, with a further negative credit watch, something that clearly angered Vybornov when he referred to it at the last Antwerp diamond symposium.

Ostensibly, that anger seems justified. One would expect that the government control of Alrosa would be assuring to investors. There is something scary about what is currently happening in Moscow. This week, Russia had its debt rating cut by Fitch Ratings for the first time in more than a decade as falling oil prices contributed to dwindling foreign currency reserves and record capital flight. (Russia has spent $210 billion, or more than a third of its currency reserves, supporting the ruble since the onset of the financial crisis; foreign investors have pulled about $290 billion out of the country since last August). With the Russian government’s credit status plunging to near-junk-bond status, one wonders how much cash and political will the government can muster to sustain its diamond purchases.

Could Alrosa Default?

Alrosa’s gross margins (EBITDA) are in the range of 26-33 percent of sales. Its 2008 gross profits were in the range of $770 million (or $130 million net profits). It surely seems like a darned solid company. Conventional wisdom would have it that as the company is basically government owned, investors ought to have the comfort that the company’s loans will be repaid.

It doesn’t seem to work that way, though. Investors view Alrosa mostly as a company with some $3.6 billion worth of debt on its balance sheet – and additional liabilities off its balance sheet. The company is constantly trying to raise new debts in order to pay off maturing debts. (In a way, this puts Alrosa on par with a lot of other conglomerates, including major diamond companies that also pay for maturing debt through securing new credit lines.)

Could, heaven forbid, Alrosa at some point default? Could it go bankrupt? Will it come through the present crisis unscathed? These are awful questions and, sadly, the answers don’t depend at all on the management capabilities of Alrosa’s Vybornov and his colleagues. The answers depend on the Russian government and Vladimir Putin’s domestic agendas – not only in respect to government control of mineral resources, but also Moscow’s leverage over the Republic of Sakha.

A few months ago, the state-owned VTB Bank provided a loan of about $1.6 billion for a period of about 18 months only to refinance maturing loans. Alrosa has between $500- $900 million worth of lines of credit from western and Russian banks, but some of these facilities may be just theoretical and not available when the needs arise. A possible default would be from one state-owned entity to another. That makes it far more a political than an economic issue.

Like other mining companies, Alrosa has ceased most of its exploration activities. The company will also start selling off non-core assets, just as with other mining companies. But, mostly, it will do everything to avoid a plunge in diamond values. Management will do all it can do – but we fear that its future will be determined by politicians. Would the Russian federal government allow a default to occur just to step in and take 100 percent?

The Standard & Poor’s rating agency has recently completed a “Debt Recovery Scenario” exercise for the event Alrosa defaults on any of its loans. In such event, says the agency, it is not expected that more than 30-50 percent of the amounts in default will actually be recovered. That’s the bad news.

The “good news” is that “given the valuable nature of Alrosa's assets and status as a government-related entity, we believe that the group would be reorganized rather than liquidated under a potential default,” says the agency. In plain English: if something goes wrong, the government will step in and do as it pleases. This scenario shouldn’t worry the industry; it really doesn’t matter who does the mining. Industry is concerned with the marketing.

The rating agency further simulates a “deterioration of the trading terms due to a decline in production volumes and margins as the company's existing open pits become deeper and underground mining, which is by nature a more costly mining technique, proves less profitable than initially expected.” To make a long story short, the interest rates Alrosa is expected to pay in the future are forecast to go up.

Rating agencies have in the past year proven that they basically don’t have a clue what is happening. It remains puzzling how powerful they still are – and how they can make or break companies. A forecast that an Alrosa default would give investors 30 to 50 cents on the dollar is not comforting, even those most of the world’s potential defaults of leading banks in the world would yield far less than that.

In the diamond business we must continue to appreciate (and salute) the current cautious course of Alrosa’s management. At the same time we must wonder how long the Russian government will be willing to buy the company’s production – and, if not, whether Alrosa will be forced to sell its stock because of pressures from its lenders. Moreover, inventories in the hands of Alrosa are one thing; the Gokhran is something else.

Anyone remembering the 1990s will recall that some of the great damaging excesses that took place (such as Golden Ada) were Gokhran-related. It is a different situation with different people today, but as the Russian government’s foreign currency reserves are dwindling again, we shouldn’t be overjoyed with the idea that the diamonds are in government hands. It wouldn’t be unprecedented for the Russians to dump diamonds – just for the cash.

What will happen in such event is better left unsaid. Unfortunately, there is little Alrosa would be able to do about it. Vybornov hopes that by September the market will have recovered and normal sales can be resumed. We doubt it – but clearly hope that Vybornov has it right – and that he can minimize the rough sales to the government. That’s better for all of us.

Have a nice weekend.