Public Joint Stock Company ALROSA (ALRS) Earnings Call Transcript & Summary

Dear ladies and gentlemen, welcome to the Q2 2020 IFRS results conference call of ALROSA. At our customers' request, this conference will be recorded. [Operator Instructions] May I now hand you over to Sergey Takhiev, who will lead you through this conference. Please go ahead.

Thank you. Good morning and good afternoon, ladies and gentlemen. My name is Sergey Takhiev, Head of Corporate Finance, and I am happy to welcome you to our second quarter 2020 results conference call. Today, our company represented by CEO, Sergey Ivanov; CFO, Alexey Filippovsky; and Head of Sales, Evgeny Agureev. Mr. Ivanov will start with a discussion on recent developments, market update and overview of our approach to new COVID-related reality, then pass the floor to Alexey who will comment on company's results and then we'll be happy to take your questions. As always, elements of our presentation are forward-looking and based on our best view of the market. Now I pass the floor to our CEO, Sergey Ivanov. Mr. Ivanov, please go ahead.

Good evening, ladies and gentlemen. Thank you for joining us on this call dedicated to Q2 2020 IFRS results. I hope you and your loved ones are absolutely safe and healthy. And this is the first time I am talking to you since March and, obviously, the world has changed a lot since then due to COVID-19 pandemic. It's hard to underestimate how challenging is the world today for the diamond industry and the whole value chain. We, as the largest diamond producer, fully understand our responsibility to the industry, our employees, shareholders and act in the best interests of our stakeholders. First of all, we have done utmost to safeguard our employees from COVID-19 and as of today we invested over RUB 0.5 billion in safety measures and medical equipment. We equipped our corporate medical center with 6 mini labs for COVID express diagnostics, provided specific financial benefits to corporate health care workers during pandemic, sponsored many other activities related to the first against the virus including support to public health care sector in Yakutia, primarily in Mirny region. As we regularly run COVID testing on our employees, we have identified a number of cases, but we have already developed several scenarios of a quick response to the possible spread of the virus at our production sites. These measures helped us to quickly react to the disease cases at our international underground mine. Early prevention measures helped to restore operations as early as 5 days after the closure of the site for quarantine. We also set up separate quarantine facilities for shift workers arriving to the remote sites in order to protect the staff as well as local communities. All measures taken are not in vain and help us get through the challenges without significant operational issues. We also set up a new plan for catering our clients' interests to help the sector to restore its supply/demand balance as soon as possible. To keep our organization resilient during this unprecedented market, we have implemented a number of measures from active production management to strengthening our balance sheet, to build up enough fire power to pass this crisis safely. Just a brief update on our health and safety performance, which is always our top priority. As you can see from the chart, we have reached stable ratio of different cases, which can potentially lead to injuries of 34%. This results from an introduction of the early prevention programs motivating our team to identify and report potential cases. This led to structural growth of reported cases as we were explaining at our previous conference call, but at the same time, share of the serious cases and fatalities structurally dropped. And we are happy to report 0 fatalities this year. All accidents are considered as a lesson that is taught once. We investigate each case and learn those lessons. We are raising the bar and adding more discipline to our safety controls. We have 0 tolerance to any injuries at ALROSA and fully understand there is room for further work to be done. Now let's talk about our response to new terms of the industry. There is absolutely no doubt that during this pandemic, the whole diamond value chain has been hit by supply and demand shocks on the scale never seen before. And in such conditions, we managed our organization dynamically to both shape our environment in which we had to operate and adapt to it. The history of industry shows that responsible approach to a supply side is the main way to support and accelerate market recovery after a demand shock. So first and foremost, we consistently followed our price over volume strategy, supplying products only when there is real demand for them. We provided unprecedented flexibility for our clients since April so that they could use their existing stocks to satisfy at some point really anemic demand. As a result, this approach prevented from speculative stockpiling and helped keeping prices relatively stable. Secondly, we decided to cut production in 2020 from 34 million to a range between 28 million and 31 million carats, reduce cash outlays and limit stock accumulation. This was done largely through reduction of the production at the least profitable operations with higher variable costs, though we keep on implementing all the operational excellence initiatives from debottlenecking production at profitable assets to optimization of maintenance function setup. Thirdly, we have revised our investment program from RUB 22 billion to RUB 20 billion, although this decision will not impact substantially our operations as well as their safety. Working on decreased OpEx, we also put an effort on reduction of administrative costs through contraction of payroll by 20% by reducing working hours. There's an intensive work directed to cut purchasing expenses while ensuring all the material feedstock is stably supplied. Now let's turn to the market overview. As you remember, underlying demand in early 2020 was very positive following strong Q4 last year. Retailers and the midstream were preparing to restock ahead of the year. The COVID outbreak affected China first back in Q1, but most of the world was hit in Q2, leading to demand shock. From April this year, China demonstrated an enviable rate of recovery, and we reconfirm that we perceive it as a best case example rather than a proxy for the global market. Demand in developed markets, including USA, demonstrated a mixed recovery numbers, but first signs of improved dynamics is here. Although developed economies lifted lockdowns, they still haven't come back to their pre-COVID mode, and we are not expecting jewelry demand in the second half of the year will return back to last year's levels. Through our channels checks, retailers place a lot of hope on the seasonal demand recovery in November, December this year. As monthly statistics show that imports of rough into India still lag behind edged up exports of polished, meaning that the midstream continued to rely on their existing stocks from April through July. And we believe that both retailers and polishers will have to start replenishing their diamond inventories in order not to miss the season already in early autumn. And also, I would rather refrain from making any short-term forecasts as the market is in the early stage of recovery, but I would like to highlight is that supply discipline and client-oriented approach matter a lot. And every crisis only accelerates changes that were already happening from digitalization of the production, efficiency improvements to growing importance of online shopping. And in the extraordinary times like this, our organization demonstrated our capability to quickly adapt and stay resilient, which is essential, and I believe to make the most of the opportunities every crisis presents. Now let me give the floor to our CFO, Alexey Filippovsky, to take you through the numbers, and I'll be happy to answer the questions later on. Thank you.

Thank you, Sergey. Hello, ladies and gentlemen. I suggest we turn to Page #7. As we already discussed previously, in response to freezing trades and drop in demand, ALROSA allowed its customers to defer purchases of previously contracted volumes as at some point, due to travel restrictions, no trade was possible. This profoundly impacted our sales numbers for the quarter, making it the lowest in a decade. Our diamond stock dynamics are presented on Page #8. In response to the market situation and looking to limit our cash outflows, our second quarter production was cut by 42% year-on-year. This helped us to partially offset growth in inventories, which still grew by 25% to 26.3 million carats. We also saw an increase in our work-in-process inventories, as we temporarily scaled down our sorting operations due to the pandemic. Now let's go to Page 9. Like-for-like prices were pretty much flat, as we continued to implement a price-over-volume strategy. At the same time, average realized selling prices saw a spike of 63% quarter-on-quarter and 54% year-on-year, as the share of large stones in our sales structure has increased. Now let's go to Page #10 and take a closer look at our financials. The results are following the sales trend and our top line and, consequently, EBITDA and net profit have slipped. Our second quarter revenue was down by 83% to RUB 10 billion. As you can see on the Page 11, a key driver for the revenue decline was decrease in volumes, only marginally offset by an improvement in mix. The cost of sales was down by 69%, while overall production costs, excluding stock movements, were down 7% on lower output. On EBITDA level, the company was marginally positive, driven, as you can see on Page 13, by a drop in sales volumes. As a result, profitability margins were squeezed. This is [indiscernible] low, but still positive numbers for the quarter. Now let's go to Page #14. As we discussed earlier, we further scaled down our CapEx for the year, though in the second quarter, CapEx was up from the previous quarter due to a previously committed payment for the new building for our sales and sorting unit of RUB 2.5 billion. Excluding this factor, our CapEx was 23% lower compared to Q1. Long-term CapEx outlook at this point remains unchanged. However, there might be further revisions towards the end of the year once our medium-term production plans are updated. Now let's move to Page 15, where we will discuss our debt position. Faced with the impact of the pandemic, we significantly strengthened our liquidity position. In May, we raised RUB 25 billion for 5 years at 5.75% coupon rate in the local market. And in June, we raised another $500 million for 7 years at 3.1% coupon rate in the international debt capital markets. This helped us to boost our liquidity position at the end of the quarter to $1.7 billion, while extending the maturity profile from 1.9 to 2.9 years and substantially decreasing the cost of debt. Our leverage remains in a comfortable zone of 1.2x ratio of net debt to EBITDA. Now let's turn to Page 17, where we will discuss our free cash flow. Impacted by lower sales, our free cash flow for the second quarter was negative at RUB 30 billion. Our working capital buildup of RUB 24 billion resulted from a growth in diamond inventories as well as an increase in ores and sands inventories. Let's turn to Page 18, where I will comment on dividends. On June 24, our shareholders approved the distribution of RUB 19.4 billion in dividends, which represents 100% of free cash flow for the second half of 2019. Total dividends for 2019 reached RUB 47.7 billion. Looking ahead, according to our dividend policy, there is no base for interim dividend payments for the first half of 2020, as our free cash flow was negative. Now let's go to Page 19. Today, there is still a high uncertainty regarding market development and the pace of the recovery of consumer demand. A lot of it depends on such highly uncertain factors such as the future trend of the pandemic, vaccine development and on government stimulus actions. However, we believe the fundamentals of our business remain strong, and we are well positioned to benefit from an expected recovery in the global economy. The supply of rough diamonds continues to tighten as deposits are depleting. Argyle is on track to be closed by 2021, and a number of mines are currently on hold due to the pandemic. The market anticipates a squeeze of supply in upcoming years. As for ALROSA, we are looking closely at market developments and are working on a different production scenarios for the next 3 to 5 years. These scenarios will be discussed at our Supervisory Board Meeting in early October. In any case, with our production plans, we will try to keep as much flexibility as possible, while maintaining our top priorities of maximizing free cash flow, promoting the value of diamonds and long-term value creation. This concludes my presentation, and we are now ready to take your questions. Thank you.

[Operator Instructions] We've received the first question. It is from Anton Fedotov of Bank of America.

I have 2 questions. First of all, you mentioned that the current debt level is seen by the company as comfortable. It's 1.2x net debt to EBITDA. What debt level might not be seen as comfortable going forward? And is there any debt threshold in the covenants of your debt terms? And my second question relates to the long-term production outlook. You mentioned that you are going to discuss several production scenarios with your Board in early October. Can you give us a little bit of details regarding these production scenarios and the direction and the possible range of production in long term?

Thank you, Anton. I will take these questions. According to our financial policy, the comfortable debt level for us is below 1.5x net debt to EBITDA. However, given the unique situation at the market today, we expect that this ratio towards the end of the year will be higher and our current estimate is that the net debt-to-EBITDA level at the end of the year will be in the range between 2x to 3x net debt to EBITDA, driven by lower sales and lower EBITDA. In terms of the covenants, there is a covenant of net debt to EBITDA in our 2024 Eurobonds, which says that if the company is not in investment-grade area, which is not the case today, our net debt to EBITDA should not be higher than 3.5x. So at this point, in pretty much any potential scenario for the second half of 2020, we do not see a possibility that we will break 3.0x net debt to EBITDA at the end of the year. In terms of your second question, the production will be [Technical Difficulty]

Sorry, we can't hear at the moment? Are you still there?

I think we lost Alexey, distant connection, I'm sure it will be fixed within seconds. Follow-up answering the question, so in terms of scenarios for next year, we will have different options. And the main -- we will stick to the market situation, of course. That will depend on the size of the Gokhran deal, and it will depend on the market conditions. And as I reported a little bit earlier, we worked a lot this year in terms of being more flexible, responding to market conditions. So we shutdown our several assets for months provided that we defend our cash flow and next year, so we can take 1 program in September. It doesn't mean that we will leave with the same program next year. Either we can scale down or we can ramp up. It will depend on the market conditions. Alexey, if you're with us, maybe you answer in terms of the scenarios.

I believe Alexey has some difficulties connect into the call. So we can continue and I believe he will be soon.

Maybe we move forward with the questions.

May I ask a follow-up question in the meantime. You mentioned that Gokhran deal, can you give us some detail about the time line of the purchase by Gokhran and the potential size?

So the size will be from $0.5 billion to $1 billion. I would say that we can comment only when the documents will be signed. So I would say that the deal is highly likely. ALROSA is the largest taxpayer in Yakutia and in most of the locations, we are one of the major employers, and purchase by Gokhran allows the company to offload an accumulated stock in exchange for cash. But at the same time, these stocks are not getting to the market, which is more important. And these proceeds will help the company to further improve our financial position, sustainability and, at the same time, keep on with the flexible sales strategy, which in the end will speed up supply/demand balance restoration. As previous cases in 2008 shown -- have shown that Gokhran was selling stones in small installments to the market in upcycle, hence selling at higher prices in coordination with ALROSA. So we expect that if the government would finally approve this instrument, there can be several installments. Half of them, for example, in end of this year and the second half Q1 or Q2 next year. But it will depend on the company's needs and on the market situation for -- so for example, if the market will be recovering quickly in September, October, we can shift these volumes to next year and have it as an instrument. So for us, it's important that the government generally approves this instrument so that the company can use it within the next 6 to 7 months. And the product mix, it will be average production mix. No specific sizes, no -- like cherry-picking. There will be no limitations on use of proceeds and no, how should I say, strings attached, at least it's not discussed and it wasn't the case in 2008. So we don't expect any limitations for our business. And this would not be, how should I say, an instrument to ramp up production or to keep the level of stock at the same level. There is no link between our optimization measures and the possible Gokhran deal. But we should be very [Technical Difficulty] in case the market recovers, not to be low on stock to support the market, of course. So it's a flexible instrument.

This is Alexey. I'm back. I'm sorry, I had a connection problem. Can you hear me?

Yes, Alexey, we answered, I think, the question in terms of long-term scenarios, so we can move forward.

Thank you.

Okay. Then we go to the next question now. It is from Sergey Donskoy of SocGen.

Can you hear me?

Yes.

Yes.

Yes. Great. I have 2 questions, if I may. One is a follow-up regarding the possible Gokhran deal. I just wonder what approach you will take with respect to pricing given that current crisis is very different from the one we experienced in 2008 in a sense that today the sales volumes have practically dried up. So the question of how to price these goods is not so trivial as before, I think? And my second question is about your marketing strategy. I think that the approach that you and your colleagues from De Beers have taken, which can be summarized indeed as value over volume or price over volume, amounts to giving your customers ability to defer purchases of goods for as long as they find it comfortable. As a result, you prevent buildup of inventories in midstream, which would ultimately clog the system. But you have those inventories accumulating on your books. But at the same time, by going this way, you essentially level the field for your smaller competitors that capitalize on your efforts and sell as much as they can at a significant discount. So your customers are basically buying from them, not from you, which I guess can be described as free-riding on your efforts. So my question essentially is, do you see any [Technical Difficulty] to change or adjust your marketing strategy in the future to prevent this free-riding behavior because chances are this is not the last crisis we are going through and it's good to have some instruments to tackle the issue?

I will comment on both questions. Maybe I'll ask to Evgeny then to comment on the situation with small producers and their pricing models and their strategy -- sales strategies with what we've seen so far. So in terms of Gokhran pricing, I would say that the price would be like Minfin or the government price list -- the Ministry of Finance or the government price list, so called, which is -- which will be on the day or on the month when -- if the deal will be commenced. So it's quite absolutely transparent, and it will depend on whether -- what the pricing will be at that time. So we understand that last several months, there was just speculative pricing. There were just offers from a limited number of players. Some of them just buying rough for keeping it in the vault, understanding that the price will correct further because everybody believes in sustainability of diamond prices in long term and understand the short term that there can be speculative margin. As for the inventory buildup, I'll ask Alexey and again Evgeny to comment later. But as for the like free-ride of some small players, well, first of all, these were pure speculative deals because very little amount of players bought this rough for polishing because key players, they had enough rough -- expensive rough both in Q4 or Q1 for processing. So this was primarily put in vaults or have been traded on the secondary market. I would not like to, like, discuss the situation with relatively smaller diamond producers. But you can see from the press that they are struggling hard. Some of them stopped -- suspended operations, still better times. Some of them are experiencing really, really challenging times because of their balance sheets. And we understand that when the market recovers and what we already see now is that, well, big players like top 20 companies, top 30 companies, midstream, they need the run of mine, which is provided only by 2 major companies, ALROSA and De Beers. And they cannot rely on tenders, auctions or willingness to sell some rough by smaller companies. They need consistent supply of specially sorted goods according to their needs in terms of assortments of precise diamonds. So we understand that small miners were even -- maybe more successful last 6 months because ALROSA and De Beers were like supporting the market. This is the price for the whole market stability. So on the one hand, we enjoy being a leader and enjoy good EBITDA margin, in times -- excellent EBITDA margin when the market is strong but at the same time, it's the price for market stability in bad times. And we don't think something can be changed here except that there's a risk of just like 2, 4, 5 companies remaining on the market soon. And we're afraid that the market share of the 2 leading companies will just grow automatically, and maybe this is the solution in the future because we understand a lot of small producers will be struggling, and we don't know what will happen with their assets in the midterm -- in the short term and in the midterm. Maybe Evgeny will comment also on the level of stock and how he sees this situation now.

Good afternoon, ladies and gentlemen. It's Evgeny Agureev speaking. First of all, I would like to start with the feedback from our long-term clients regarding the approach ALROSA took, and it was this maximum flexibility provided to the midstream. This approach was highly appreciated from the clients. And that is the start and -- starting point for next recovery. So rational behavior and price-over-volume approach allowed the industry to keep prices stable. ALROSA took a hit, allowing customers to postpone purchases and letting the industry destock or avoid excessive stocking. So we are committed to supporting our clients. And for April and July trading session for this period of time, ALROSA offers maximum flexibility to its customer. And ALROSA doesn't set an obligatory buyout limit, allowing its clients to keep off the trade if they won't. And we saw that during this difficult period of time. Some of the clients, they were ready to buy some of positions based on frozen prices levels from our last normal sales. Talking about junior miners and the small companies, so it's difficult to -- for them, it is difficult to maintain financial stability in the face of falling demand. Therefore, they are likely to make speculative deals or provide deal discounts in order to maintain liquidity. And we saw all these speculative deals with significant discounts. But as a result of price-over-volume strategy took by ALROSA, we see that overall market discounts, they moved from the levels like minus 40%, minus 30%, it was in April and May, to the current levels like minus -- between minus 10%, minus 15%. That is the current market request for some price correction if we can compare these prices with the February levels.

At the moment, there are no further questions. [Operator Instructions] The next question is from Nina Dergunova of Goldman Sachs.

I have a couple of questions. First one, when we speak of expecting to reach 2x to 2.5x net to debt EBITDA this year, how many million carats of sales do you assume in this estimate?

The range will be for the second half of the year between 10 million to 15 million carats. And we believe that it's quite achievable given our current state of negotiations with Gokhran, even in the negative market scenario.

So your 10 million to 15 million carats in second half of the year already includes Gokhran purchases, yes?

Yes, that is correct.

My second question is the following. Your revenue has been roughly unchanged at $30 million per month starting April. Same in June, July. Do you expect to reach $100 million per month in third quarter or fourth quarter, excluding Gokhran? Or you would expect more?

I will answer the question, Nina. So it's -- I think, first of all, it's reachable because we see some positive signs from the market. And I would also say that, previously, we had traditional sites, like it's 1 week, and we reported. We did manage to deliver the goods and get all the payments. Now with the current market conditions, not only with our company, but with the main peer, these sessions, they like dilute, and we will be in negotiations with clients, not only within 1 week but, well, we're in touch all the time. And in case we see some demand between the so-called sites or sessions, I think we will be ready to keep discussing. And that means that, for example, in August, we can show insignificant results, but -- for example, we will not be just able to deliver the goods in August, and this will be presented in September terms. The same with the rest of the remaining months within the year. So there will be fluctuations between months just because the current state of the market. But I think we can update investors on it further on.