MOSCOW. Jan 15 (Interfax) - The Russian Audit Chamber has published a report on a probe into foreign trade operations by Kristall, the country's biggest diamond-cutting enterprise. The purpose of the inspection was to see how uncut diamonds classified as an asset contribution by the government to the state-owned Kristall during the 2008-2009 crisis were put to use.

The state transferred cut and uncut diamonds worth $130 million to Kristall as payment for a share issue in 2010. This included 563,000 carats of rough diamonds worth $65 million and 40,000 carats of cut diamonds, also worth $65 million.

The report, signed by auditor Alexei Kuzmin, focuses on a sharp increase in the re-sale of uncut diamonds by Kristall, whose core activity is diamond cutting and not re-export, in 2010-2011. This does not totally comply with measures "to strengthen Russia's position in the world gemstone market" but has a lot to do with the objective problems faced by the gem industry and flaws in the regulation of gem sales in Russia. Kristall itself denied the Audit Chamber's claims that it sold the lion's share of the diamond aid.

The Audit Chamber notified the Finance Ministry and the government of its findings.

RESALE ACCORDING TO THE AUDIT CHAMBER

Kristall, like other Russian diamond cutters, was not able to export more than 15% of the value of rough diamonds purchased in a year before 2011. A presidential decree of September 20, 2012 lifted this restriction. The Audit Chamber claims Kristall quadrupled rough diamond exports after the restriction was lifted. It sold 14.4% of the rough diamonds it bought in 2010 for $51.4 million, but the diamond exports grew to $205.75 million in 2011 or 40% of the value of purchased diamonds that year, the Audit Chamber says.

Kristall buys 97% of its rough on the domestic market. It bought more than half from diamond monopoly Alrosa in 2008-2011. The long-term contract with Alrosa lapsed at the end of 2012 and the companies are now negotiating a new one.

RESALE ACCORDING TO KRISTALL

Kristall has always maintained that it sells only rough diamonds that cannot be cut and polished at a profit. The Finance Ministry has endorsed those criteria. Kristall CEO Mikhail Shkadov has said the exports did not exceed 15% after the quota was scrapped.

Kristall puts the abrupt increase in rough diamond exports in 2011 down to it beginning to work with the Yakutia-based OJSC Nizhne-Lenskoye. Shkadov told Interfax that the company had bought the full range of rough diamonds worth up to $100 million from Nizhne-Lenskoye for a number of years.

Nizhne-Lenskoye mines around 2 million carats of diamonds per year in northwest Yakutia and had revenue of 4.44 billion rubles in 2011. The company has high-quality rough diamonds at its disposal, but experts have said its sales policy is not transparent and noted flaws in corporate governance, which reduced the enterprise to technical default in 2011. Alrosa subsidiary Almazy Anabara bought 51% of Nizhne-Lenskoye for 3.7 billion rubles from Yakutia's Property Ministry at the end of December 2012.

Kristall specializes in high-end (Triple Excellent) products and takes pains to select diamonds that fall into this category, Shkadov said. "The diamonds we need might constitute just 20% of an entire box, and all the rest are sold. This is an entirely market mechanism," he said. "If you were to take the whole assortment of diamonds mined, Kristall only processes 10% of that in terms of weight, but 40%-45% in value," he said.

"All the clients of Alrosa and De Beers are rough diamond dealers and generally re-sell rough, putting selected sale consignments together. Kristall, as a fully fledged world market participant, follows the same rules, making money on all transactions. The company cannot process all the rough it buys, this makes no economic sense," Shkadov said.

INCOMMENSURABLE MARGIN

The margin on operations with cut and uncut diamonds is incommensurable, the Audit Chamber's materials suggest. This is mainly why the diamond cutters are re-selling uncut diamonds.

The Chamber says that profit from the sale of Kristall's main products, cut diamonds, has been minimal at 3%-6% due to the high cost of cutting and polishing them. In contrast, added value when exporting uncut diamonds has varied from 10% to 30% of the purchase price. The minimum trade markup for Kristall to sell uncut diamonds has been 10%-12% and when world diamond prices have been good the company has set a markup of up to 25% over procurement prices.

This imbalance, which was evident in 2011, was caused by sharp growth in rough diamond speculation on the part of Indian companies, which effectively received unsecured loans with the state's help, Shkadov said. "At the time, rough diamond prices were so far ahead of cut diamond prices that it became unprofitable to cut diamonds and, so as not to lose money, the cutters often opted not to cut but sell these diamonds," he said.

EXPORT OUTLET

Kristall's main export outlet is the Antwerp-based Smolensk Diamonds N.V. Kristall owns 99.89% of this company and its managing director, Raymond Cohen, owns 0.11%.

The Belgian subsidiary and other subsidiaries in the United Arab Emirates, Hong Kong and Israel sell 96.5% of the rough and 32% of the cut diamonds that Kristall exports. They generated 48% of the company's sales revenue in 2011, up from 22% in 2009 and 27% in 2010.

Smolensk Diamonds N.V. worked at a los in 2008-2009 (EUR472,000 for the two years) but at a profit in 2010-2011 (EUR734,300).

THE DIAMOND CONTRIBUTION

It follows from the Audit Chamber's report that the increase in turnover by Smolensk Diamonds N.V. in 2011 was down to the sale to the subsidiary of a significant quantity of diamonds received as the federal asset contribution to Kristall.

Kristall disagrees. Shkadov said those diamonds accounted for just 10% of all rough diamonds sold. He said most of the rough that was re-sold had previously been bought on the market. "We buy rough diamonds at market prices and sell at market prices too. We have bought 90% of the diamonds we have re-sold from various sources on general principles. And what if we did re-sell them? What's so bad about that?" he said. The money that Kristall did earn from this stayed at the enterprise, it did not find its way abroad, he said.

The Audit Chamber says a market valuation of the state diamonds was not carried out. The State Precious Metals and Gemstones Repository (Gokhran) effectively calculated how much they were worth on the basis of a Finance Ministry price list with mark-ups of 16% for the rough diamonds and 36%-43% for the cut diamonds.

Kristall had to sell some of the state diamonds - 79% by carats and 34% by value - from the outset because they could not be profitably cut and polished.

With the additional diamonds received from the Gokhran, Kristall boosted borrowing 64% by the end of 2011 to 9.87 billion rubles. According to the Audit Chamber, the funds raised were used not only to buy rough diamonds but also for financial transactions like approximately 3 billion rubles in loans to various firms and individuals, sometimes without security. The loans issued by Kristall were repaid, but the borrowers did not provide collateral, and there was a risk of financial impairment to Kristall and its liquidity. Kristall issued 80% of the borrowed money to one of its major rough diamond suppliers, Nizhne-Lenskoye, as an advance for diamond supplies with determent of more than eight months in delivery.

The funds were used to issue loans to employees under a home-loans program with a view to keeping hold of staff, Shkadov said. Wages were used as the collateral in this case. The growth in borrowed funds was caused by a 50% increase in prices for rough diamonds.

PRODUCTION

Kristall explained that it needed to obtain rough diamonds from the government fund because while they are being cut the company will be able to work at full capacity, while in 2011 only 46% production capacity was used, which is even lower than in 2010 (52.3%). The Audit Chamber reckons production capacity can only be used to the full when there are mining assets.

"Kristall did not stop for even one day even during the deepest crisis in the industry's history and the fact that production capacity is not used to the full indicates that the company maintained a balance between the number of personnel (2,200) and the machinery stock," the head of the Smolensk company said. "It was last used to full capacity in Soviet times, when the government really supported the processing of natural resources," Shkadov said.

Of the volume of rough diamonds that were transferred to Kristal, $38.5 million worth of precious stones were produced (59% at cost and 17% at mass), the Audit Chamber report shows.

The transfer of rough diamonds to Kristall did not just lead to a build-up of reselling: the Audit Chamber notes an increase in production in 2010-2011 of 24%-34% compared to 2009. Kristall produced 178,440 carat cut diamonds worth $299.5 million and sold 191,900 carats for $366.7 million.

The Audit Chamber said that Kristall did not adopt an investment and innovation program or mid-term development program before 2012. The Audit Chamber considers that the investment of 344 million rubles that Kristall carried out in 2008-2011 did not contribute to modernization of the production process and technology, reduce costs and increase productivity.

The program was confirmed in 2012 and that was when the majority of the investment was made, Shkadov said. "This is because real money from the sale of property only appeared in the second half of 2011."

As a result, in terms of increasing Russia's share and that of the biggest Russian producer, Kristall did not make much progress on the global market. Russia's share in global cut diamond production was 8% in 2011. Kristall had a 1.62% share of the global market at the end of 2011 (1.94% in 2010) and 40.7% in Russia (55% in 2010). There are also objective reasons - a significant expansion in the Indian diamond business, products with a wide range of prices with a predominance of low price category goods.

SELLING CUT DIAMONDS

Apart from rough diamonds, Kristall obtained cut diamonds from the State Depository. In 2011 97% of cut diamonds transferred from the state fund in payment for Russia's contribution were sold. Revenue was around 2 billion rubles and the sale price was 5.2% over the cost price.

Kristall sold 74% of cut diamonds ($904 million) on the foreign market in 2008-2011. Some of the cut diamonds went to subsidiary Smolensk Diamonds N.V. (16.7% of Kristall sales in the four years), to Hong Kong-based Smolensk Diamonds Asia (8.1%) and to Smolensk Diamonds USA (7.2%). The biggest buyer of Kristall products was Finstown Enterprises from United Arab Emirates, which accounted for 18.6% of sales in 2008-2011. Other Kristall customers include several Israeli, U.S. and Belgian companies.

The State Depository Gokhran was not just a supplier of rough diamonds and cut diamonds to Kristall but also a buyer of its products. On the domestic market, Gokhran acquired over 92% of Kristall cut diamond sales in 2008-2011 for $292 million. This buying was also carried out as part of government support for the company.

SECTOR REGULATION SHORTCOMINGS

The Audit Chamber is not inclined to dramatize the fact and scale of rough diamond reselling - otherwise it would complain to the Prosecutor General, the Interior Ministry and the Federal Security Service (FSB). The Audit Chamber concluded that "exports of rough diamonds, the processing of which is not economically justified in the company, with a mark-up provides an opportunity for additional profit and speed up stock turnover."

It is convenient for Kristall to sell rough diamonds to foreign clients through its Belgian subsidiary, as sales on the domestic market are not advantageous for non-mining companies that cannot offer appealing prices to the end consumer, the document says. In addition, rough diamond exports from Russia are linked with a large volume of document turnover and approval from government structures. The process of putting together a package of export documents takes from three to six months, which leads to overstocking in warehouses. Kristall re-sorts the acquired lots in order to select the best rough diamonds for cutting and re-sorting is the prerogative of Gokhran overseers.

The long process for obtaining rough diamonds when buying in Russia is making foreign buyers think again about buying in Russia amid a fast-changing market, the Audit Chamber said. It is much more convenient to sell through subsidiaries in Belgium, Israel, Hong Kong and United Arab Emirates, which can get the product to the buyer within a guaranteed term and also promote products in world rough and cut diamond trade centers. In Antwerp where 90% of all the operations on this market take place, any deal takes a maximum of three hours, which includes studying and examining the assortment, agreeing a price, putting together the consignment, payment and release of the product.

"Rough diamonds are only sold abroad because of the lack of a competitive and market mechanism for their sale in Russia due to excessive legislative regulation