Alrosa - Tactical Trade Idea: Short Alrosa

We expect Alrosa's sales volumes to fall sharply this year due to the coronavirus-related quarantines and falling consumer confidence. This outcome is not yet fully priced in by the market, in our view. We open a tactical idea to short the stock ahead of its 2Q20 trading reports.> Entire diamond value chain shut down. Two weeks ago, diamond exchanges were shut down in Belgium and Israel as part of coronavirus containment measures. Last week, India announced a 21-day nationwide quarantine, which included a shutdown of diamond polishing facilities located in Surat, which accounts for around 80% of Indian polishing and around 70% of diamond polishing worldwide. Diamond retail activity is almost non-existent now as lockdowns have been implemented across the US and Europe - the key diamond markets, accounting for around 60% of global diamond jewelry demand. On Monday, De Beers canceled its third sight of 2020, which was set to be held this week, while today Alrosa allowed its customers not to buy any diamonds in April> City-to-countryside exodus in India poses risks for prolonged mid-stream shutdown. Bloomberg has reported that India's nationwide lockdown triggered an exodus of people from cities to rural areas in the space of a few days, which could accelerate the spread of the virus across the country. In addition, around 150k of Surat's 600k diamond polishing workforce moved out of the city last week (and this movement continues), which could trigger prolonged labor force shortages in the polishing segment even when the lockdown is lifted. Overall, there is a risk that Surat's polishing industry is unlikely to restart by mid-April, when the nationwide quarantine is set to end due to a lack of demand for polished stones.> Big price drop in Rapaport price list sparked protest from sellers. On March 20, Rapaport published its influential price list, which indicated a drop of 5-9% for all stone types. According to the industry magazine JCK, the list has drawn protests from traders, who have claimed it is misleading given the lack of sales. Following a vote in which 72% of the members of the RapNet trading network supported suspending the publication, Rapaport agreed to do so until May 1. This is the first time in Rapaport's 42-year history that it has suspended publication of its price list. > Gokhran may not step in this time to the extent it did in 2009. The head of the Sakha local government recently asked Russia's state precious metals and diamonds repository, Gokhran, to buy diamonds to support the company in 2020, as it did in 2008-09, when it bought $1 bln worth of stones (we estimate 6-8 mln cts). Alrosa BoD member and Deputy Finance Minister Alexei Moiseev said that the government is discussing the suggestion. This statement sent the stock up 10% yesterday. We think the probability of such support this time around is low, or if anything, the size will likely be limited. At the end of 2019, Alrosa's net debt was just $1.3 bln, versus $4.3 bln at end-2008. At the federal government's request, the Duma yesterday lifted the limits on Gokhran asset disposals. Moiseev said that Gokhran is likely to sell gold, as it has faced difficulties selling diamonds. The proceeds are likely to be used to fund the budget deficit stemming from spending on the coronavirus containment measures and measures to mitigate the negative fallout on the economy. In this regard, we think direct subsidies to the Sakha government would be more appropriate than an increase in proceeds from Alrosa via Gokhran diamond purchases.> Worst case for sales volumes is not priced in. Given the high risk that quarantines in Europe and the US will be extended, we outlined a negative scenario for Alrosa this year that would be similar to the crisis in 2009 (see our report). Assuming no purchases from Gokhran, Alrosa's sales volumes could drop to as low as 18-20 cts this year. We expect Alrosa to protect pricing as part of its price-over-volume strategy, but as in any crisis, price erosion is probably unavoidable. Using a ballpark number of a 10% LFL diamond price index decline and taking the current USD/RUB rate of 80, we project 2020 EBITDA of $860-950 mln for Alrosa, with the bulk of this coming in 1Q20 and sales volumes dropping materially from 2Q20. These earnings imply negative FCF of around $200 mln. Net debt/EBITDA would near 2.0 by the year-end, which is above the upper boundary for dividend payments for 2020 (1.5). Should we see another leg down in the equity market, we would expect investors to decide what to sell next to raise funds to meet the outflows. The probability of dividends is likely to be a key consideration to make the choice. We thus open a tactical short trade idea on Alrosa.> Risks to our idea. Risks include a significant slowdown in the coronavirus spread across the globe and the early removal of lockdowns in Europe, the US and India.