Lazare Kaplan International (LKI) reported its lowest fourth quarter results in more than a decade, $30 million. Annual sales are expected to total $192 million. The company may receive a “going concern” opinion.

 

LKI, the Diamond Trading Company (DTC) Sightholder whose shares are traded on the American Stock Exchange, notified the Securities and Exchange Commission (SEC) of three issues:

 

• Revenues in the fourth fiscal quarter ended May 2009 were just over $30 million, by far the smallest level in more than a decade. Management was unable to provide an estimate of the extent of its operating losses for either the May quarter or the full year. IDEX Online Research estimates that its fourth quarter and full year losses, mostly due to one-time charges, could be tens of millions of dollars.

• The company will not be able to file with the SEC its fiscal year-end financial reports on a timely basis. Its key document, a 10-K which contains highly detailed information about the company’s operations, was due to be filed by the end of August. On September 1, management notified the SEC that its filing would be delayed.

• At this point, LKI’s outside auditors will not be able to give an unqualified opinion about the company’s financials for the fiscal year. If the company receives a “qualified” opinion, it would most likely be a “going concern” opinion, which essentially means that there is some material issue that could affect the company’s ability to continue day-to-day operations on a long term basis). This would affect its ability to deal with its lenders. Some lenders may have clauses in the loan agreements which say that if a company receives a “qualified opinion” from its auditors, its interest rate on borrowings substantially jumps and/or its loan becomes due, but could possibly be renegotiated. The terms of the loan would likely be much less favorable.

LKI has said it would be unable to file up-to-date financials due to the following issues:

 

• The inability, at this time, to resolve a material uncertainty concerning the collectibility and recovery of certain assets. We believe that this means there are some questions about the company’s ability to collect certain accounts receivable – monies owed to the company by its customers – as well as amounts that it may be owed under its various minority ownership agreements and other business partnerships it has formed around the world.

• The company has potential obligations under certain lines of credit and a guaranty which its auditors have not been able to quantify. LKI apparently has co-signed certain financial instruments with its various business partners. The full extent of LKI’s liability may be unclear, especially if the financial strength of its business partners is precarious. With the freeze in the credit markets, lenders are looking for anyone with assets, regardless of the original terms of the lending agreement, and LKI could be directly in those lenders’ cross-hairs.

Because of these issues, the company’s independent auditor – BBDO Seidman – has said that it will not be able to deliver an unqualified opinion concerning LKI’s financial statements for the fiscal year ended May 2009. It is not clear if BBDO Seidman would be able to deliver an unqualified opinion, if these two key issues – collectability of assets and liability to lenders – are resolved.

 

The SEC rules say that a publicly held company must file its year-end reports within ninety days of the close of its year. LKI’s fiscal year ended May 2009; hence, its year-end reports were due by the end of August.

 

While the company has filed a “Notification of Late Filing,” there are no specific guidelines about when the final report must be ultimately filed. Year-end reports are sometimes filed, and later amended.

 

Typically, the stock exchange on which the company’s shares are traded has more to say about when the documents must ultimately be filed. If LKI is unable to file the proper documents, it will likely be delisted from the American Stock Exchange at some point in the future.

 

However, even if it is delisted, its shares can continue to trade. Under certain circumstances, those shares can continue to trade, even if the company never makes another public financial filing.

 

May 2009 Quarter Results Extremely Weak

Along with its Notification of Late Filing to the SEC, LKI management gave a preview of its fourth fiscal quarter sales and gross margin trends. Here’s essentially what they said:

 

• Revenues in the fourth quarter are expected to be about $30.3 million. This is by far the smallest quarter for the past twelve years, as the graph below illustrates. IDEX Online Research has estimated the sales split between rough and polished diamonds; the company did not provide this information.

Soruce:  Company & IDEX Online Research

• Sales for the full fiscal year are expected to be about $192 million, one of the lowest levels in the past decade. Last year, sales were $369.7 million. Sales for LKI peaked in the fiscal 2006, when revenues reached $528 million, a company record.

• Gross margin remains under pressure. For the year-to-date, it was 5.5 percent, about half (or less) of its historic range.

• Based on these assumptions, it is clear that the company’s fourth quarter gross profit from operations – estimated to be $1-1.5 million before unusual items – will not cover its reduced estimated operating expenses estimated to be $5-6 million in the fourth quarter. In addition, the company had interest payments and certain other expenses during the quarter. Finally, we expect the company to take major one-time write-offs for the fiscal year, all of which will be charged in the fourth quarter. It is not possible to estimate the size of these write-offs, though they could be tens of millions of dollars.

• As of February 2009, LKI’s net worth was about $94.5 million. Its accounts receivable were nearly $75 million, some of which we believe that its auditors are recommending writing down or writing off. Further, the company has other assets that could be written down or written off, based on the auditor’s recommendation. While it is unlikely that LKI’s net worth will drop below zero, we believe that it will be reduced substantially.

• It is not possible to estimate the final loss that LKI will report for its fiscal year. In the first three quarters, its pre-tax loss was $10 million. With one-time write-offs, its final loss is likely to be multiples of its nine-month loss.

Here’s how the company described the jewelry industry and its impact on financial results in the Notification of Late Filing with the SEC:

 

“The recent global financial crisis and economic downturn has negatively impacted the sectors of the diamond and jewelry industry in which the company operates. Diamond and jewelry purchases are ultimately dependant on the availability of consumer discretionary spending. Uncertainties regarding future economic prospects and a decline in consumer confidence during fiscal 2009 translated into lower purchases and sales by diamond retailers, wholesalers and producers and adversely impacted the company’s operations. During the fourth fiscal quarter of 2009, the company continued to focus its efforts on cash flow while reducing operating costs and manufacturing overhead. Gross margins in the fourth quarter remained under significant pressure as a result of price competition, overhead absorption and inventory valuation considerations.”

 

The Role of the Independent Auditor

In a public company, the appointment of the independent auditors/accountants is ratified by the shareholders, since the auditors are supposed to be the eyes and ears of the shareholders. For example, LKI’s proxy statement dated October 3, 2008, for its shareholder meeting of November 6, 2008, asked stockholders to ratify four issues, including the selection of its independent accountants. The independent accountants report to the independent directors of the board (non-executive directors) who ultimately report to the shareholders.

 

But, there is a potential conflict of interest. Auditors want to build their accounting business, so they may work with company management as much as possible to avoid losing the account. Management, along with independent directors, selects candidates to be potential auditors.

 

Most of the time, there is no problem with this arrangement. But shareholders of Enron, WorldCom, and Friedman’s Jewelers, to name a few, were not fully informed by the company’s auditors, and those companies eventually went out of business, primarily because their auditors didn’t follow the established line of authority to shareholders.

 

Further, companies sometimes reach an impasse with their auditors. Auditors have accounting guidelines, called “Generally Accepted Accounting Practices” (GAAP). However, these are guidelines, and sometimes company management and its auditors differ on the “materiality” and interpretation of certain accounting guidelines. We are guessing – it is important to understand that this is no more than an educated guess – that BBDO Seidman wants LKI to charge off some of its liabilities related to its guaranties, and perhaps write off certain receivables. It is likely that LKI management is resisting the level of write-off that BBDO Seidman is recommending.