IDEX Online Research: Lazare Kaplan – Analysis & Outlook

Despite soaring sales, Lazare Kaplan’s (LKI) August quarter pretax profits dropped by nearly 2/3.  Is this an aberration or a trend?  Our analysis suggests that a mix of external and internal factors have put the squeeze on profits, and that it could be several quarters before the company’s bottom line improves substantially. 

Overview

In his annual letter to shareholders, Maurice Tempelsman, chairman of Lazare Kaplan, says “...the Company seeks market and sourcing diversification, it tries to align its long-term interests with those of its customers and suppliers and, whenever possible, it seeks to establish strategic relationships that can adjust to the increasing degree of price volatility that is now part of the diamond industry.”  As the letter continues, it outlines several sources of rough diamonds for LKI – the DTC, Angola (SODIAM), Russia (Alrosa), Namibia (NamGem), South Africa (Nozala), and Botswana. 

Tempelsman then summarizes the company’s diversified marketing program for both ideal-cut and fine-cut stones sold to wholesalers, distributors, and retailers.  LKI has also developed a line of jewelry, according to Tempelsman, and it plans to reinvigorate the Bellataire (enhanced diamonds) project.  In our opinion, all of these programs are both the company’s strength and weakness.  In fact, LKI may be so diversified that it cannot focus on any one of its projects; as a result, its thin management team could be too busy “fighting fires” rather than building profits. 

• Revenues – Total LKI revenues for the August quarter were about $139 million, up 77% from the prior year’s $78 million.  Revenues were driven by several factors:

  August Quarter Revenues $ mil    % Chg Y/Y Total Revenues       $138.9         +77% Polished Diamonds   $42.0         +23% Rough Diamonds      $96.9       +119%

  • Polished diamond sales were $42 million, up 23% -- Polished diamond sales were driven primarily by increased output of fine-cut commercial diamonds from LKI’s relatively new Namibian operation as well as increased productivity from the company’s sales force. 
    
  • Rough diamond sales were $97 million, more than double last year’s $44 million – Rough diamond sales were driven primarily by availability of stones from LKI’s Angolan rough buying and trading operations.  Sales of rough sourced from Angola in last year’s first quarter were nominal, though we can’t assume that the entire $50 million-plus of incremental diamond sales in this year’s quarter is related to Angolan sources. 
    
  • Historically, the August quarter (the company’s first fiscal quarter) is the company’s smallest quarter of the year; it typically represents about 20% of annual revenues – If this year follows historic trends, then we would expect LKI’s annual revenues for the fiscal year ending May 2006 to be in the range of $650 – 700 million, a dramatic increase over last year’s $421 million. 
    
    
• Gross margin – The company’s gross margin dropped by half to 6.5% in the August 2005 quarter versus 12.6% last year.  The composition of LKI’s gross margin is complex.  We’ve seen quarters where both the polished and rough gross margin have risen, but the blended gross margin has fallen.  This relates to sales mix swings between low-margin rough and higher-margin polished stones.  In the August 2005 quarter, the trend was clear – all margins were under severe pressure. 
  
  • Polished gross margin dropped to 12.5% vs 17.2% last year – A sales mix shift toward a higher percentage of revenues from fine-cut commercial diamonds which carry an inherently lower gross margin than branded ideal-cut stones hurt the company’s polished gross margin.  In addition, LKI was unable to pass on higher diamond prices (primarily rough stones it purchased for its polishing operations).  The graph below illustrates recent quarterly gross margin trends for polished diamonds for Lazare Kaplan.

• Rough gross margin dropped to 3.8% vs 9.1% last year – The company’s sharp decline, year-over-year, in its rough diamond gross margin is due to four factors:
  • Lack of profits from its Angolan operations – Angola is expected to begin contributing modestly to profits sometime in early-to-mid 2006.  The company began operations in Angola in late 2004. 
    
  • Weakening rough pricing and price erosion – Concerns about a possible over-supply of diamonds has hurt rough pricing.  Last year, the market was worried about an under-supply, and LKI benefited.  This Fall, De Beers had two back-to-back sights in excess of $800 million each; this dumped an unusually large number of diamonds onto the market and hurt prices. 
    
    Some diamantaires think the unusually large DTC sights are a power play to show that the DTC still controls the market.  Clearly, these large sights have created a potential over-supply of stones and pushed prices and margins downward.  The diamond pipeline is rapidly becoming choked with product.  As a result, LKI’s margins were affected negatively. 
    
  • Tightening industry liquidity – With a full pipeline, the already high – and increasing – level of bank and trade financing makes suppliers vulnerable.  In the U.S., retail bankruptcies appear to be increasing, making suppliers even more vulnerable.  Thus, demand has waned modestly. 
    
  • Exceptional comparisons against a strong 2004 – Gross margins were at record levels in the quarter ended August 2004 for LKI, as the graph below illustrates.  Demand was strong, and prices for better quality rough stones were high.  Thus, comparisons were very difficult this year. 

•  Profitability – Historically, August quarter profits are about 25% of annual profits.  However, start-up losses in Angola represent an aberration this year.  None-the-less, LKI earned a paltry after-tax profit of about $900,000 ($1.4 million pre-tax) on revenues of nearly $139 million in the August quarter, for a net profit margin of 0.7%.  That continuing level of profitability will likely drive Wall Street investors to sell LKI shares.  Over the past 12 months, LKI shares have ranged in price from about $7.50 to $12.50; they are currently selling for just below $9 per share. 
  

• Other trends
  • Higher inventories – While rough diamond inventories declined by nearly 6% year-to-year, LKI’s polished diamond inventories rose by nearly 18%.  The company says three factors are responsible for this trend:
    • Higher anticipated sales – LKI is expecting stronger sales near term.
    • Greater supply of diamonds – The company has several sources of supply that are beginning to sharply increase their ability to supply diamonds, including Angola (Sodiam), Russia (Alrosa), Namibia (NamGem), South Africa (Nozala), and Botswana.  LKI is also a DTC Sightholder, and it is a co-Sightholder with Nozala. 
    • Longer cycle – As LKI becomes for vertically integrated, there will be an inherent increase in inventories at all levels of the company’s operations. 
  • Increased receivables – LKI’s accounts receivables were up 89% versus an overall sales gain of 77%, year-over-year.  This trend bears watching; we are a bit uncomfortable with both a sharp rise in receivables and growth which exceeds revenue gains. 

    Revenue Analysis Rough & Polished Sales By Region Percent of Total Revenues 2005   2004   2003 United States              20%    30%    36% Far East                      9%      9%      9% Europe, Israel & Other 71%    61%    55%

  • Distribution by region – LKI is trying to increase its global distribution.  It has focused on the Far East.  Operations in Southeast Asia remain modest, but management says they are seeing an economic re-birth in Japan which is driving demand for its ideal-cut diamonds.  Further, LKI is investigating the market for their diamonds in both China and India. 
  • Bellataire – Originally, Bellataire enhanced diamonds were developed through a joint venture between LKI and General Electric.  In 2004, GE spun off the production facility which produced Bellataire stones.  LKI is in continuing talks to see about rejuvenating Bellataire operations. 

T he author of this report owns 100 shares of LKI stock.