Lazare Kaplan International F2Q08 (Quarter End 11/30/07) Earnings Call Transcript

| About: Lazare Kaplan (LKI)

Lazare Kaplan International, Inc. (LKI) F2Q08 Earnings Call January 11, 2008 4:30 PM ET

Executives

Leon Tempelsman – Vice Chairman, Principal Executive Officer & President

William H. Moryto – Chief Financial Officer & Vice President

Operator

Ladies and gentlemen thank you for standing by. Welcome to the Lazare Kaplan second quarter earnings conference call. At this time all participants are in a listen only mode. Later we’ll conduct a question and answer session with instructions being given at that time. (Operator Instructions) As a reminder this conference is being recorded. I would now like to turn the conference over to your house Mr. Ed Nebs. Please go ahead.

Ed Nebs

Thank you to all of you for joining us today for the Lazare Kaplan International fiscal 2008 second quarter conference call. Earlier today after the close of market trading we announced the company’s results for the second quarter. If you have not seen that release, please contact my office at 203-972-8350 and we will be happy to send you a copy.

Before we get started I’d like to briefly read the safe harbor statement under the Private Securities Litigation Reform Act of 1995. This conference call may contain forward-looking statements that are subject to significant risks and uncertainties including statements related to the future operating and financial performance of the company. Although the company believes that the expectations reflected in its forward-looking statement are reasonable it can give no assurance that such expectations or any of it’s forward-looking statements will prove to be correct. Important risk factors that could cause actual results to differ materially from those reflected inthe statements are included in the company’s filings with the SEC. I will also remind you that the conference call is being broadcast over the web and can be accessed at www.InvestorCalendar.com.

Joining us today from Lazare Kaplan International management team are Leon Tempelsman, President and William Moryto, Vice President and CFO. With that, I’ll turn things over to Leon Tempelsman.

Leon Tempelsman

Good afternoon. This is Leon Tempelsman with me is Bill Moryto. I’d like to extend my best wishes to you all for a happy, healthy and prosperous New Year. We’ll follow the usual format which we’ve adopted. I’ll make some brief comments on strategic changes in the industry and on the overall market conditions. I will then focus on company specific operation issues and put them in the context of how we’re affected by the overall industry conditions. Bill will then follow with a review of the financial results and of course, at the end we would welcome any questions that you may have.

As we launch into the New Year there are a number of broader trends occurring in the industry that are worth noting. All of LKI’s strategic initiatives take on board our access of these trends and try to anticipate their ultimate outcome. Each one represents the best and we believe with careful long term cultivation, skills, hard work and a bit of luck LKI is well positioned to take advantage of these industry trends.

First, the industry from a supply driven to a demand driven model. There is no longer a custodian of the industry, a role traditionally played by DeBeers and consequently one must expect increased diamond priced volatility. Offsetting this, there appears to be no new diamond mine discoveries coming on stream to offset the diminution of supply from existing mines and growth in the emerging consumer market particularly in the larger size that are quality diamond.

Second, there is an irreversible trend towards beneficiation in the bigger and large quality rough to the southern African and other producing companies where the host governments can exert their comparative advantage through an instance on local supply. Consequently, the existing better quality large stone manufacturing centers such as Israel and Belgium will come under increasing pressure. It is likely that the industry will further bifurcate as less smaller, lower quality diamonds which can be most cost effectively manufactured in lost cost labor centers such as India and China will likely prove to be uneconomic to manufacture in the rough diamond producing countries.

Third, there will be an increasing drive towards transparency and accountability in an industry historically steeped in secrecy as a result of the changes brought on by the Kimberly Processes Certification scheme in globally strengthening banking and ALM legislation.

Fourth, technology will play an increasing role in both the manufacturing and distribution in an industry that has traditional been reluctant to embrace it.

Fifth, the financing structure of the industry will need to change from its historical patterns. These changes will be accelerated by, among other things, changes in global banking regulations such as [inaudible] and industry specific changes brought on by the changes in banking institutions that service the industry. For example, first the emergency of large banks based in India as a source of financing. Second, the as of yet unclear role of ABN Amro bank which has historically played an enormous role in industry financing and third the effect on the risk appetite of other industry banks that have been hard hit by the subprime lending crisis. The need for medium and long term financing structures will grow more critical as the industry must be prepared to weather [inaudible] downturns as well as changing bank practices.

Sixth, consolidation is a historical inevitability. There are simply too many players in a variety of different stages of the pipeline. This consolidation will create opportunities for establishing a better basis for doing business in the long term although it will present dislocation and margin pressure in the short term. Looking at the current market conditions I can report the following seemingly inconsistent facts: first, on the rough diamond side prices are firm and demand is stronger. Earlier this week the Diamond Trading Company denounced an overall price increase averaging 3.5%. It is expected that the increase in larger, better quality diamonds will be significantly larger than the overall 3.5. Other rough diamond producers have or will undoubtedly follow suite.

Thus far the announced reports of the publicly listed jewelers in the mass market segment of the industry are showing a disappointing Christmas selling season in the US which accounts for more than 50% of the global retail jeweler market. The mass merchants however, do not constitute the company’s traditional customer base. Nevertheless, they represent an important barometer for the market as a whole. Very example, Zales reports same stores sales down 9%, Signant reports US sales down 8% overall and [inaudible], finally reported same store sales down 6%. JC Penney reported 1.5% down, Nordstrom 4% down, Macys 1% down on same store sales in the holiday period. Even Tiffany, hardly a mass merchant today reported same store sales down 2% in the US – it should an 8% worldwide growth resulting from weakness in the dollar.

These retail sales appear even more discouraging when considered the rapidly increasing raw material costs that affected underlying jewelry costs in 2007. Raw materials costs increased by approximately 45% in platinum price, approximately 50% in gold price, approximately 30% in silver price in addition to more modest increases in polished diamond prices which significantly lag rough diamond prices in most categories during the course of the calendar year. Furthermore, in addition to be unable to reconcile this bifurcation I cannot reconcile the delinking of rough and polished diamond prices. These preliminary sales results seem to be pointing to a more challenging operating environment in 2008.

Now, LKI specifically. While we continue to strive for better results we are of course glad that we’ve been able to bring the company’s operation back into equilibrium and marginal profitability over the last four quarters. The six month year-on-year comparisons while not really where we’d like them to be show improvement in profitability and cash flow. In earlier conference calls we outlined a detailed plan for positioning LKI in the challenging and rapidly changing conditions facing the diamond industry.

We’ve made substantial progress in the implementation of the action plan previously outlined to you. We continue to expect an even more challenging period ahead largely as a result of the continued turbulent global economic environment including general conditions stemming from difficulties in the subprime housing market plus $90 per barrel oil prices, the weaker dollar and talk of a recession in the United States, all issues which affect consumer confidence. We are constantly examining our approach to see if the tough macroeconomic conditions warrant an alteration of our operations. In spite of this however, we see a wide range of opportunities as the industry itself consolidates and the structure of LKI’s business evolves to accommodate the industries changing profile.

LKI has invested heavily in positioning itself to capitalize on these industry changes and believes that it is well positioned to implement its action plan. Specifically, LKI will continue to move it’s manufacturing beneficiation functions to Southern Africa and other producing countries. First, in Namibia LKI expects to take up its option to acquire an

ownership interest in NamGem as provided in the existing technical assistance agreement. LKI has so far in one form or another invested more than $3 million and expects to acquire it’s ownership for approximately the amount invested thus far. In October, NamGem was notified by the Namibia Diamond Trading Company, NDTC the recently created joint venture between DeBeers and the government in Namibia which is charged with supplying the newly emerging Namibia diamond cutting industry, that it has been appointed as one of the 11 NDTC site holders.

Second, in Botswana in December LKI Botswana was appointed as one of the 16 site holders of the Botswana Diamond Trading Company, BDTC the recently created joint venture between the government of Botswana and the Diamond Trading Company. We have begun training and cutting in a temporary facility in Gaborone. We plan to begin outfitting of a permanent manufacturing plant during this month drawing on the state of the art equipment and expertise from other operations.

Finally, in South Africa LKI hopes to expand its relationship with its empowerment partner Novella. In December, Novella was reappointed as the DTC site holder and though operating in an extremely challenging supply environment hopes to expands its position. All stakeholders are examining what needs to be done to establish a sustainable and economically viable beneficiation project in a newly developing cutting center. Supply itself is not a panacea given the global competition in the diamond industry.

In all three countries in Southern Africa LKI will proceed after aligning its interest with the other principal stakeholders and will structure medium to long term project finance in accordance with the terms and conditions of the framework agreement with the overseas private investment corporation discussed in earlier calls. To that end we hope LKI will begin to be able to utilize this banking facility in the coming months now that Namibia Diamond Trading Company has begun its direct sales. It is our hope that this open finance agreement will set the pattern for appropriate long term financing for the future LKI beneficiation projects in Botswana, South Africa and other producing countries as well. We believe that this approach to term structured financing will be an increasingly important competitive advantage for LKI in a new diamond industry that is seeing significant shifts in focus, general liquidity and in the structure and risk appetite in the industry’s primary lending bank.

LKI’s facility in Puerto Rico is being further refocused to become more of a service center for LKI downstream marketing and a resource center for expatriate technical teams to help bring the Southern African operations on stream. The Diamond Trading Company is currently modifying it’s approach to rough diamond distribution and adjusting it’s customer base to conform to this new approach. In June of 2007 the Diamond Trading Company gave notice of termination to all of its site holders effective December 31, 2007. Based on published reports it appears as if the Diamond Trading Company has preliminarily reduced the number of clients they will supply to 79. Though pending verification and contract signing LKI will be reappointed as a site holder for another three and one-half year contract period beginning April, 2008 in London, South Africa, Namibia and Botswana.

LKI’s joint manufacturing agreement in Russia has a year remaining. However, both parties believe that negotiations to recalibrate by mutual consent the successful long term relationship to reflect current industry realities could be of benefit to both parties. Negotiations are underway and hopefully will build upon and develop new opportunities stemming from the successful long term cooperation.

Angola benefiting from peace, stability and high oil prices is experiencing rapid economic growth and development. It represents one of the most important diamond exploration mining and sourcing opportunities in the world. Accordingly, LKI’s four year technical assistance agreement with Sodiam signed in 2004 has been supplemented by a minority holding in the company that purchases rough diamonds from formal specter.

The company is actively negotiating opportunities in the field of diamond exploration, mining and construction. These operations will be self standing in management, finance and are being reported on the equity account method. An exploration agreement for a highly attractive perspective area has been reached with Endiama and has received government approval. A significant amount of exploration work and expense has been undertaken during this last quarter. The company is also pursuing and hopes to receive shortly at least two additional prospecting areas in Angola which show great promise.

Technology plays an increasingly important role in the diamond industry. LKI has decided that it is essential to defend vigorously its patents and intellectual property rights ranging in laser inscription to HPHT detection. Accordingly, LKI began a patent infringement lawsuit in May, 2006 against PhotoScribe Technologies and subsequently amended its complaint to include the Gemological Institute of America, the GIA for both patent infringement, breach of contract and other violations of business practice and conduct. In July, 2007 LKI filed a second amended complaint which included David Benderly, President of PhotoScribe as and individual defendant based on facts uncovered during the discovery phase of the case so far. A trial date has been set for the end of February. We have absorbed and expect to continue to absorb high litigation costs. The financial impact of the litigation in the last few quarters both in terms of lost revenue and additional expense has ranged from $1 to $2 million per quarter. LKI will aggressively pursue this and perhaps other litigation as it believes the valid portfolio of patents it holds has considerable commercial value.

On the distribution side LKI will continue to lead in downstream marketing of its premium Lazare Diamond Brand diamond as well as fine quality commercial made diamonds that will broaden coverage in existing markets. We will seek out and develop new markets and will continue to develop the concept of free standing stores, particularly in Japan, and boutiques and counter space in other markets. In Japan a new Lazare Diamond store was opened in Kyoto in August and in Osaka in December. We are examining how we should modify our approach to branded diamond distribution in Japan to take on board the changing consumption patterns in the Japanese market. Considerably focus will be placed on distribution in the Middle East and Southeast Asia. LKI will strengthen its bulk selling capabilities for fine cut commercial stones in wholesale markets such as Belgium, Israel, Hong Kong and Dubai.

LKI will continue to streamline it’s jewelry division, emphasizing diamond centric classic designs and diamond intensive layouts and presentations. LKI will continue to differentiate and scribe and certify the product line and will broaden the product offering through wholesale diamond sales. We will limit or where appropriate eliminate our offering in smaller size diamonds in order to improve profitability even at the risk in reducing the overall size of our polished business. During this challenging implementation period, LKI is continuing its policy of streamlining overhead, expenses and inventory. Emphasis has been placed on inventory and SG&A reduction through redeployment of human resources to sales focus functions, technical improvements in our rough trading and diamond manufacturing operations either alone or in ventures with specialized technical partners. Our policies have resulted in redundancy. We have implemented a significant reduction in head office staff and there were additional reduction in staff in satellite offices as well. These types of changes are particularly trying in a company of our size.

Let me summarize by saying that we feel our strategic positioning is sound. We have long term confidence in the growth of our business model. We have a vision and a plan and the trained personnel to execute that plan. We believe that the future of the rough supply side of this business will migrate to the producing countries where the company has enjoyed its strong historical position and we will be able to bring our comparative advantage to bear. We will protect our intellectual property assets and pursue innovative financing opportunities to improve the company’s capital structure.

On the distribution side we believe the company’s 103 year history and the reputation for integrity and quality of product will serve it well as the overall market consolidates and consolidates much more rapidly. In the short term however, we are operating with our eyes wide open. We believe trading conditions will remain difficult and the cost of developing our platform for long term growth will remain high which will present continuing challenges for improving the company’s earnings. We will continue to take measures to minimize but unfortunately probably not eliminate the short term pain. We will manage the costs and carefully monitor the overall changing industry risk reward profile and take corrective steps as necessary.

Finally, we will continue on the prudent course of adjusting our tolerance to risk in response to changing macroeconomic conditions. We firmly believe that with careful and tactical implementation in the short term LKI will emerge stronger in the consolidation the diamond industry is currently experiencing. Bill, at this time I’ll turn the floor over to you.

William H. Moryto

Good afternoon. As to the financial results net sales for the three and six months ended November 30, 2007 were $90.5 million and $193.1 million respectively as compared to $94.4 million and $233.3 million for the prior year periods. Polished diamond revenue for the three and six months ended November 30, 2007 were $43 million and $76.9 million respectively as compared to $41.5 million and $74.5 million for the prior year periods. The current quarter reflects increased sales in [inaudible] branded diamonds and fine cut commercial diamonds. The year-to-date increase reflects increased sales of branded diamonds partially offset by lower sales in fine cut commercial diamonds.

Rough diamond sales were $47.5 million and $116.2 million for the three and six months ended November 30, 2007 as compared to $52.9 and $158.8 million for the comparable prior year periods. The decrease in rough diamond sales for the six months ended November 30, 2007 primarily reflects the transport formal sector on gold and rough diamond buying and trading operations during the second fiscal quarter of 2007 to a formal joint venture which the company accounts for on the equity method. The decrease in rough diamond sales for the three months ended November 30, 2007 primarily reflects lower activity in the informal on gold rough trading operations as compared to the prior year period.

Gross margin on net polished sales on the three and six months ended November 30, 2007 was 9.5% and 10.6% respectively as compared to 6.5% and 8.8% for the prior year periods. The increase in polished gross margins reflects the shift in sales mix towards branded diamonds which typically carry a higher gross margin as compared to fine cut commercial diamonds and efforts on the part of the company to pass through to customers higher rough diamond costs. Polished gross margin for the six months ended November 30, 2007 reflects reduced revenue and margins derived from laser inscription fees.

Rough gross margin during the three and six month period ended November 30, 2007 was 4.8% and 5.6% respectively as compared to 4.2% and 2.3% in the prior year periods. The increase in rough gross margin during the three and six months ended November 30, 2007 reflects favorable rough market conditions and goods which the company effectively trades. As a result of the foregoing overall gross margin percentage during the three and six month periods ended November 30, 2007 was 7% and 7.6% respectively as compared to 5.2% and 4.4% in the prior year periods.

Turning to expenses selling, general and administrative expenses for the three and six months ended November 30, 2007 were $6.9 and $13.2 million respectively as compared to $6.8 and $13.1 million for the same periods in the prior year. The increase for the three and six months ended November 30, 2007 reflects higher legal costs partially offset by lower advertising and related costs. Increased legal costs relate primarily to costs associated with litigation the company has initiated to protect certain of its intellectual property rights.

Net interest expense for the three and six months ended November 30, 2007 was $1.5 and $3 million respectively as compared to $1.5 and $3.3 million for the same period as in the prior year. The decrease in the six months ended November 30, 2007 reflects lower net borrowing levels as compared to the prior year period.

Moving to the balance sheet on November 30, 2007 accounts receivable were $108.5 million compared to $134 in May, 2007. Rough inventories were $23.7 million at November 30, 2007 as compared to $14.3 million at year end 2007. Polished inventories were $89.9 million at November 30, 2007 as compared to $97.9 million at May, 2007. In terms of liquidity working capital at November 30, 2007 was $106.9 million versus $105.4 at May, 2007. At November 30, 2007 the company had approximately $137 million of available borrowing facilities of which it had outstanding $95.9 million. During the six months ended November 30, 2007 the company generated approximately $21.8 million cash flow from operations.

As a result of this recent reverse in forward stock split the company acquired 8,872 treasury shares. At November 30, 2007 total treasury shares held by the company amounted to 696,417 shares at an average cost per share of approximately $8.14 per share.

With that I’ll turn the discussion back to Mr. Tempelsman.

Leon Tempelsman

At this point we’re happy to entertain any questions that anyone might have.

Question-and-Answer Session

Operator

(Operator Instructions) There are no questions at this time. Please continue.

Leon Tempelsman

Thank you very much for joining this second quarter conference call. I want to again, take this opportunity to wish you all my best wishes for a happy and healthy and prosperous 2008. Thank you very much and we look forward to speaking to you again in the future.

Operator

That does conclude our conference for today. Thank you for your participation and for using AT&T Executive Teleconference service. You may now disconnect.

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