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

Dear ladies and gentlemen, welcome to the Q3 2020 IFRS Results Conference Call of ALROSA. At our customers' request, this conference will be recorded. [Operator Instructions] And now with that, may I now hand you over to Sergey Takhiev who will lead you through this conference. Please go ahead, sir.

Thank you. Good morning, and good afternoon, ladies and gentlemen. My name is Sergey Takhiev, Head of Corporate Finance, and I'm happy to welcome you to our third quarter 2020 results conference call. With that, today, our company represented by CEO Sergey Ivanov; CFO, Alexey Filippovsky; and Head of Sales, Evgeny Agureev. Mr. Ivanov will start with a discussion of recent developments and overview of our approach to new COVID-related reality and then pass floor to Alexey who will comment on the market and company's results. And then we will be happy to take your questions. As always, elements of our presentations 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, dear, ladies and gentlemen. Thank you for joining us on this call dedicated to Q3 2020 IFRS results. And again, I'll start with the hope that you and your loved ones are safe and healthy. This is a unique and challenging year, and every quarter is very much different. In Q2, it seems the industry was in the middle of a perfect storm, while today, market activity is returning, which has already translated into our third quarter numbers. The COVID-19 pandemic that has swept the globe notably affected the diamond industry with new developments unfolding every day. Today, many countries of the world are seeing growth in new cases. We have already reported on our actions taken to prevent spread of the disease at our assets. And as of today, our investments exceeds RUB 800 million. We have very strict terms for shift workers. They have 2 weeks of obligatory quarantine and have to pass 3 consequent negative COVID tests to be admitted to the assets. Unfortunately, despite all these measures, we had a number of cases at Nyurba Division, and thanks to the elaborated action for such emergency cases, we managed to hold the spread of the virus at the assets. Employees who had severe symptoms were sent to hospitals for further examination and treatment, and people without any symptoms were placed in our observatories. An additional observatory was deployed to isolate workers with symptoms temporarily before the arrival of exporting flights. Employees with negative testing results continued their work, and in this case, didn't affect the production process at the asset. We fully understand that these days, the epidemiological situation remains tense, so we are at a high level of readiness. Let's go to Page 4. The unprecedented flexibility provided to our clients since April remains in place. We decided to extend the expiry date of existing long-term contracts from the end of this year to the end of Q1 next year. This measure will give our clients a better opportunity to forecast their sales and purchases for the next 3-year contract period based on actual market needs. As we have announced in June, we exercised flexibility in our 2020 production and CapEx, supporting the company's cash flow. In terms of production volumes for next year, the management is developing various scenarios, subject to the Board approval in December this year. One of such scenarios is that next year production will be at the range of 28 million to 30 million carats, essentially flat against this year. In terms of CapEx outlook, I believe we will be able to end up this year with investment of RUB 18 billion despite our previous guidance of RUB 20 billion on the back of continued optimization of project time lines and approaches to execution of certain investments. To sum up the slide, we, as the management, will keep our -- managing our business very prudently mindful of the nascent market recovery and focusing on our customers' needs, health of our team and financial sustainability. Now let's turn to next page to give you a recent market update. In the third quarter, we saw buying activity improving from both end consumers and midstream as lockdowns were lifted, and midstream started to restock to satisfy improving demand from retail. In USA, September jewelry sales were up 14% year-on-year. According to analysts' estimates, U.S. pre-holiday retail sales in November, December should increase by high single digits against last year. In China, retail sales of gold, silver and jewelry in September expanded by 13% year-on-year. Pent-up recovery in demand for bridal jewelry and lack of international travel increases budgets for luxury items. Although developed economies lifted lockdowns, travel restrictions are still in place in most of the countries, make it one of the biggest challenges for the industry as it hinders diamond trades through the value chain. Diamond producers are solidary in costs of production for 2020. During -- over the last 9 months according to industry experts, the long-term trend of supply reduction will only accelerate. Again, this is a positive mark for long-term industry development. As for the midstream, cutters and polishers have dried up their stocks significantly and started actively replenishing them, which is confirmed by the recent Indian trade statistics that you can see on the left chart. Lockdown for Indian polishers was eased. And today, they operate at close to 70% to 80% of capacity load, still having some social distancing measures being in place. However, in order to stress the level of current demand, I would note that an important Indian holiday of Diwali that usually lasts for 3 weeks has been announced to be cut to 1 week only. Our sales channels checks confirm that the end demand in the fourth quarter should be healthy, driven by catch-up in jewelry demand and seasonality. On this positive note, let me give the floor to our CFO, Alexey Filippovsky, to take you through the numbers and outlook, and then we'll be happy to take your questions. Thank you.

Thank you, Sergey. Let's move to Page #6, please. In Q3, we saw a strong rebound from the pressures the company experienced at the peak of the lockdowns as the world gradually moved into the recovery phase. This rebound in terms of sales dynamics continues into the fourth quarter and can be described as the one that exceeds our expectations. In Q3, our rough diamond sales increased to 5 million carats, generating over $0.5 billion in revenue, which was only 8% lower year-on-year. On a sequential basis, Q3 sales grew 8x, both in value and volume terms. Now let's move to Page 7 to look at our diamond stock dynamics. Because our sales were sizably lower than our production, the stock levels grew to 30.6 million carats. This growth was partially offset by our earlier decision to decrease production in order to minimize cash outlays and limit stock accumulation. The stockpile is expected to gradually decrease, as the next -- as in the next several years, the company aims to plan its production in carats at levels annually, roughly 5 million carats lower than the anticipated volume of annual sales. And due to the current favorable market environment, we should expect to see our diamond stock levels coming down in the fourth quarter of this year already. Now let's move to Page #8. From April to July, during the market freeze, when demand from the midstream was virtually nonexistent, we consistently followed a price over volume strategy, keeping the prices stable. Once the market was back to activity in order to kick-start the trade, we offered to our customers a certain degree of price flexibility. Speaking about the mix, in Q2, we noticed a stable demand for higher end products, leading to a spike in our average realized price to $200 per carat on seeing sales volumes containing mostly expensive stones. In Q3, the mix reverted back to normal as the impact of the stimulus in the U.S. increased the demand for lower quality stones as well. Now let's go to Page #9 and take a closer look at our financials. Our results for the third quarter reflect the gradual improvement in the market conditions once lockdowns were lifted. The results are following the sales trend, and our top line profitability expanded both sequentially and on a year-on-year basis. Revenue recovered to RUB 50 billion, driven primarily by volumes recovery. Growth against last year was due to a better mix as well as a stronger dollar. These drivers were also behind EBITDA recovery and margin expansion. Free cash flow strongly rebounded, reaching RUB 23 billion, driven by sales growth and cost control measures. Now let's look at Page #14. This year was marked by active debt management efforts as a strong balance sheet was more critical than ever in the recent decade. We boosted our liquidity in Q2 and enjoyed a very strong cash position at these turbulent times, extending maturity profile and further reducing cost of funding. At the end of Q3, our cash flow was around $1.7 billion. Net debt-to-EBITDA ratio at the end of Q3 was almost flat at 1.25x. And as the market stabilizes, we expect this ratio will decrease down to targeted range of between 0.5 to 1.0 net debt to EBITDA. In October, taking advantage of our sizable cash balance, we repaid a USD 200 million bank loan due in Q1 2021 ahead of time. And in November, we fully repaid the remaining portion of our 2010 Eurobond of $494 million. As of today, our total debt stands at USD 2.3 billion with approximately $1 billion in cash. Overall, we are sticking to a prudent and rather conservative financial policy, which allows us to meet investment-grade criteria and maintain the stability of our business. Now let's move to Page #16. Free cash flow for the third quarter amounted to RUB 23 billion, driven by top line growth as well as working capital release. These factors offset growth in CapEx as we cut up with maintenance investments. Another factor for CapEx growth was the second tranche payment for the new building for our sales and sorting unit acquired earlier this year. For the past 9 months, our free cash flow turned positive at RUB 14.3 billion, fully offsetting the negative impact of the second quarter. Now let's go to Page #17 and discuss the prospects as we see them today. The supply of rough diamonds in 2020 will be significantly down as miners were forced to cut production in the first half of the year, and supply continues to tighten as deposits are depleting. 2020 diamond production is estimated at between 100 million to 110 million carats, which is well below the 140 million to 150 million carats annual production in the previous 3 years. It should also be noted that Rio Tinto's Argyle, an asset producing around 10% of the global supply, was depleted and closed several days ago, an impact that will be seen in 2021 production numbers globally. The midstream following massive lockdowns and significant destocking is back to work. Based on the feedback we are getting from our customers in India, most polishers are operating at 80% to 90% of their capacities, which is remarkable given the strict social distancing rules still in place. On top of that, as Sergey mentioned, most of the polishers chose to reduce the Diwali holiday vacation due to high demand. They are also enjoying expanded margins as the prices for polished diamonds are at approximately the same levels as they were a year ago, while in the same time period, the prices for rough stones went down by about 10%. Jewelry demand continues to recover, though we should admit that the road is bumpy. People are tired of this current situation and are trying to return to their normal lives. According to recent research, people are shifting their expenses from experiences towards things due to lockdowns and further overall unease with crowds, so they have a tendency to spend more on the tangible goods including diamond jewelry at the expense of things like travel and dining out. Worth mentioning is skyrocketing growth in online sales channels including retail, which supports new buying patterns as well. While the situation remains fluid, overall, we believe that the diamond market has very strong long-term fundamentals, and our resilient business with low-cost, long-life asset portfolio and dominant market share gives us a unique opportunity to deliver strong results in the future. As for our plans, we are developing various scenarios for 2021 production, including keeping 2021 output flat at 28 million to 30 million carats, and we will continue our efforts on efficiency and cost control. Capital allocation strategy remains intact. We stay focused on our core business and invest only in NPV-positive projects. Our cash-generating profile allows us to both develop our business, remain financially sound and deliver strong returns to our shareholders. This concludes my presentation, and we are now ready to take your questions. Thank you.

[Operator Instructions] Our first question comes in from Dan Shaw of Morgan Stanley.

I just have 1 question actually on CapEx. So you've managed to find further savings here. If I look over the last few years, CapEx depreciation ratios have been falling. CapEx per carat produced, for example, has also been falling too. So my question really is how do you think about this? And how do you sort of gain confidence that you are continuing to invest sufficiently in the business, both in terms of sustaining your ongoing operations, making sure that you have sort of sufficient mining areas open and also things like insurance safety? How are you basically confident that all these things are going to be covered off with the budget that you have set?

This is Alexey Filippovsky. I'll take your question. The current CapEx profile around RUB 20 billion to RUB 23 billion per year up until at least 2025 will allow us to keep our current production potential of between 36 million to 38 million carats per year and also it includes all the necessary spending for required safety measures. Looking ahead, towards the latter half of the next year, we expect to make a decision on the reconstruction of the Mir mine, and if that decision will be positive, which at this point we expect it to be positive, this will increase our CapEx profile starting from 2025, maybe 2026, by about $200 million to $300 million a year for a period of 5 to 7 years, depending on the duration of the CapEx-intensive phase. And this will allow us to keep our production potential of 36 million to 38 million carats up until the end of 2030.

Okay. So I suppose the answer is that right now, you're running on really pure sustaining capital. Whereas if we were looking over past years, there's perhaps been a little bit more on top of that and going forward, currently here in sort of sustaining mode and then when Mir comes back, then that's when we'll see the CapEx go up. That's very clear.

Just to add to this, Dan, if you look at our structure of our CapEx, around RUB 7 billion of it on an annual basis is the CapEx devoted to various small-scale brownfield projects that allows us to maintain our production potential. So it's not purely maintenance. Maintenance is about RUB 7 billion to RUB 8 billion of it, and RUB 7 billion is the ongoing expansion CapEx, but it's more like a brownfield, smaller type of projects developing the existing mines and facilities.

Moving on, question #2 comes in from Daniel Major.

A few questions. First, the sales in October were fairly robust, but I'm not sure it was exactly a perfect like-for-like comparison. But can you give us any color on how sales have progressed into November?

This is Evgeny Agureev. So I will take this question. Good afternoon and good morning, ladies and gentlemen. It's important to mention that in October, our sales -- during the October sales, we decided not to run the normal October trading session because current cycle is broken. The period of sales is longer than it was before. And it's not like a usual way, we have on a regular month regulatory pressure. So in October, all these results were based on the results partially from September sales because our September trading sale was still [Technical Difficulty] plus auction results and [Technical Difficulty]. We see that these results are quite positive. Talking about the current market situation, I would like to confirm that demand is strong. We started last in our November trading side, and we believe that our results will be at the same level as it was in September.

Very good. And can you give us any indication on your expectation for pricing and mix effect of your own portfolio into 2021?

I will take that question as well. Regarding the price, so we decreased our prices [Technical Difficulty] sales following the real market demand. And at this moment, we don't forecast significant price changes, price [Technical Difficulty] till the end of this year. About the product mix, from one side, stones are really in demand. And we see that from this point of view, we are able to sell the requested volumes. From the other side, we see that from small sizes and mid-sizes also, there is demand. And maybe not so strong as for big sizes, but also we have clients, we have sales, and as Sergey and Alexey already mentioned, the product mix and the average price moved to normal levels as it was in previous quarters.

Okay. Second question is around the dividend and the balance sheet. You're above 1x net debt-to-EBITDA currently. If you are above 1x net debt-to-EBITDA at the end of the year, will you rigidly follow your dividend policy, so we should expect 50% net income -- sorry, 50% of free cash flow? Or will there be any flexibility around that payout ratio depending on market conditions and the outlook into 2021?

Our current dividend policy actually allows us some flexibility. So if the net debt-to-EBITDA is about 1.0 but below 1.5, we can pay anything in the range between 50% to 70% of our free cash flow for the year. So let's see where we'll be. Our current forecast shows that we should be somewhere between 1.0 to 1.1 of net debt-to-EBITDA. But if the sales in December are strong, then we could even be below 1.0. And in that case, the range is between 70% to 100% of the free cash flow. But the decision on what number to peak out of these ranges will be made by our shareholders in April.

Okay. And then a final question on working capital. You had a build-in inventory, but a favorable impact from net payables, I think. What is the outlook there? Do you expect that increase in trade payables to reverse in Q4?

Well, our payables have a certain seasonality because most of our supplies are done on a seasonal cycle. So towards the end of the year, the payables come down somewhat. I think the bigger factor is the diamond inventory that we hold on our balance sheet. There, we expect to see a certain decrease. We expect to finish the year with about 26 million to 27 million carats of inventory, which has a pretty significant decrease versus what we saw at the end of September.

Okay. So net basis, we should still get a working capital release in the fourth quarter?

Yes.

We continue with Sergey Donskoy of Societe Generale.

First of all, 1 follow-up on a question asked before. Just could you confirm that you think that if I said correctly that third quarter sales mix is a good representation of your normal sales mix and that going into 2021, we should take it as a starting point.

I'll take this question. Our sales mix is driven by 3 factors. First, of course, the demand. And the demand, as Evgeny mentioned, was geared towards the higher value stores, both in Q2 and somewhat in Q3. That's why the mix impact was positive. Second is the structure of our inventory, and third is the structure of our production profile. We believe that going into the next year, the value of inventory that we hold will be somewhat lower than what the market demands at this point. Currently, the average value, the average market value of our inventory is about $8 per carat. And the market, at this point, if you look at the mix that it demands, it's about $90 per carat. Our production profile going into the next year will be more or less in line with what the market expects. But taking it all together, we believe that the average mix impact going into the next year, accounting for all these 3 factors should be about $5 to $7 lower than what you saw in Q3.

I see. Very helpful. And second question is actually on your Udachny underground. I think that this year, we have seen a ramp-up more or less stalling. I guess that COVID had some impact here. But could you give us an idea of what do you expect in terms of ramp-up going forward? And when you think the mine will be up and running at full capacity?

Well, for the next year, we expect to produce slightly above 4 million carats, which is in line with the expected capacity of the mine. There is somewhat -- some upside potential to that numbers. But at this point, we cannot confidently say that that potential will be realized in 2021.

It's Sergey. Sergey, I just wanted to add that the decrease in production in terms of Q3, it's not related to COVID, but as we announced, we stopped one of our assets the Verkhne-Munskoye field, it's now working on a seasonal basis. So now they are -- since 1st of November -- sorry, 1st of October, they are running now again. And it was done to support -- to shield the cash flow because of the OpEx and CapEx reductions, and the decisions in terms of production cuts which we have taken in April this year. So there are some technical issues in the underground facility as well. We're coping with them, but nothing related to COVID, just our own decision in April to hold down production in order to meet the market needs.

Understood. And the long-term outlook for 5 million to 5.5 million carats remains unchanged, right?

Yes, it will depend on the market situation. So Verkhne-Munskoye field can be -- it's a division at the Udachny unit, it can be put into operation for a full scale without the seasonality. And this will mean that additional, I think, 1 million of carats will be produced. Please, Alexey, in terms of -- please correct me if I'm wrong, in terms of figures.

Yes. For the next year in terms of production at the underground mine in terms of carats, we expect 4.9 million carats, and we also expect to produce no less than 1.4 million carats at Verkhne-Munskoye. So the total output of the facility will be 6.3 million carats. And there is a further potential to ramp up the underground mine by about 300 million to 400 million carats that will be done in 2022 and later.

Understood. Understood. And the -- maybe my last question is about dividend policy. You sort of commented on it, also answering to the previous question, but again, just to confirm. You refrained from paying or announcing any dividends in respect of first half based on negative cash flow. If second half and fourth quarter lead up to your expectations and you end up this year with -- in a comfortable position in terms of your balance sheet, we should expect no deviation from your policy for the full year, right? So you will make your decision according to your policy as it now stands?

Yes, absolutely.

We continue with Anton Fedotov of Bank of America Securities.

I have a question which relates to the possible sales of diamonds to Gokhran. If the current positive dynamic in the market continues, will you still consider -- or will the Russian state consider supporting the company by the purchase from Gokhran next year?

I'll take this question and then maybe Sergey will add to that. Gokhran is essentially an option for the company. When we first started the discussions with the government on this Gokhran option, it was back in April and the sales outlook was not very transparent to say the least. And the reason we did that is to ensure that there is a certain backstop for the company's liquidity. Currently, the liquidity position is quite strong. So at this point, we are quite comfortable without this option for this year. Speaking about the next year, I mean, no one knows what will happen, assuming there will be a severe second wave, vaccine doesn't work and all other nightmare scenarios, it is nice to have this option. So as of now, the budget of Russian Federation for 2021 includes a provision to purchase up to RUB 40 billion of diamonds from ALROSA, but it will be up to the company to use that option. Hopefully, we will not need it.

I will just add that even for this year, we have such a possibility, theoretically. If the market deteriorates in December, we can easily transact with Gokhran, but we don't see any reason that the situation in December -- as of today, that the situation in December will worsen significantly. But for next year, Alexey is absolutely right where he suggests that this instrument should be on the table. And in case the situation gets -- worsens from the current scenarios, we see more probable that this instrument could be used. And the state can take separate decisions to increase this sum, which is already allocated in the budget. So I think this instrument shouldn't be actual even before Q2 next year, but let's see how the COVID situation and the macroeconomics in the world will go on. But summarizing, yes, we don't expect that -- so this year, we can use this instrument, but it won't be -- even if we use it, the amount would not be significant. But the most important is next year to have this instrument in case it is needed to stabilize the financial situation. Thank you.

My second question relates to the production outlook for the next year. You are saying that the company is now considering at the range between 28 million to 30 million carats to be produced next year as a possible scenario, which effectively implies almost flat production versus 2020. And at the same time, you still expect to have some significant inventory of diamonds by the end of this year. Would it make sense in your view to decrease your production lower next year and to sell down your venturing spend?

Well, it's a balancing question. It's -- yes, we could do that. But at the same time, given the ongoing depletion of the diamond deposits, we might as well see a situation when the demand will be very strong, as, for example, happened in 2010 and 2011, right after the great financial crisis. So taking it all in consideration, we would like to have a bit more flexibility on the upside. So we believe that 28 million carats is the number that is conservative enough, given all the pros and cons that we see today. And as I mentioned...

I would like to add -- yes, sorry, Alexey, please go on.

I just mentioned that longer term, we would like to keep our production at a level of about 5 million carats less than the amount of anticipated sales. And in terms of sales, our base case scenario for next year is 34 million to 35 million carats. So this would allow us to gradually run down our inventory to more or less normal levels by the end of 2023.

I just wanted to add that this is actually the basic scenario for next year, which should be presented to the Board in December. Let's wait till December, but we think December will be -- we see November is strong, and we expect December to be strong. That means that our stock will be decreasing. And like this year, we took decision to cut production in April. We started some initiatives -- first initiatives in May, then we readjusted production. So next year, we should be flexible. This is the best -- like basic scenario, but we'll see. It's difficult to decrease production. So it will need some expensive measures to cut production further. And at the same time, if the market improves significantly next year, for us, it's quite a challenge to increase production within like short period of time. So for some assets, it takes actually 1 year for all the necessary procedures, to hire proper people, to put -- to buy all the necessary equipment, to get them working. So we want to have this flexibility not to lose the opportunity when the market recovers to gain our market share and at least to keep our market share at the level it's -- we're comfortable with.

We continue with Nikolay Sosnovskiy of VTB Capital (sic) [ Prosperity Capital ].

Do you hear me?