Alrosa - Coping with Structural Headwinds

While the cyclical problems of the current diamond crisis could be addressed by a "price over volume" strategy, the deeper structural issues - the erosion of the diamond brand and competition with LGDs - require a sophisticated marketing campaign in response. We do not think the proper concept for this has been found yet. Diamond demand, which has been underperforming the overall jewelry market since 2018, declined in 2019. Meanwhile, Alrosa is doing all the right things to manage the downturn as well as it can - the reduction in capex and shift to selling bigger stones should support FCF next year. We upgrade the stock to HOLD ahead of the 4Q19 earnings results, lifting our target price to R80 per share, but we reiterate our long-term cautious outlook.> The recent recovery in Alrosa's share price was triggered by miners having posted higher m-o-m natural diamond sales and hopes for a stabilization of midstream inventories based on Indian import statistics. On the other hand, India's net exports of polished diamonds still point to sluggish end demand. Also, diamond jewelry demand has underperformed the overall jewelry market and is lagging the luxury market massively due to the devaluing of diamonds as a brand and strong competition with LGDs, in our view. > We have continued tracking the LGD market closely. The supply of melees from China has expanded aggressively, which seems to have pressured the prices of natural rough diamonds. Based on the Russian Finance Ministry's price lists, the decline in melees prices over the last three years has been 10-15 pp steeper than the drop in prices on 0.5-1.0 ct stones. Moreover, we think that the supply of relatively big diamonds is building up too, as Chinese LGD prices for 0.5-1.5 ct (1.4-4.0 cts rough equivalent) stones have dropped roughly 30% over the last 12 months, making this category more affordable for consumers.> While the price over volume strategy will be successful in addressing the high inventories, we think the structural issues will require a major marketing campaign to develop the right message. Using blockchain technology to track the origin of natural diamonds and developing detection machines are just ways to protect the market - the real fight is to recapture the hearts of consumers. > We note that Alrosa's business should be strong enough to avoid a hard landing due to its flexible operations and low costs. We estimate that it would require a more than 45-50% reduction in the prices of small stones for the company to consider shutting down the mines with the worst product mix. > Meanwhile, Alrosa seems to be doing all the right things - cutting both capex and output and improving the product mix, which should offset any further diamond price erosion next year. We estimate next year's FCF at $1.0 bln, for a 10% yield, and expect the dividends over the next 12 months to yield 6%. We put the stock tactically on a HOLD ahead of the 4Q19 earnings results, but with a cautious long-term outlook.