10-Q 1 a41764.txt LAZARE KAPLAN INTERNATIONAL INC. UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED FEBRUARY 28, 2006. OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM TO Commission File No. 1-7848 LAZARE KAPLAN INTERNATIONAL INC. (Exact name of registrant as specified in its charter) Delaware 13-2728690 (State or other jurisdiction of (IRS Employer incorporation or organization) Identification No.) 19 West 44th Street, New York, NY 10036 (Address of principal executive offices) (Zip Code) (212) 972-9700 (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X] As of March 14, 2006, 8,199,859 shares of the registrant's common stock were outstanding. LAZARE KAPLAN INTERNATIONAL INC. Index
Page ------- Part I. Financial Information Item 1. Financial Statements (Unaudited) Consolidated income statements 3 Three and nine months ended February 28, 2006 and 2005 Consolidated balance sheets 4 February 28, 2006 and May 31, 2005 Consolidated statements of cash flows 5 Nine months ended February 28, 2006 and 2005 Notes to consolidated financial statements 6 - 12 Item 2. Management's Discussion and Analysis of Financial 13 - 16 Condition and Results of Operations Item 3. Quantitative and Qualitative Disclosure of Market Risk 17 Item 4. Controls and Procedures 17 Part II. Other Information Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 18 Item 6. Exhibits and Reports on Form 8-K 18 Signature 19
2 PART I - FINANCIAL INFORMATION Item 1. Financial Statements. -------------------------------------------------------------------------------- CONSOLIDATED INCOME STATEMENTS -------------------------------------------------------------------------------- (In thousands, except per share and per share data)
Three Months Ended Nine Months Ended February 28, (unaudited) 2006 2005 2006 2005 --------------------------------------------------------------------------------------------- --------------------------- Net sales $ 157,912 $ 120,013 $ 393,043 $ 291,521 Cost of Sales 149,003 112,204 369,098 265,755 --------------------------------------------------------------------------------------------- --------------------------- 8,909 7,809 23,945 25,766 --------------------------------------------------------------------------------------------- --------------------------- Selling, general and administrative expenses 7,080 5,868 20,196 17,260 Interest expense, net of interest income 1,070 573 2,314 1,672 --------------------------------------------------------------------------------------------- --------------------------- 8,150 6,441 22,510 18,932 --------------------------------------------------------------------------------------------- --------------------------- Income before income taxes 759 1,368 1,435 6,834 Income tax provision 249 288 424 2,186 --------------------------------------------------------------------------------------------- --------------------------- NET INCOME $ 510 $ 1,080 $ 1,011 $ 4,648 ============================================================================================= =========================== EARNINGS PER SHARE ============================================================================================= =========================== Basic earnings per share $ 0.06 $ 0.13 $ 0.12 $ 0.55 ============================================================================================= =========================== Average number of shares outstanding during the period 8,265,208 8,423,481 8,319,697 8,461,959 ============================================================================================= =========================== ============================================================================================= =========================== Diluted earnings per share $ 0.06 $ 0.12 $ 0.12 $ 0.54 ============================================================================================= =========================== Average number of shares outstanding during the period assuming dilution 8,392,567 8,683,248 8,651,136 8,655,335 ============================================================================================= ===========================
See notes to consolidated financial statements. 3 CONSOLIDATED BALANCE SHEETS -------------------------------------------------------------------------------- (In thousands, except share data)
February 28, May 31, (Unaudited) (Audited) 2006 2005 --------------------------------------------------------------------------------------------------------------- Assets CURRENT ASSETS: Cash and cash equivalents $ 8,046 $ 10,320 Accounts and notes receivable, net 113,200 86,990 Inventories, net Rough stones 20,489 22,779 Polished stones 104,499 101,805 --------------------------------------------------------------------------------------------------------------- Total inventories 124,988 124,584 --------------------------------------------------------------------------------------------------------------- Prepaid expenses and other current assets 13,323 11,697 Deferred tax assets-current 1,940 1,944 --------------------------------------------------------------------------------------------------------------- TOTAL CURRENT ASSETS 261,497 235,535 Other non-current assets, net 9,436 8,747 Deferred tax assets, net 5,993 6,002 --------------------------------------------------------------------------------------------------------------- $ 276,926 $ 250,284 =============================================================================================================== Liabilities and Stockholders' Equity CURRENT LIABILITIES: Accounts payable and other current liabilities $ 56,409 $ 77,241 Current Portion of long-term debt 65,478 16,738 --------------------------------------------------------------------------------------------------------------- TOTAL CURRENT LIABILITIES 121,887 93,979 Long-term debt 60,000 60,000 --------------------------------------------------------------------------------------------------------------- TOTAL LIABILITIES 181,887 153,979 --------------------------------------------------------------------------------------------------------------- COMMITMENTS AND CONTINGENCIES --------------------------------------------------------------------------------------------------------------- STOCKHOLDERS' EQUITY: Preferred stock, par value $.01 per share: Authorized 1,500,000 shares; no shares outstanding - - Common stock, par value $1 per share Authorized 12,000,000 shares; issued 8,821,345 at February 2006 and 8,802,679 at May 2005, respectively 8,821 8,803 Additional paid-in capital 62,187 62,090 Cumulative translation adjustment (712) (241) Retained earnings 29,783 28,772 --------------------------------------------------------------------------------------------------------------- 100,079 99,424 Less treasury stock at cost; 618,436 shares at February 2006 and 407,376 shares at May 2005 (5,040) (3,119) --------------------------------------------------------------------------------------------------------------- TOTAL STOCKHOLDERS' EQUITY 95,039 96,305 --------------------------------------------------------------------------------------------------------------- $ 276,926 $ 250,284 ===============================================================================================================
See notes to consolidated financial statements. 4 CONSOLIDATED STATEMENTS OF CASH FLOWS -------------------------------------------------------------------------------- (In thousands) Nine months ended February 28, (unaudited) 2006 2005 -------------------------------------------------------------------------------- Cash Flows From Operating Activities: Net income $ 1,011 $ 4,648 Adjustments to reconcile net income to net cash used in operating activities: Depreciation and amortization 970 865 Provision for uncollectible accounts 105 22 Deferred income taxes 13 1,622 Changes in operating assets and liabilities: Accounts receivable (26,315) (11,396) Rough and Polished inventories (404) (26,199) Prepaid expenses and other current assets (1,625) (5,116) Other assets 121 150 Accounts payable and other current liabilities (20,832) 11,038 -------------------------------------------------------------------------------- Net cash used in operating activities (46,956) (24,366) -------------------------------------------------------------------------------- Cash Flows From Investing Activities: Capital expenditures (1,781) (1,265) -------------------------------------------------------------------------------- Net cash used in investing activities (1,781) (1,265) -------------------------------------------------------------------------------- Cash Flows From Financing Activities: Increase in borrowings 48,740 28,848 Purchase of treasury stock (1,921) (1,481) Proceeds from exercise of stock options 115 331 -------------------------------------------------------------------------------- Net cash provided by financing activities 46,934 27,698 -------------------------------------------------------------------------------- Effect of foreign currency translation adjustment (471) 257 -------------------------------------------------------------------------------- Net increase / (decrease) in cash and cash equivalents (2,274) 2,324 Cash and cash equivalents at beginning of period 10,320 1,209 -------------------------------------------------------------------------------- Cash and cash equivalents at end of period $ 8,046 $ 3,533 ================================================================================ See Notes to Consolidated Financial Statements 5 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 1. Interim Financial Reporting This financial information has been prepared in conformity with the accounting principles and practices reflected in the financial statements included in the annual report filed with the Securities Exchange Commission for the preceding fiscal year. In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments (consisting of normal recurring accruals) necessary to present fairly Lazare Kaplan International Inc.'s operating results for the three and nine months ended February 28, 2006 and 2005 and its financial position as of February 28, 2006. The balance sheet at May 31, 2005 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company's annual report on Form 10-K for the year ended May 31, 2005. The operating results for the interim periods presented are not necessarily indicative of the operating results for a full year. 2. Accounting Policies Sales arrangements with customers: The Company's polished diamond and diamond jewelry customers consist primarily of wholesale and retail clients. The Company's rough diamond customers consist primarily of rough diamond cutters. The Company generally ships polished diamond inventory to customers subject to verification of the diamond particulars. In addition: o The Company has an arrangement with a diamond producer whereby the Company sells certain polished diamonds that are cut and polished in Russia. The risk and rewards of ownership of these diamonds is transferred to the Company upon delivery to the Company of the diamonds in polished form. Generally, upon receipt, the Company pays a negotiated base price and the producer receives an economic interest in future profits associated with the diamonds. o The Company has a technical cooperation agreement with an entity responsible for the development and marketing of diamonds produced in Angola. Pursuant to this agreement the Company has established a joint buying and rough diamond trading operation. The Company takes title to the diamonds upon acquisition in Angola and assumes responsibility for risk of loss. Sales by the Company are recorded at their gross invoice value. Profits in excess of operating and rough acquisition costs as defined are allocated between parties with such costs classified as cost of sales by the Company. o Where the Company believes profitability can be maximized, the Company may combine, and jointly sell, certain of its diamonds with those of other wholesalers. In such instances, the Company 6 is obligated to share profits it realizes on the sale of such stones. Typically, the participating wholesaler is required to advance funds to the Company equal to their proportional interest in the underlying diamonds. The Company's policy is to recognize revenue when title and risk of ownership have passed to the buyer, the earnings process is complete and the sale price is fixed and determinable. In addition, in certain instances, the Company may be entitled to receive incremental profits from its customers on the sale of certain stones. Such profits are recognized as revenue when realized. Where the Company acts as a principal in the sales transaction, takes title to the product and has risks and rewards of ownership the gross value of diamonds invoiced is recorded as sales with the portion of profits allocable to others (where applicable) included in cost of sales. Credit is extended to customers based on an evaluation of each customer's financial condition and generally collateral is not required on the Company's receivables. Incentive Programs: The Company participates in cooperative advertising arrangements with customers in order to build brand awareness and product acceptance. Under such an arrangement a customer is eligible to receive an allowance of up to a specified percentage of its purchases from the Company if certain qualitative advertising criteria are met and if specified amounts are spent on qualifying advertising. The Company characterizes as selling, general and administrative expense the consideration it pays to customers for cooperative advertising. In addition, the Company offers programs whereby certain sales staff employed by the Company's customers can receive consideration for sales of the Company's products. The Company characterizes as selling, general and administrative expense the consideration it pays to the salesperson. Customer rebates: From time to time the Company has had arrangements whereby it would rebate to a customer a percentage of certain of its qualifying purchases. The Company characterizes such rebates as a reduction of sales. Consideration received from vendors: Periodically, the Company negotiates agreements with vendors to share certain promotional costs. The Company classifies amounts expended on such promotions as selling general and administrative expense when incurred. Similarly, amounts reimbursed by vendors are characterized as a reduction of selling, general and administrative expense. Shipping and handling: Shipping and handling costs incurred by the Company to deliver product to customers are classified in the Company's income statement as selling general and administrative expense. Inventories: Inventories, including amounts on consignment with customers, are stated at the lower of cost or market, using the average cost method. Prior to June 1, 2005 a portion of the Company's inventory 7 was accounted for using the first-in, first-out method. The effect of this change was immaterial to the overall inventory valuation. 3. Stock Incentive Plans The Company accounts for stock options granted to employees and directors under the Plan in accordance with Accounting Principles Board Opinion No. 25 and related interpretations. Accordingly, no compensation cost has been recognized for stock option awards. Had compensation cost been determined in accordance with Statement of Financial Accounting Standard No. 123, "Accounting for Stock-Based Compensation", as amended by SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure", the Company's income and income per common share would have been as follows: Three Months Ended Nine Months Ended February 28, 2006 2005 2006 2005 --------------------------------------- ------------------- ------------------ (In thousands, except per share data) Net income as reported $ 510 $ 1,080 $ 1,011 $ 4,648 Less: Stock-based employee compensation, net of taxes (111) (80) (334) (240) --------------------------------------- ------------------- ------------------ Pro forma $ 399 $ 1,000 $ 677 $ 4,408 --------------------------------------- ------------------- ------------------ Earnings per share: As reported: Basic $ 0.06 $ 0.13 $ 0.12 $ 0.55 Diluted $ 0.06 $ 0.12 $ 0.12 $ 0.54 ======================================= =================== ================== Pro forma: Basic $ 0.05 $ 0.12 $ 0.08 $ 0.52 Diluted $ 0.05 $ 0.12 $ 0.08 $ 0.51 ======================================= =================== ================== 4. Taxes Certain of the Company's subsidiaries conduct business in foreign countries. These subsidiaries are not subject to Federal income taxes and their provisions have been determined based upon the effective tax rates, if any, in the foreign countries. Deferred income taxes reflect the net tax effects of (a) temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes, and (b) operating loss carryforwards. The Company's net deferred tax asset as of February 28, 2006 is approximately $8,066,000 less a valuation allowance of approximately $133,000 resulting in a net deferred tax asset of $7,933,000. At February 28, 2006 the Company has available U.S. net operating loss carryforwards of $20.5 million, which expire as follows (in thousands): 8 Net Operating Year Losses ---- ------------- 2019 $ 9,858 2020 298 2021 120 2022 10,209 ------------- $ 20,485 ------------- 5. Earnings Per Share Basic and diluted earnings per share are computed in accordance with Financial Accounting Standards Board Statement No. 128 "Earnings per Share." Basic earnings per share is computed based upon the weighted average number of common shares outstanding. Diluted earnings per share include the impact of dilutive stock options.
Three Months Ended Nine Months Ended February 28, (unaudited) 2006 2005 2006 2005 -------------------------------------- --------------------- --------------------- Average number of shares outstanding during the period 8,265,208 8,423,481 8,319,697 8,461,959 Effect of dilutive stock options 127,359 259,767 331,439 193,376 -------------------------------------- --------------------- --------------------- Average number of shares outstanding during the period assuming dilution 8,392,567 8,683,248 8,651,136 8,655,335 ====================================== ===================== =====================
6. Comprehensive Income Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income" (SFAS 130) established rules for the reporting and display of comprehensive income and its components. SFAS 130 requires foreign currency translation adjustments to be included in other comprehensive income. For the three months ended February 28, 2006 and 2005, total comprehensive income was $730,000 and $987,000, respectively. For the nine months ended February 28, 2006 and 2005, total comprehensive income was $540,000 and $4,905,000, respectively. 7. Lines of Credit The Company has a $25.0 million and a $45.0 million unsecured, uncommitted line of credit with a bank. Borrowings under both lines bear interest at a rate 160 basis points above the 90 day LIBOR. As of February 28, 2006 the balance outstanding under both lines was $57.7 million. Borrowings under these lines are available for the Company's working capital requirements and are payable on demand. The Company has a long-term unsecured, revolving loan agreement. The agreement provides that the Company may borrow up to $45.0 million (including up to $1.0 million under letters of credit) in the aggregate through December 1, 2007. The loan term may be extended in one year increments commencing November 30, 2006, subject to the consent of the lending banks. Borrowings under this agreement bear interest at (a) the higher of the banks base rate or one half of one percent 9 above the Federal Funds Effective Rate, or (b) 160 basis points above LIBOR. The applicable interest rate is contingent upon the method of borrowing selected by the Company. The proceeds of this facility are available for working capital purposes. The loan agreement contains certain provisions that require, among other things, (a) maintenance of defined levels of working capital, net worth and profitability, (b) limitations on borrowing levels, investments and capital expenditures and (c) limitations on dividends and the repurchase of treasury shares. As of February 28, 2006 the balance outstanding under this facility was $38.0 million, excluding outstanding letters of credit in the amount of $0.7 million. The Company also maintains an additional long-term unsecured, revolving loan agreement with a bank under which it may borrow up to $30.0 million in the aggregate through December 1, 2007. The loan term may be extended in one year increments commencing November 30, 2006, subject to the consent of the bank. Borrowings under this agreement bear interest at (a) the higher of the banks base rate or one half of one percent above the Federal Funds Effective Rate, or (b) 160 basis points above LIBOR. The applicable interest rate is contingent upon the method of borrowing selected by the Company. The proceeds of this facility are available for working capital purposes. The loan agreement contains certain provisions that require, among other things, (a) maintenance of defined levels of working capital, net worth and profitability, (b) limitations on borrowing levels, investments and capital expenditures and (c) limitations on dividends and the repurchase of treasury shares. Borrowings under this loan agreement amounted to $29.2 million at February 28, 2006. A subsidiary of the Company maintains a loan facility which enables it to borrow up to 520 million Japanese Yen (approximately $4.4 million U.S. dollars) at an interest rate 1% above the Japanese yen LIBOR through November 2007. Borrowings under the facility are available for working capital purposes. The Company guarantees repayment of amounts borrowed. Borrowings under the loan are used in support of its operations in Japan. As of February 28, 2006, the balance outstanding under this facility was $0.6 million U.S. dollars. Long-term debt of $60.0 million outstanding at February 28, 2006 is scheduled to be repaid in the fiscal year ended May 31, 2007. The Company was in compliance with its debt covenants at February 28, 2006. The Company guarantees a portion of certain indebtedness ($1.3 million, at February 28, 2006) relating to a joint diamond cutting and polishing operation in South Africa. The Company's long-term facilities do not contain subjective acceleration clauses or require the Company to utilize a lock box whereby remittances from the Company's customers reduce the debt outstanding. 8. Transactions with related parties A member of the Company's Board of Directors is of counsel to a law firm which serves as counsel to the Company. Amounts paid to the law firm for the nine months ended February 28, 2006 and 2005 were $0.5 million and $0.3 million, respectively. For the nine months ended February 28, 2006 and 2005 the Company sold approximately $0.4 and $1.7 million, respectively, of jewelry to a relative of a non-employee member of the Company's Board of Directors. 10 9. Segment Information GEOGRAPHIC SEGEMENT INFORMATION -------------------------------------------------------------------------------- (In thousands) Revenue, gross profit and income/(loss) before income taxes for the three months ended February 28, 2006 and 2005 and identifiable assets at the end of each of those periods, classified by geographic area, which was determined by where sales originated and where identifiable assets are held, were as follows (in thousands):
North Far Elimi- Consoli- America Europe Africa East nations dated ------------------------------------------------------------------ Three months ended February 28, 2006 Net sales to unaffiliated customers $ 24,312 $ 117,016 $ 12,691 $ 3,893 $ - $ 157,912 Transfers between geographic areas 35,803 15 76,534 - (112,352) - ------------------------------------------------------------------------------------------------------------- Total revenue $ 60,115 $ 117,031 $ 89,225 $ 3,893 $ (112,352) $ 157,912 ------------------------------------------------------------------------------------------------------------- Gross Profit $ 5,031 $ 787 $ 2,206 $ 881 $ 4 $ 8,909 ------------------------------------------------------------------------------------------------------------- Income/(loss) before income taxes $ (1,590) $ 192 $ 2,145 $ 8 $ 4 $ 759 ------------------------------------------------------------------------------------------------------------- ============================================================================================================= Three months ended February 28, 2005 Net sales to unaffiliated customers $ 28,074 $ 88,234 $ - $ 3,705 $ - $ 120,013 Transfers between geographic areas 46,430 327 38,644 - (85,401) - ------------------------------------------------------------------------------------------------------------- Total revenue $ 74,504 $ 88,561 $ 38,644 $ 3,705 $ (85,401) $ 120,013 ------------------------------------------------------------------------------------------------------------- Gross Profit $ 6,364 $ 713 $ (181) $ 906 $ 7 $ 7,809 ------------------------------------------------------------------------------------------------------------- Income/(loss) before income taxes $ 1,542 $ 131 $ (245) $ (66) $ 6 $ 1,368 ------------------------------------------------------------------------------------------------------------- =============================================================================================================
Revenue and gross profit for the three months ended February 28 and 29, 2005 and 2004 classified by product were as follows (in thousands): Polished Rough Total --------------------------------------------------------------------------- Three months ended February 28, 2006 Net Sales $ 36,560 $ 121,352 $ 157,912 --------------------------------------------------------------------------- Gross Profit $ 5,345 $ 3,564 $ 8,909 =========================================================================== Three months ended February 28, 2005 Net Sales $ 40,281 $ 79,732 $ 120,013 --------------------------------------------------------------------------- Gross Profit $ 5,758 $ 2,051 $ 7,809 =========================================================================== 11 9. Segment Information GEOGRAPHIC SEGEMENT INFORMATION -------------------------------------------------------------------------------- (In thousands) Revenue, gross profit and income/(loss) before income taxes for the nine months ended February 28, 2006 and 2005 and identifiable assets at the end of each of those periods, classified by geographic area, which was determined by where sales originated and where identifiable assets are held, were as follows (in thousands):
North Far Elimi- Consoli- America Europe Africa East nations dated ------------------------------------------------------------------ Nine months ended February 28, 2006 Net sales to unaffiliated customers $ 81,340 $ 283,493 $ 16,393 $11,817 $ - $ 393,043 Transfers between geographic areas 121,342 497 152,999 9 (274,847) - ------------------------------------------------------------------------------------------------------------- Total revenue $202,682 $ 283,990 $169,392 $11,826 $ (274,847) $ 393,043 ------------------------------------------------------------------------------------------------------------- Gross Profit $ 18,075 $ 2,087 $ 980 $ 2,790 $ 13 $ 23,945 ------------------------------------------------------------------------------------------------------------- Income/(loss) before income taxes $ 68 $ 484 $ 798 $ 72 $ 13 $ 1,435 ------------------------------------------------------------------------------------------------------------- Identifiable assets at February 28, 2006 $157,405 $ 85,674 $ 25,649 $ 8,255 $ (57) $ 276,926 ============================================================================================================= Nine months ended February 28, 2005 Net sales to unaffiliated customers $ 78,896 $ 200,636 $ - $11,989 $ - $ 291,521 Transfers between geographic areas 124,844 1,149 64,366 45 (190,404) - ------------------------------------------------------------------------------------------------------------- Total revenue $203,740 $ 201,785 $ 64,366 $12,034 $ (190,404) $ 291,521 ------------------------------------------------------------------------------------------------------------- Gross Profit $ 21,035 $ 1,934 $ (768) $ 3,511 $ 54 $ 25,766 ------------------------------------------------------------------------------------------------------------- Income/(loss) before income taxes $ 6,338 $ 391 $ (678) $ 730 $ 53 $ 6,834 ------------------------------------------------------------------------------------------------------------- Identifiable assets at February 28, 2005 $149,461 $ 47,744 $ 17,862 $ 9,359 $ (73) $ 224,353 =============================================================================================================
Revenue and gross profit for the nine months ended February 28 and 29, 2005 and 2004 classified by product were as follows (in thousands): Polished Rough Total --------------------------------------------------------------------------- Nine months ended February 28, 2006 Net Sales $116,218 $ 276,825 $ 393,043 --------------------------------------------------------------------------- Gross Profit $ 16,818 $ 7,127 $ 23,945 =========================================================================== Nine months ended February 28, 2005 Gross Profit Net Sales $113,292 $ 178,229 $ 291,521 --------------------------------------------------------------------------- Gross Profit $ 18,536 $ 7,230 $ 25,766 =========================================================================== 12 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. -------------------------------------------------------------------------------- Introduction This quarterly report contains, in addition to historical information, certain forward-looking statements that involve significant risks and uncertainties. Such forward-looking statements are based on management's belief as well as assumptions made by, and information currently available to, management pursuant to the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995. The Company's actual results could differ materially from those expressed in or implied by the forward-looking statements contained herein. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in "Liquidity - Capital Resources" and in Item 1 - "Description of Business" and elsewhere in the Company's Annual Report on Form 10-K for the fiscal year ended May 31, 2005. The Company undertakes no obligation to release publicly the result of any revisions to these forward-looking statements that may be made to reflect events or circumstances after the date of this quarterly report or to reflect the occurrence of other unanticipated events. Overview The Company is engaged in the cutting, polishing and selling of diamonds, including ideally proportioned diamonds, which it markets internationally under the brand name "Lazare Diamonds(R)". Ideally proportioned diamonds are distinguished from non-ideal cut ("commercial") diamonds by the symmetrical relationship of their facets, which optimize the balance of brilliance, sparkle and fire in a polished diamond. The Company's domestic manufacturing facility, located in Puerto Rico, is believed by the Company to be the largest diamond cutting facility in the United States. In addition, through various cooperation agreements, the Company cuts and polishes fine commercial make diamonds which it markets to wholesalers, distributors and retail jewelers. A subsidiary of the Company has an agreement under which it markets natural diamonds that have undergone a new high pressure high temperature process to improve the color of certain gem diamonds without reducing their all-natural content. These diamonds are sold under the Bellataire(R) brand name. Rough stones purchased by the Company are either selected for manufacturing or resold as rough diamonds in the marketplace. The Company's overall revenues are, in part, dependent upon the availability of rough diamonds, the world's known sources of which are highly concentrated. The Diamond Trading Company ("DTC") is the world's largest rough diamond selling organization. The Company has been a client of the DTC for approximately 60 years. The Company supplements its rough diamond needs by secondary market purchases and has entered into relationships with other primary source suppliers. The Company has a technical assistance and cooperation agreement regarding the purchasing and marketing of rough diamonds with Sociedade de Comercializacao de Diamantes de Angola SARL ("SODIAM"), the government entity responsible for development and marketing of diamonds produced in Angola. Rough diamond buying from this operation commenced during the first fiscal quarter of 2005. During the third fiscal quarter of 2006 the Company's Angolan operations included rough diamond buying in both the formal and informal mining sectors. The Company has two agreements with AK ALROSA of Russia, which is the largest producer of rough diamonds in Russia. Under the terms of these agreements, the Company sells 13 polished diamonds that are cut in facilities jointly managed and supervised by the Company and ALROSA personnel. The proceeds from the sale of these polished diamonds, after deduction of rough diamond cost, generally are shared equally with ALROSA. The Company has an agreement with NamGem Diamond Manufacturing Company (PTY) Ltd. ("NamGem") for the cutting and polishing of diamonds in Namibia. NamGem is Namibia's flagship venture in the international diamond polishing industry. Under the terms of the agreement, the Company provides marketing and technical manufacturing assistance to NamGem. The Company purchases rough diamonds and supervises the manufacturing of those deemed suitable to cut and polish. The Company pays NamGem for manufacturing on a fee for services basis. All rough and polished diamonds are bought and sold by the Company for its account. The Company has an agreement with Nozala Investments (Pty) Ltd., a broadly based women's empowerment investment group, for cooperation in South Africa's diamond sector. The agreement contemplates diamond mining, cutting, polishing and distribution. The joint venture is in line with the South African Government's recently announced program to promote new entrants and investment in the domestic diamond sector, increasing the sector's contribution to economic development. Initial cutting and polishing activities, which commenced during the three months ended February 28, 2006, concentrate on local sources of rough diamond supply. In the period ended November 30, 2005, the Company (including certain of its subsidiaries) amended certain terms of its agreement with Diamond Innovations Inc. relating to the sourcing, manufacture and marketing of Bellataire(R) brand diamonds. The amendment and related agreements seek to increase the sales and profitability of Bellataire diamonds by more closely aligning the economic interests of the parties through shared management of product sourcing, manufacturing and marketing as well as the sharing of related costs. While the Company believes that its success in maintaining quantities and qualities of polished inventory that best meet its customers' needs is achieved through its ability to fully integrate its diverse rough and polished diamond sources, any significant disruption of the Company's access to its primary source suppliers could have a material adverse effect on the Company. Results of Operations Net Sales Net sales for the three and nine months ended February 28, 2006 were $157.9 and $393.0 million, respectively, an increase of $37.9 and $101.5 million over the comparable period in the prior year. Polished diamond revenue for the three and nine month periods ended February 28, 2006 was $36.6 and $116.2 million as compared to $40.3 and $113.3 million in the prior year. This decrease in polished diamond sales for the three months ended February 28, 2006 reflects market resistance to price increases the Company seeks to pass through to customers. Increased polished diamond sales for the nine months ended February 28, 2006 reflects higher sales of fine cut commercial diamonds offset in part by lower sales of branded diamonds. Factors leading to this increase include increased availability of fine cut commercial diamonds from the Company's Namibian operation and sales growth attributable to investments in personnel made during the preceding year. Rough diamond sales were $121.4 and $79.7 million, an increase of $41.6 and $98.6 million for the three and nine months ended February 28, 2006. The increase in rough diamond sales is primarily related to an increase in the Company's Angolan rough buying and trading operations. 14 Sales of rough sourced through the Company's Angolan operation were nominal for the initial period of operations through August 31, 2004. Gross Profit Gross Margin on net polished sales for the three and nine months ended February 28, 2006 was 14.6% and 14.5%, respectively, as compared to 14.3% and 16.4% for the prior year periods. The decline in polished gross margin for the nine month period reflects a shift in sales mix with a higher percentage of polished sales derived from fine cut commercial diamonds which typically carry a lower gross margin than branded diamonds. For the three and nine month periods ended February 28, 2006 polished diamond gross margin also reflects increased rough diamond prices which the Company was unable to fully pass through to customers. Rough gross margin during the three month period ended February 28, 2006 was 2.9% as compared to 2.6% in the prior year period. Rough gross margin during the nine months ended February 28, 2006 was 2.6% as compared to 4.1% for the prior year period. The decrease in rough gross margin percentage for the nine months ended February 28, 2006 reflects increased rough costs and associated fees charged by diamond producers at a time of excess supply and soft demand from diamond manufacturers. During the nine months ended February 28, 2005 rough market expectations concerning the future availability and price of better quality diamonds resulted in a favorable rough trading market. In contrast, rough market conditions during the nine months ended February 28, 2006 showed signs of continuing weakness with concerns of near term oversupply and heightened concerns about industry liquidity. As a result of the foregoing, overall gross margin percentage during the three and nine month period ended February 28, 2006 was 5.6% and 6.1%, respectively, as compared to 6.5% and 8.8% in the prior year periods. Selling, General and Administrative Expenses Selling, general and administrative expenses for the three and nine months ended February 28, 2006 were $7.1 and $20.2 million, respectively, as compared to $5.9 and $17.3 million for the same periods in the prior year. The increase reflects higher advertising, legal and consulting costs directed toward expanding sourcing and supporting the distribution of branded diamonds, jewelry, fine cut commercial diamonds and rough diamond trading. Interest Expense Net interest expense for the three and nine months ended February 28, 2006 was $1.1 million and $2.3 million, respectively, as compared to $0.6 million and $1.7 million for the same periods in the prior year. Interest expense for the three and nine months ended February 28, 2006 reflects increased interest rates and outstanding borrowings compared to the prior year periods. Income Tax The Company's effective tax rate for the nine months ended February 28, 2006 was 30% as compared to 32% for the prior year period. The year to date decrease is primarily attributable to an increase in the percentage of income earned in lower tax rate jurisdictions. 15 Liquidity and Capital Resources The Company's working capital at February 28, 2006 was $139.6 million as compared to $141.6 million at May 31, 2005. The Company maintains two long-term unsecured, revolving credit facilities that it utilizes for general working capital purposes in the amounts of $45 million and $30 million, respectively ($67.2 million aggregate outstanding at February 28, 2006). In addition, the Company has a 520 million Yen denominated facility that is used in support of its operations in Japan (approximately $0.6 million U.S. dollars outstanding at February 28, 2006). The Company's long-term facilities do not contain subjective acceleration clauses or require the Company to utilize a lock box whereby remittances from the Company's customers reduce the debt outstanding. The Company also maintains $70 million of uncommitted lines of credit ($57.7 million outstanding at February 28, 2006) that are used to finance rough inventory transactions and other working capital needs. Long-term debt includes the portion of borrowings which the Company has both the intention and the ability to refinance on a long-term basis. Stockholders' equity was $95.0 million at February 28, 2006 as compared to $96.3 million at May 31, 2005. No dividends were paid to stockholders during the three and nine months ended February 28, 2006. The Company believes that it has the ability to meet its anticipated financing needs for at least the next twelve months. New Pronouncements In December 2004, the Financial Accounting Standards Board (FASB) revised Statement of Financial Accounting Standards (SFAS) No. 123 "Share-Based Payment". SFAS No. 123(R) will require the Company to expense stock options. Adoption is required for the annual reporting periods beginning after June 15, 2005. The effect of expensing stock options on the Company's results of operations using the Black-Scholes model is presented in the accompanying Notes to Consolidated Financial Statements (Note 3 - Stock Incentive Plans) Transactions with related parties A member of the Company's Board of Directors is of counsel to a law firm which serves as counsel to the Company. Amounts paid to the law firm for the nine months ended February 28, 2006 and 2005 were $0.5 million and $0.3 million, respectively. For the nine months ended February 28, 2006 and 2005 the Company sold approximately $0.4 and $1.7 million, respectively, of jewelry to a relative of a non-employee member of the Company's Board of Directors. 16 Item 3. Quantitative and Qualitative Disclosure About Market Risk. -------------------------------------------------------------------------------- At February 28, 2006, the Company had borrowings totaling approximately $125.5 million outstanding under various credit agreements. The interest rates on these borrowings are variable and therefore the general level of U.S. and foreign interest rates affects interest expense. Increases in interest expense resulting from an increase in interest rates could impact the Company's results of operations. The Company's policy is to take actions that would mitigate such risk when appropriate. These actions include staggering the term and rate of its borrowings to match anticipated cash flows and movements in interest rates. Item 4. Controls and Procedures. -------------------------------------------------------------------------------- As of February 28, 2006 an evaluation was performed under the supervision and with the participation of the Company's management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures. Based on that evaluation, the Company's management, including the Chief Executive Officer and Chief Financial Officer, concluded that the Company's disclosure controls and procedures were effective as of February 28, 2006. There has been no change in the Company's internal controls over financial reporting during the Company's most recent fiscal quarter that has materially affected, or is reasonably likely to affect, the Company's internal controls over financial reporting 17 PART II - OTHER INFORMATION Item 2. Unregistered Sales of Equity Securities and Use of Proceeds. -------------------------------------------------------------------------------- (c) Issuer Purchase of Equity Securities Total Number of Maximum Shares Dollar Value Total Average Purchased as that May Yet Number of Price Part of Publicly Be Purchased Shares Paid per Announced Under the Period Purchased Share Programs Programs ---------------------------------------------------------------------- Dec-05 22,830 $ 9.38 22,830 Jan-06 30,438 $ 9.27 30,438 Feb-06 58,108 $ 8.65 58,108 ---------------------------------------------------------------------- Total 111,376 $ 8.46 111,376 $ 78,704 ====================================================================== On April 7, 2006, the Company adopted a resolution to continue to purchase in the open market, at any time and from time to time during the fiscal year ending May 31, 2007, shares of the Company's common stock with an aggregate value not to exceed $2.0 million. Item 6. Exhibits and Reports on From 8-K. -------------------------------------------------------------------------------- (a) Exhibits (31) Rule 13a - 14(a) / 15d - 14 (a) Certifications (32) Section 1350 Certifications (b) Reports on Form 8-K None 18 SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. LAZARE KAPLAN INTERNATIONAL INC. By /s/ William H. Moryto ----------------------- William H. Moryto Vice President and Chief Financial Officer Dated: April 07, 2006 19