Companies Diamond Industry Series

Alrosa 2013 Review (excluding Catoca)

Equity Communications

July 25, 2013

Table of Contents
Production Revenue Diamond Reserves Shareholder Value Disposal of Assets Page 2 Page 6 Page 9 Page 10 Page 11

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Figure 1: Alrosa

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 companys 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.

Alrosa Main Office Russia

Mining Operations Russia Angola 32.8%

Exploration Pipeline

Russia Angola Zimbabwe

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1. Production
Figure 2: Alrosa diamond production

Source: Company Reports, Equity Communications

Figure 3: Alrosa diamond production 2

Source: Company Reports, Equity Communications

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.

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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

Source: Company Reports, Equity Communications

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 Alrosas 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.

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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 groups 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.

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2. Revenue
Figure 5: Alrosa Diamond Sales
Alrosa Diamond Sales 2007 Revenue Carats Sold US$/ct 3,125,680,000 35,600,000 $87.80 2008 3,145,140,000 34,600,000 $90.90 2009 2,088,140,000 26,200,000 $79.70 2010 3,333,800,000 39,500,000 $84.40 2011 4,260,550,000 32,900,000 $129.50 2012 4,450,128,000 33,200,000 $134.04 2013F 4,825,000,000 36,000,000 $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

Source: Company Reports, Equity Communications

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Figure 8: Alrosa Price Index

Source: Company Reports, Equity Communications

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 longterm 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.

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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.

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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 companys Russian mineral resource base (based on the Russian resource classification).

Figure 9: Alrosa Reserve Statement

Alrosa's JORC Reserves and Resources 2011

Category
Reserves Proven Probable Sub Total Resources Measured Indicated Inferred Total JORC Resources inclusive of Reserves 5569 493790 237715 737034 1.69 1.31 1.31 1.31 9393 646513 311616 967522 5569 474063 479632 1.69 1.31 1.31 9393 621162 630555

Tonnes (000s)

Grade (ct/t)

Carats (000s)

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. Alrosas 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.

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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 2025 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.

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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.

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About Authors
Gerald Manyengavana isthe a Research Analyst at Series, Equity a Communications. You may contact by email This publication is part of Diamond Industry series of diamond industry reportshim produced by at: Equity mgerald@equityzw.com; Communications ahead of the 2013 Diamond Report. Equity Communications Diamond Report provides detailed analysis of trends in the diamond industry value chain in 2012-2013, from theCommunications. production end to the may retail end. It Supervision was provided by Tinashe Takafuma , Head of Research at Equity You contact is in by its email third edition. him at: ttinashe@equityzw.com

For Further Contact About Authors If you would like to discuss this report, please contact either of the above.
Tinashe Takafuma is Head of Research at Equity Communications. You may contact him by email at: ttinashe@equityzw.com. 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 Gerald Manyengavana is a Research Analyst at Equity Communications. You may contact him by email at:
mgerald@equityzw.com;

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

Please Note The views expressed herein are solely those of Equity Communications as of the date of this report and are subject to change without notice. Data Tables, Survey Results and Financials provided in this report are not intended, nor implied, to be a substitute for the professional advice you would receive from a qualified accountant, attorney or financial advisor. Always seek the advice of an accountant, attorney or financial advisor with any questions you may have regarding the decisions you undertake as a result of reviewing the information contained herein. Nothing in this report should be construed as either investment advice or legal opinion.

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