Fitch Affirms PJSC ALROSA's IDR at 'BB'; Outlook Stable
The affirmation of the IDR and the Outlook reflects ALROSA's resilience to ongoing pressure on the diamond market since early 2015 when major players repetitively announced price and volumes cuts. ALROSA mitigates this pressure with a strong cost position underpinned by weak rouble, and positive free cash flow (FCF) generation. This contributed to the reduction of FFO gross adjusted leverage to 1.7x from 2.4x during 1H15. The Stable Outlook also reflects a good liquidity position as of 1H15 with less than 20% of total debt due in 2H15 and 2016 against a RUB43bn cash cushion and positive FCF.
KEY RATING DRIVERS
Outperformance in 2014 and 2015
ALROSA outperformed our previous expectations in both 2014 and 1H15. Outperformance in 2014 was largely driven by the strong diamond market in 1H14 and the weaker rouble in 4Q14. Better-than-expected performance in 1H15 was largely due to lower oil prices, which led to a rebased USD/RUB rate and to ALROSA's higher margins and strong FCF. As a result, ALROSA's net debt dropped by 20% to RUB141bn during 1H15 despite the fact that 95% of debt is dollar-denominated.
We expect ALROSA to deliver a strong performance in 2015 with revenue peaking at RUB271bn and EBITDA margin exceeding 50% on the back of the structurally rebased rouble. This is despite conservatively assumed mid-teens cost inflation, 5% average rough diamond price cut and 10% sales volumes reduction in 2015 yoy. A capex-to-sales ratio of around 14% and a 35% dividend payout ratio, should result in the FCF margin over 20% and leverage staying within 2x during 2015-2016. Should market pressure be materially stronger than our expectations, this could drive leverage back to 2x or above.
Market Pressure Ongoing
In mid-2015 ALROSA and DeBeers, the largest rough diamond producers, cut diamond prices by 6% and 9%, respectively, compared to end-2014. This followed DeBeers' announced intent to cut 2015 production by 3 mln carats (2% of global output) to support diamond prices. We believe that market pressure will continue, so conservatively assume a 5% annual average rough diamond price cut in 2015 and a further 7% reduction in 2016. Since 2016, high single-digit cost inflation, price pressure, strengthening rouble and softly growing sales volumes will result in single-digit revenue reduction at ALROSA towards RUB248bn by 2017, and its EBITDA margin shrinking by 4pp-5pp per year over the rating horizon.
A low capex-to-sales ratio of 11%-13% and 35% dividend payout ratio will moderate the FFO decrease from its 2015 peak levels, and result in 7%-8% FCF margin and 1.4x-1.6x leverage over the next two years. This is subject to the absence of a more adverse and short-term diamond market contraction.
Gas Asset Disposal Uncertain
The timing and cash-flow impact of ALROSA's plans to divest its non-core assets to Russian oil major Rosneft are uncertain. We therefore do not incorporate the sale into our forecasts. If realised, this will likely to have neutral-to-positive effect on ratings subject to the transaction terms and conditions.
Diamond Industry Risks
The diamond industry can be characterised by significant volume risks, which are applicable even to the cost leaders like ALROSA. For instance, the 2008-2009 financial crisis led to a 45% decline in ALROSA's sales in 2009 (excluding state-financed sales). ALROSA's response was the 55% capex reduction and minimal dividends for both 2009-2010, which led to leverage recovery to below the 2007 level by 2010.
While we expect ALROSA to remain exposed to diamond market shocks, its medium-term ability to reduce capex and dividends to a significant extent provides stability of ALROSA's long-term financial profile. In this respect, medium-term and prolonged market pressure appears to be more manageable for ALROSA compared to short-term, but less expected, market shocks.
One-Notch Uplift for State Support
We continue to assess the level of the Russian state support to ALROSA on a regular basis. The Russian Federation (BBB-/Negative) and the Republic of Sakha (BBB-/Negative) hold 44% and 25% of ALROSA's voting shares, respectively, and control its board of directors and top management.
Moderate strategic but weak legal ties with the parents are reflected in a single-notch uplift from ALROSA's standalone rating of 'BB-'. The company benefited from state support during 2008-2009 when the Russian State Depository for Precious Metals and Stones purchased around 40% of 2009 diamond sales, and state-owned Bank VTB refinanced ALROSA's short-term debt.
Two-Notch Discount for Corporate Governance
We apply a standard two-notch discount due to ALROSA's higher-than-average systemic risks stemming from its operations concentrated in Russia. ALROSA's standalone profile sits at the 'BB+' level, excluding the two-notch corporate governance discount and one-notch state support. The rating is underpinned by its leading position in the rough diamond market globally, strong reserves base, robust cost position, recent deleveraging and adequate liquidity. The standalone rating remains constrained by ALROSA's limited product diversification and its exposure to a cyclical single end-market (retail jewellery).
Fitch's key assumptions within the rating case for ALROSA include:
- Average diamond selling price to decline at 6% CAGR in 2015-2016 and flat thereafter;
- Rebased but strengthening USD/RUB, modest sales volume growth to lead to sales peaking in 2015 and single-digit decline thereafter;
- EBITDA margin to exceed 50% in 2015 and drift towards 40% by 2017-2018;
- No M&A deals, 12%-14% capex/sales and 35% dividend payout ratio to result in positive FCF and FFO adjusted gross leverage within 1.4x-1.6x in 2016-2017.
Future developments that may, individually or collectively, lead to positive rating action include:
- FFO adjusted gross leverage below 2x on a sustained basis;
- Better clarity regarding the scale and longevity of the current diamond market downturn.
Future developments that may, individually or collectively, lead to negative rating action include:
- Reduced support from the Russian Federation;
- FFO adjusted gross leverage above 3x on a sustained basis;
- EBITDAR margin below 25% (FY14: 43%).
At end-1H15 ALROSA had only RUB10bn (5% of total) debt due in 2H15 and RUB24bn (13%) due in 2016, both well covered by a RUB43bn cash cushion and positive free cash flow. This is a step-up improvement in its debt maturity profile since early 2014 when above 45% of ALROSA's debt was falling due within two years from the end-1Q14.