OREANDA-NEWS. Fitch Ratings has upgraded Russian diamond producer PJSC ALROSA's Long-Term Issuer Default Rating (IDR) and ALROSA Finance SA's senior unsecured rating to 'BB+' from 'BB'. ALROSA's Short-Term IDR has been affirmed at 'B'. The Outlook on the Long-Term IDR is Stable.

The upgrade reflects Fitch's expectations that ALROSA will maintain funds from operations (FFO) gross adjusted leverage at a conservative level at or below 2.0x (2015: 2.0x) on a sustained basis, as already seen at end-2015 and 1H16, which was our previous positive rating guidance. This is a result of ALROSA's outperformance of our conservative expectations over the past few years, driven by a weaker rouble and higher than expected diamond pricing, which allowed ALROSA's leverage to rebase at 1.0x-1.3x for the rating horizon from above 2.0x before 2015. The ratings also reflect ALROSA's strong operating profile as the largest diamond producer (30% global diamond production share in 2015), and its cost leadership.

The Stable Outlook reflects the improved, albeit still fragile outlook for the diamond market. It also reflects ALROSA's good liquidity position as at end-1H16 with less than 15% of total debt due in 2H16 and 2017 against a RUB60bn cash cushion and positive free cash flow (FCF).

KEY RATING DRIVERS

Outperformance in 2016

ALROSA outperformed our expectations in 2015 and 1H16. The outperformance in 1H16 was driven by an improved market environment and supported by a de-stocking phase in 2015 following a build-up in inventories in 2014. This followed weak diamond jewellery demand expectations in 2014 and 2015, due to the slowdown in China. There has been a y-o-y recovery in volumes in 1H16, which had a positive impact on ALROSA's performance. Reported rouble-denominated EBITDA was up by 58% y-o-y and net debt down by 25% in 1H16 to RUB153bn from RUB202bn at end 2015.

We expect that performance in 2H16 will not be as strong as 1H16. However, we expect revenue and EBITDA to peak in 2016 at RUB333bn and RUB177bn, respectively. After that, we project EBITDA to fall to around RUB125bn in 2018, on the assumption of stable prices and demand and a gradual strengthening of the rouble against the USD. Therefore, although we expect falling EBITDA, moderate capex and dividends would still allow ALROSA to generate positive FCF and keep leverage within 1.0x-1.3x, well below our previous 2.0x positive rating guidance.

Price Over Volume Strategy

ALROSA and DeBeers (which together represented around 53% of global diamond production in 2015) built up inventories in 2015, despite DeBeers cutting its production guidance by three million carats during 2015. ALROSA has lowered its production guidance by two million carats this year. We believe that the companies will continue to follow a price over volume strategy, as they have done historically.

Fitch expects that producers will gradually release their high inventory levels, aiming to balance the rough diamond supply with demand, which is expected to be between 0%-2% annually, until 2019. However, we note oversupply risk stemming from potential new capacities (eg DeBeers' Gahcho Kue and Misery pipe) might increase supply by around 4% per year for the next two years. If they come into production it will create significant medium-term price pressure. Consequently, we believe that a price increase is highly unlikely in the short to medium term. Prices could come under further pressure if realised oversupply risk does not match the demand dynamics.

Higher Dividends

ALROSA's dividend policy states a payout ratio of at least 35% of IFRS net income. This year the company paid out 50% of IFRS net income. Fitch expects a moderate capital spending programme during the forecast period along with resilient cash flow generation, which is supported by the rouble. This should allow ALROSA to continue pay increased dividends at 50% of IFRS net income, which would lead to a cash dividend payment of above RUB50bn in 2017 and 2018.

Gas Asset Disposal Uncertain

ALROSA continues to streamline its business as it focuses on its core business of diamond mining. The main non-core asset that ALROSA holds is its gas assets, which it has been planning to divest. 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 have a neutral to positive effect on ratings subject to the transaction's terms and conditions.

Diamond Industry Risks

The diamond industry can be characterised by significant volume risk. 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 a 55% capex reduction and minimal dividends for 2009-2010, which led to leverage recovering to below the 2007 level by 2010. ALROSA's exposure to diamond market shocks is mitigated by its medium-term ability to reduce capex (expansion capex is around 30%-40% of total, and maintenance capex can be partly delayed for one to two years) and dividends to a significant extent. This provides stability to ALROSA's long-term financial profile.

Synthetic diamonds pose a potential risk to the industry but we view this risk as longer term. We do not believe that it will have any material impact on ALROSA in the medium term.

One-Notch Uplift for State Support

We continue to regularly assess the level of the Russian state support to ALROSA. The Russian Federation (BBB-/Negative) and the Republic of Sakha (BBB-/Negative) hold 33% 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 (including corporate governance discount) 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 is 'BBB-', excluding the two-notch corporate governance discount and one-notch state support. The rating is underpinned by the company's 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).

KEY ASSUMPTIONS

Fitch's key assumptions within our rating case for the issuer include:

-Flat prices for the next three years.

-Average RUB/USD exchange rate of 69 in 2016 trending towards 57 by 2019

-Diamond sales of around 37 million carats per year in 2016-2018

-EBITDA margin to exceed 50% in 2016 and drift towards 40% by 2018-2019

-No M&A deals, 8%-12% capex/sales and 50% dividend payout ratio to result in positive FCF

RATING SENSITIVITIES

Future developments that may, individually or collectively, lead to positive rating action:

-We do not anticipate positive rating action in the foreseeable future, but this would be a possibility with a stable diamond market outlook and positive FCF, translating into FFO adjusted gross leverage sustainably below 1x, underpinned by a more conservative financial policy.

Future developments that may, individually or collectively, lead to negative rating action:

- FFO adjusted gross leverage above 2.0x on a sustained basis

- Prolonged market deterioration leading to EBITDA margin below 35% on a sustained basis

- Reduced support from the Russian Federation

LIQUIDITY

In June 2016 ALROSA refinanced its USD720m bank loan with JSC Alfa-Bank, which postponed its maturity to 2019 from 2017. At end-1H16 ALROSA had no debt due in 2H16 and RUB24bn (14%) due in 2017, which is well covered by RUB60bn cash cushion (adjusted for not readily available cash of RUB8bn) and positive FCF. We expect liquidity to continue to be strong as ALROSA continues to use it large cash balance and positive FCF to pay down debt.