10-Q 1 a44707.txt LAZARE KAPLAN 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 AUGUST 31, 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 September 14, 2005 8,197,634 shares of the registrant's common stock were outstanding. LAZARE KAPLAN INTERNATIONAL INC. Index
Part I. Financial Information Page ------------- Item 1. Financial Statements (Unaudited) Consolidated statements of operations 3 Three months ended August 31, 2006 and 2005 Consolidated balance sheets 4 August 31, 2006 and May 31, 2006 Consolidated statements of cash flows 5 Three months ended August 31, 2006 and 2005 Notes to consolidated financial statements 6 - 12 Item 2. Management's Discussion and Analysis of Financial 13 - 17 Condition and Results of Operations Item 3. Quantitative and Qualitative Disclosure of Market Risk 18 Item 4. Controls and Procedures 18 Part II. Other Information Item 1. Legal Proceedings 19 Item 2. Changes in Securities and Use of Proceeds 19 Item 5. Other Information 20 Item 6. Exhibits and Reports on Form 8-K 20 Signature 21
2 PART I - FINANCIAL INFORMATION Item 1. Financial Statements -------------------------------------------------------------------------------- CONSOLIDATED STATEMENTS OF OPERATIONS -------------------------------------------------------------------------------- (In thousands, except per share and share data)
Three Months Ended August 31, 2006 and 2005 (unaudited) 2006 2005 --------------------------------------------------------------------------------------------------- Net sales $ 138,884 $ 138,856 Cost of Sales 133,639 129,874 --------------------------------------------------------------------------------------------------- 5,245 8,982 --------------------------------------------------------------------------------------------------- Selling, general and administrative expenses 6,239 6,687 Equity in (income) / loss of joint ventures (293) - Interest expense 1,722 903 --------------------------------------------------------------------------------------------------- 7,668 7,590 --------------------------------------------------------------------------------------------------- Income / (loss) before income taxes (2,423) 1,392 Income tax provision / (benefit) (598) 484 --------------------------------------------------------------------------------------------------- NET INCOME / (LOSS) $ (1,825) $ 908 =================================================================================================== EARNINGS PER SHARE --------------------------------------------------------------------------------------------------- Basic earnings / (loss) per share $ (0.22) $ 0.11 --------------------------------------------------------------------------------------------------- Average number of shares outstanding during the period 8,197,259 8,368,621 --------------------------------------------------------------------------------------------------- --------------------------------------------------------------------------------------------------- Diluted earnings / (loss) per share $ (0.22) $ 0.10 --------------------------------------------------------------------------------------------------- Average number of shares outstanding during the period assuming dilution 8,197,259 9,011,287 ---------------------------------------------------------------------------------------------------
3 CONSOLIDATED BALANCE SHEETS -------------------------------------------------------------------------------- (In thousands, except share data)
August 31, May 31, (Unaudited) (Audited) 2006 2006 ---------------------------------------------------------------------------------------------------- Assets CURRENT ASSETS: Cash and cash equivalents $ 6,200 $ 8,160 Accounts and notes receivable, net 112,314 91,403 Inventories, net Rough stones 15,372 24,746 Polished stones 111,053 108,368 ---------------------------------------------------------------------------------------------------- Total inventories 126,425 133,114 ---------------------------------------------------------------------------------------------------- Prepaid expenses and other current assets 15,837 12,763 Deferred tax assets-current 1,921 2,024 ---------------------------------------------------------------------------------------------------- TOTAL CURRENT ASSETS 262,697 247,464 Non-current assets, net 8,718 8,741 Deferred tax assets, net 8,232 7,507 ---------------------------------------------------------------------------------------------------- $ 279,647 $ 263,712 ==================================================================================================== Libilities and Stockholders' Equity CURRENT LIABILITIES: Accounts payable and other current liabilities $ 52,611 $ 55,771 Current portion of long-term debt 69,461 47,969 ---------------------------------------------------------------------------------------------------- TOTAL CURRENT LIABILITIES 122,072 103,740 Long-term debt 63,719 64,176 ---------------------------------------------------------------------------------------------------- TOTAL LIABILITIES 185,791 167,916 ---------------------------------------------------------------------------------------------------- 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 8,821,845 and 8,821,345 in August 2006 and May 2006, respectively 8,822 8,821 Additional paid-in capital 62,221 62,187 Cumulative translation adjustment (575) (425) Retained earnings 28,475 30,300 ---------------------------------------------------------------------------------------------------- 98,943 100,883 Less treasury stock, at cost, 624,211 shares at August 31, 2006 and May 31, 2006 (5,087) (5,087) ---------------------------------------------------------------------------------------------------- TOTAL STOCKHOLDERS' EQUITY 93,856 95,796 ---------------------------------------------------------------------------------------------------- $ 279,647 $ 263,712 ====================================================================================================
See notes to consolidated financial statements. 4 CONSOLIDATED STATEMENTS OF CASH FLOWS -------------------------------------------------------------------------------- (In thousands)
Three months ended August 31, 2006 and 2005 (unaudited) 2006 2005 --------------------------------------------------------------------------------------------------------------- Cash Flows From Operating Activities: Net income / (loss) from operations $ (1,825) $ 908 Adjustments to reconcile net income to net cash used in operating activities: Depreciation and amortization 370 311 Provision for uncollectible accounts 67 41 Compensation expense - noncash 31 Deferred income taxes (622) 450 Changes in operating assets and liabilities: Accounts receivable (20,978) (31,856) Rough and Polished inventories 6,689 (6,223) Prepaid expenses and other current assets (3,074) 964 Other assets (144) (28) Accounts payable and other current liabilities (3,160) 6,215 --------------------------------------------------------------------------------------------------------------- Net cash used in operating activities (22,646) (29,218) =============================================================================================================== Cash Flows From Investing Activities: Capital expenditures (203) (1,069) --------------------------------------------------------------------------------------------------------------- Net cash used in investing activities (203) (1,069) =============================================================================================================== Cash Flows From Financing Activities: Increase in borrowings 21,035 27,491 Purchase of treasury stock - (638) Proceeds from exercise of stock options 4 46 --------------------------------------------------------------------------------------------------------------- Net cash provided by financing activities 21,039 26,899 =============================================================================================================== Effect of foreign currency translation adjustment (150) (239) --------------------------------------------------------------------------------------------------------------- Net decrease in cash and cash equivalents (1,960) (3,627) Cash and cash equivalents at beginning of period 8,160 10,320 --------------------------------------------------------------------------------------------------------------- Cash and cash equivalents at end of period $ 6,200 $ 6,693 ===============================================================================================================
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 months ended August 31, 2006 and 2005 and its financial position as of August 31, 2006. The balance sheet at May 31, 2006 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 fiscal year ended May 31, 2006. 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. 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. Polished diamond sales include revenue derived from the sale of polished diamonds and fees associated with the cutting, polishing and laser inscription of polished diamonds. 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. 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 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 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. 6 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 for diamonds sourced in the Angolan informal sector. During the third fiscal quarter of 2006, the Company's rough buying operations expanded to include buying in the Angolan formal sector. 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. The Company is currently negotiating a further expansion and restructuring of its Angolan operations to include exploration, development and distribution through various joint ventures. 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. 7 Equity Investments: The Company utilizes the equity method of accounting to record its proportionate share of income and losses from joint ventures. 3. Stock Incentive Plans --------------------- In the quarter ended August 31, 2006, the Company adopted SFAS No. 123(R) "Share-Based Payment". SFAS No. 123(R) focuses primarily on accounting for transactions in which the Company obtains employee services in exchange for share-based payments. Under SFAS No. 123(R), share-based awards that do not require future service (i.e., vested awards) are expensed immediately. Share-based employee awards that require future service are amortized over the relevant service period. The Company adopted SFAS No. 123(R) under the modified prospective method, whereby the provisions of this standard are generally applied only to share-based awards granted subsequent to adoption, and therefore the Company's financial statements for periods prior to adoption are not restated.
Three months ended August 31, 2006 -------------------------------------------------------- ----------- (In thousands, except per share data) Share-Based compensation included in income before tax $ 31 Income tax benefit (10) -------------------------------------------------------- ----------- Share-Based compensation included in income (net of tax) $ 21 -------------------------------------------------------- ----------- Share-Based compensation effects on earnings per share: Basic $ -- Diluted $ -- -------------------------------------------------------- -----------
Prior to the adoption of SFAS No. 123(R), compensation expense was measured using the intrinsic value method under Accounting Principles Board Opinion No. 25 and related interpretations. Accordingly, no compensation cost has been recognized for stock option awards as they are issued at or above fair market value. 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: 8
Three months ended August 31, 2005 -------------------------------------------------- --------------- (In thousands, except per share data) Net income as reported $ 908 Less: Stock-based employee compensation, net of taxes (148) -------------------------------------------------- --------------- Pro forma $ 760 -------------------------------------------------- --------------- Earnings per share: As reported: Basic $ 0.11 Diluted $ 0.10 -------------------------------------------------- --------------- Pro forma: Basic $ 0.09 Diluted $ 0.08 -------------------------------------------------- ---------------
A summary of the Plans' activity for each of the three years in the period ended May 31, 2006 is as follows:
Weighted Number of average price shares Option Price per share ------------------------------------------------------------------------------------------------------------ Outstanding - May 31, 2006 1,304,451 $ 5.000 - $ 14.750 $ 8.697 Options expired/cancelled (90,000) $ 5.280 - $ 5.280 $ 5.280 Options issued -- $ -- - $ -- $ -- Options exercised (500) $ 5.480 - $ 5.480 $ 5.480 ------------------------------------------------------------------------------------------------------------ Outstanding - August 31, 2006 1,213,951 $ 5.000 - $ 14.750 $ 9.019 ------------------------------------------------------------------------------------------------------------ Exercisable options 1,027,286 -----------------------------------------------------------
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 August 31, 2006 is approximately $10,286,000 less a valuation allowance of approximately $133,000 resulting in a net deferred tax asset of $10,153,000. At August 31, 2006 the Company has available U.S. net operating loss carryforwards of $22.1 million, which expire as follows (in thousands): 9
Net Operating Year Losses ------- --------------- 2019 $ 8,690 2020 298 2021 120 2022 10,190 2023 25 2026 2,761 --------------- $ 22,084 ---------------
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 August 31, 2006 2005 ----------------------------------------- ------------------------------------- Average number of shares outstanding during the period 8,197,259 8,368,621 Effect of dilutive stock options - 642,666 ----------------------------------------- ------------------------------------- Average number of shares outstanding during the period assuming dilution 8,197,259 9,011,287 ----------------------------------------- -------------------------------------
6. Comprehensive Income / (loss) ----------------------------- 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 August 31, 2006 and 2005, total comprehensive income / (loss) was ($1,975,000) and $669,000, 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 August 31, 2006 the balance outstanding under both lines was $62.3 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 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 10 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 August 31, 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 August 31, 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 August 31, 2006, the balance outstanding under this facility was $3.7 million U.S. dollars. Long-term debt of $63.7 million outstanding at August 31, 2006 is scheduled to be repaid in the fiscal year ended May 31, 2008. The Company was in compliance with its debt covenants at August 31, 2006. The Company guarantees a portion of certain indebtedness ($2.0 million, at August 31, 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 three months ended August 31, 2006 and 2005 was $0.2 million and $0.1 million, respectively. For the three months ended August 31, 2005, the Company sold approximately $0.1 million of jewelry to a relative of a non-employee member of the Company's Board of Directors. 11 9. Segment Information ------------------- GEOGRAPHIC SEGEMENT INFORMATION -------------------------------------------------------------------------------- (In thousands) Revenue, gross profit and income/(loss) before income taxes for the three months ended August 31, 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 from and where identifiable assets are held, were as follows (in thousands):
North Far Elimi- Consoli- America Europe Africa East nations dated ------------------------------------------------------------------------------------- Three months ended August 31, 2006 ---------------------------------- Net sales to unaffiliated customers $ 22,847 $ 110,405 $ 1,487 $ 4,145 $ -- $ 138,884 Transfers between geographic areas 30,475 77,252 (107,727) -- ------------------------------------------------------------------------------------------------------------------------------- Total revenue $ 53,322 $ 110,405 $ 78,739 $ 4,145 $ (107,727) $ 138,884 ------------------------------------------------------------------------------------------------------------------------------- Gross Profit $ 3,684 $ 505 $ 82 $ 974 $ -- $ 5,245 ------------------------------------------------------------------------------------------------------------------------------- Income/(loss) before income taxes $ (2,693) $ (165) $ 349 $ 86 $ -- $ (2,423) ------------------------------------------------------------------------------------------------------------------------------- Identifiable assets at August 31, 2006 $ 173,253 $ 75,855 $ 21,641 $ 8,952 $ (54) $ 279,647 =============================================================================================================================== Three months ended August 31, 2005 ---------------------------------- Net sales to unaffiliated customers $ 31,205 $ 103,977 $ -- $ 3,674 $ -- $ 138,856 Transfers between geographic areas 49,521 471 53,858 9 (103,859) -- ------------------------------------------------------------------------------------------------------------------------------- Total revenue $ 80,726 $ 104,448 $ 53,858 $ 3,683 $ (103,859) $ 138,856 ------------------------------------------------------------------------------------------------------------------------------- Gross Profit $ 7,413 $ 760 $ (102) $ 902 $ 9 $ 8,982 ------------------------------------------------------------------------------------------------------------------------------- Income/(loss) before income taxes $ 1,283 $ 241 $ (159) $ 18 $ 9 $ 1,392 ------------------------------------------------------------------------------------------------------------------------------- Identifiable assets at August 31, 2005 $ 163,904 $ 85,807 $ 26,549 $ 7,868 $ (61) $ 284,067 ===============================================================================================================================
Revenue and gross profit for the three months ended August 31, 2006 and 2005 classified by product were as follows (in thousands):
Polished Rough Total ---------------------------------------------------------------------------- Three months ended August 31, 2006 ---------------------------------- Net Sales $ 33,043 $ 105,841 $ 138,884 ---------------------------------------------------------------------------- Gross Profit $ 3,857 $ 1,388 $ 5,245 ---------------------------------------------------------------------------- Three months ended August 31, 2005 ---------------------------------- Net Sales $ 41,990 $ 96,866 $ 138,856 ---------------------------------------------------------------------------- Gross Profit $ 5,260 $ 3,722 $ 8,982 ============================================================================
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, 2006. 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 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 cooperative agreements, the Company cuts and polishes commercial diamonds which it markets to wholesalers, distributors and retail jewelers. 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 Pursuant to this agreement the Company has established a joint buying and rough diamond trading operation for diamonds sourced in the Angolan informal sector. During the third fiscal quarter of 2006 the Company's rough buying operations expanded to include buying in the Angolan formal sector. The Company is currently negotiating a further expansion and restructuring of its Angolan operations to include exploration, development and distribution through various joint ventures. The Company has an agreement with AK ALROSA of Russia, which is the largest producer of rough diamonds in Russia. Under the terms of this agreement, the Company sells polished diamonds that are cut in facilities jointly managed and supervised by the Company and 13 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 a strategic cooperation 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 technical manufacturing assistance and supervises the manufacture of the Company's rough diamonds deemed suitable to cut and polish. The Company signed 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. Cutting and polishing activities which concentrate on local sources of rough diamond supply commenced during the third fiscal quarter of 2006. In February 2006, Lazare Kaplan Botswana (Pty) Ltd., a wholly owned subsidiary, was granted a license from the Government of Botswana to cut and polish diamonds in that country. Through February 2009, the Company's wholly-owned subsidiary, Pegasus Overseas Ltd. ("POL") has an exclusive agreement with Diamond Innovations Inc. ("DI") under which POL will market natural diamonds that have undergone a high pressure, high temperature (HPHT) process to improve the color of certain gem diamonds without reducing their all-natural content. POL sells diamonds that have undergone the HPHT process under the Bellataire'r' brand name. In November 2005, the Company (including certain of its subsidiaries) amended certain terms of its agreement with DI relating to the sourcing, manufacture and marketing of Bellataire 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 months ended August 31, 2006 were $138.9 million, equaling net sales in the comparable prior year period. Polished diamond revenue for the three months ended August 31, 2006 was $33.0 million as compared to $42.0 million in the three months ended August 31, 2005. This decrease reflects lower sales of fine cut commercial diamonds and, to a lesser extent, lower sales of branded diamonds. Factors leading to this decrease include an overall slowing of the U.S. economy, 14 liquidity concerns throughout the diamond and jewelry distribution chain, reluctance on the part of U.S. retailers to take stock positions prior to the start of the 2006 holiday season, and market resistance to price increases the Company seeks to pass through to customers. Rough diamond sales for the three months ended August 31, 2006 were $105.8 million as compared to $96.9 million for comparable prior year period. The increase in rough diamond sales is primarily related to an increase in the Company's Angolan rough buying and trading operations. Gross Profit During the three months ended August 31, 2006 gross margin on net polished sales was 11.7% compared to 12.5% in the first quarter of last year. The decline in polished gross margin reflects lower gross margins on the sale of fine cut commercial diamonds partially offset by increased margins achieved on the sale of branded diamonds. In the current operating environment, relatively high rough diamond acquisition costs are creating significant pressure on polished diamond margins. Higher interest rates and concerns about retail sell-through are weighing heavily on customer decisions concerning inventory levels. The resulting pricing pressure currently makes it difficult to pass through increased rough acquisition costs, in particular with respect to the sale of non-branded diamonds. Rough gross margin for the three months ended August 31, 2006 was 1.3% compared to 3.8% for the comparable prior year period. The decrease in rough gross margin percentage for the three months ended August 31, 2006 reflects increased rough costs and associated fees charged by diamond producers at a time of excess supply and soft demand from diamond manufacturers. Additionally, the decrease in rough gross margin reflects costs incurred by the Company in connection with the expansion of Angolan rough sourcing and trading operations. As a result of the foregoing, overall gross margin percentage during the three month period ended August 31, 2006 was 3.8% compared to 6.5% in the first quarter last year. Selling, General and Administrative Expenses Selling, general and administrative expenses for the three months ended August 31, 2006 were $6.2 million as compared to $6.7 for the prior year period. The decrease primarily reflects lower personnel and related costs. Equity in (Income) / Loss of Joint Ventures The Company recently entered into several joint ventures relating to sourcing, cutting, polishing, processing and sales of diamonds. The Company's combined share of income from these joint venture operations for the period ended August 31, 2006 amounted to $0.3 million. Interest Expense ---------------- Net interest expense for the three months ended August 31, 2006 was $1.7 million as compared to $0.9 million for the prior year period. This increase reflects increased levels of borrowing and higher interest rates during the current period. Increased borrowings during the three months ended August 31, 2006 primarily related to the expansion of rough sourcing and cutting and polishing operations. 15 Income Tax ---------- The Company's effective tax rate was 24.7% for three months ended August 31, 2006 compared to 34.8% for the same period last year. This decrease is attributable to a higher percentage of the Company's earnings in lower tax rate jurisdictions. Liquidity and Capital Resources ------------------------------- The Company's working capital at August 31, 2006 was $140.6 million, compared to $143.7 million at May 31, 2006. 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 August 31, 2006). In addition, the Company has a 520 million Yen denominated facility (approximately $4.4 million U.S. dollars) that is used in support of its operations in Japan ($3.7 million U.S. dollars outstanding at August 31, 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 ($62.3 million outstanding at August 31, 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 $93.9 million at August 31, 2006 as compared to $95.8 million at May 31, 2006. No dividends were paid to stockholders during the three months ended August 31, 2006 and 2005. The Company believes that it has the ability to meet its anticipated financing needs for at least the next twelve months. New Pronouncements ------------------ In July 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (FIN 48), which clarifies the accounting for uncertainty in tax positions. This Interpretation requires financial statement recognition of the impact of a tax position if a position is more likely than not of being sustained on audit, based on the technical merits of the position. Additionally, FIN 48 provides guidance on measurement, derecognition, classification, accounting in interim periods and disclosure requirements for uncertain tax positions. The provisions of FIN 48 will be effective as of the beginning of the Company's fiscal year 2008, with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings. The Company is currently evaluating the impact of FIN 48 on its financial position, results of operations and cash flows. 16 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 three months ended August 31, 2006 and 2005 was $0.2 million and $0.1 million, respectively. For the three months ended August 31, 2005, the Company sold approximately $0.1 million of jewelry to a relative of a non-employee member of the Company's Board of Directors. 17 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT ------ MARKET RISK ----------------------------------------------------------------------- At August 31, 2006, the Company had borrowings totaling approximately $133.2 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 August 31, 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 August 31, 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. 18 PART II - OTHER INFORMATION Item 1. Legal Proceedings -------------------------------------------------------------------------------- On May 25, 2006, the Company filed a complaint in the United States District Court for the Southern District of New York against Photoscribe Technologies, Inc. ("Photoscribe"). The complaint asserts infringement of the Company's intellectual property rights by Photoscribe with respect to two of the Company's patents. The Company's patents have claims relating to methods of, and apparatus for, laser inscribing gemstones. The Company seeks injunctive relief, as well as damages, including royalties and lost profits based on lost sales and the value added to the inscribed gemstones by reason of Photoscribe's use of infringing systems. Photoscribe has filed a counterclaim on the basis of a claim of its non-infringement of the patents and the invalidity of such patents. The Company intends to continue to pursue its complaint, as well as all other options available to it to enforce its rights against Photoscribe, and to defend against Photoscribe's counterclaim. On July 26, 2006, the Company filed a complaint against the Gemological Institute of America (the "GIA") in the Supreme Court of the State of New York, County of New York. As of February 1996, the Company and the GIA entered into an exclusive United States inscription agreement (except for the Company's own use) of certain intellectual property owned by the Company relating to certain laser inscription equipment and methods (the "Inscription Agreement"). The GIA has purported to terminate the Inscription Agreement as of July 31, 2006 under such agreement's terms. The Company believes that under the terms of the Inscription Agreement such termination by the GIA is invalid and that the Inscription Agreement should be in full force and effect until at least April 2008. The Company sought a declaratory judgment confirming the Company's interpretation of the Inscription Agreement. A recent decision by the court denied the Company's motion for a preliminary injunction against the GIA. The Company is currently assessing its options with respect to this matter. On September 1, 2006, Fifth Avenue Group, LLC ("Fifth Avenue"), a stockholder of the Company, filed a Complaint for a Declaratory Judgment and Other Relief in the Supreme Court of the State of New York, County of New York, against the Company and Mellon Investor Services. The Complaint seeks a declaratory judgment that 1,180,000 shares of the Company's stock purchased by Fifth Avenue from the Company in a private sale in January 2002 are not "restricted stock" pursuant to Rule 144(k) of the Securities Exchange Act of 1934 and that any subsequent purchaser of such shares would not be subject to an irrevocable proxy granted to Messrs. Maurice and Leon Tempelsman by Fifth Avenue in connection with the private sale. The Company intends to vigorously pursue all defenses and counterclaims available to it. Item 2. Unregistered Sales of Equity Securities and Use of Proceeds. -------------------------------------------------------------------------------- (c) Issuer Purchase of Equity Securities On April 6, 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. The Company made no market purchases during the quarter ended August 31, 2006. 19 Item 5. Other Information. -------------------------------------------------------------------------------- As noted above under the Section "Legal Proceedings," the GIA has notified the Company that is has terminated the Inscription Agreement with the Company as of July 31, 2006. As noted above, the Company believes that such termination was invalid and has filed a complaint in the Supreme Court of the State of New York to enforce its rights under the Inscription Agreement. See Legal Proceedings. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K -------------------------------------------------------------------------------- (a) Exhibits (31) Rule 13a - 14(a) / 15d - 14 (a) Certifications (32) Section 1350 Certifications (b) Reports on Form 8-K None 20 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: October 13, 2006 21 STATEMENT OF DIFFERENCES ------------------------ The registered trademark symbol shall be expressed as....................... 'r'