Description

Did I hear someone claim that we are in the decade of commodities? If this assertion is accurate, how about an investment in a dominant company in the diamond industry? Lazare Kaplan International Inc. (LKI) stock provides a timely opportunity to invest in one of the world’s largest diamond processor and distributors for approximately its net working capital and at about ten times earnings just as diamond pricing, world diamond demand and, most importantly, the company’s earnings are surging. Owning LKI shares during the five year period entering mid-2004 was unexciting. The company had minimal earnings during the period as it focused on strengthening its supply arrangements in Russia, Africa and the rest of the world. The situation changed nicely in mid 2004 as diamond prices began to increase, supply shortages appeared (especially in the company’s high-end diamonds) and the company reported outstanding earnings for its fiscal first quarter of 2005.


Let’s begin with some background on the company and the industry. This section is longer than I would like, but unfortunately it’s required to fully appreciate the company’s strength. Lazare Kaplan is no new comer to this industry as it traces it origins to 1903. LKI is engaged in the cutting, polishing and selling of ideally proportioned diamonds which it markets internationally under the brand name "Lazare Diamonds'". 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 claims that due to these characteristics, Lazare Diamonds command a premium in the marketplace. The company believes there are only a few companies worldwide engaged primarily in the production of ideally proportioned diamonds and that it is the largest U.S. provider of ideal cut diamonds. In addition, through a cooperative agreement with the largest Russian diamond mining company, LKI cuts and polishes commercial diamonds at diamond cutting facilities in Russia which it markets to wholesalers, distributors and, to a growing extent, retail jewelers. All rough stones purchased by the Company are either selected for manufacturing or resold as rough diamonds in the marketplace. The company believes that the combination of its cutting and polishing operations and its trading operations enables it to purchase larger quantities of rough diamonds from which it may select those rough diamonds best suited for the Company's current needs.

LKI’s marketing strategy in the selling of Lazare Diamonds is directed primarily toward high-end consumers throughout the world. Lazare Diamonds can be found at some of the most prestigious jewelry stores around the world. The Company also sells to certain jewelry manufacturers and diamond wholesalers. LKI has developed a comprehensive grading system which, when coupled with the "ideal cut" standard, allows jewelers to order inventory by category rather than through the more cumbersome process of visual selection. In addition, the LKI designs, manufactures (through independent contractors) and sells a line of high quality jewelry which features Lazare Diamonds.

Diamond Supply: The Key Strategic Advantage

The company’s success is dependent on its ability of maintaining quantities and qualities of polished inventory that best meet its customers' needs. The company believes that this is best achieved through its ability to fully integrate its diverse rough and polished diamond sources. The company has worked hard to diversify its sources of rough diamond supply and has been very successful in accomplishing its goal. Let’s review these sources.

Any discussion of the diamond industry without focusing on De Beers would be irrelevant. One of the Lazare’s important suppliers of rough diamonds is the Diamond Trading Company ("DTC"), an affiliate of De Beers. Based on published reports, it is clear that more than half of the world's current rough diamond output is sold by the DTC. LKI has been a client of the DTC for more than 60 years. Sales for the DTC are made in London to a select group of clients ("sightholders") which, according to published reports, number approximately 80, including LKI. In July 2000, the DTC announced significant changes in its approach to rough diamond marketing. In brief, the DTC stated that it would stop open market purchases and alter its market control and pricing policies. Henceforth, the DTC said it would focus on selling its own mining productions through its "Supplier of Choice" marketing programs. These policy changes were intended to drive consumer demand for diamond jewelry by fostering the development of efficient distribution networks. In June 2003, LKI was notified that it was selected by the DTC to become a Sightholder under the Supplier of Choice Program. LKI believes it is well positioned to benefit from these changes in the DTC's approach to diamond marketing. The DTC has been and continues to be an important supplier of rough diamonds to LKI. This relationship does not make LKI unique, but where the story gets exciting is when we start to consider the other supply arrangements the company has structured.

In July 1996 the company began its operations in Russia when it reached an agreement for a term of ten years, with AK ALROSA of Russia for the cutting, polishing and marketing of large gem diamonds. According to published reports, ALROSA is the largest producer of rough diamonds in Russia with annual production in excess of $1.6 billion, accounting for approximately 20% of the world's supply of diamonds. Under the original agreement, ALROSA agreed to supply LKI a minimum of $45 million per year of large rough gem diamonds. In March 1999 LKI and ALROSA entered into a second agreement to expand their relationship in the cutting, polishing and marketing of rough gem diamonds for up to $100 million a year. The company’s joint venture is staffed by Russian technicians and jointly managed and supervised by LKI and ALROSA personnel. Under the agreements, LKI sells the resulting polished diamonds through its worldwide distribution network. The proceeds from the sale of these polished diamonds, after deduction of rough diamond cost, generally will be shared equally with ALROSA.

During the third quarter of fiscal 2004 LKI signed a cooperation agreement with 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 LKI provides marketing and technical manufacturing assistance to NamGem. LKI purchases rough diamonds and supervises the manufacturing of those deemed suitable to cut and polish. LKI pays NamGem for manufacturing on a fee for services basis. All rough and polished diamonds are bought and sold by LKI for its account.

During the fourth quarter of fiscal 2004 LKI signed a four year technical cooperation agreement regarding the marketing of rough diamonds with SODIAM, the government entity responsible for the development and marketing of diamonds produced in Angola. LKI began active Angolan buying operations during the first quarter of fiscal 2005.


Finally, I should note that LKI operates a domestic manufacturing facility in Puerto Rico. This facility, LKI claims, is the largest diamond cutting facility in the United States.

From the above summary, it’s self-evident that LKI holds a very advantageous market position in the worldwide diamond market. This fact combined with the current inflationary market conditions should prove very rewarding for the company in the coming years.


Current Performance and Market Conditions

As LKI President, Leon Tempelsman, asserted in the company’s earnings call in October, the company is now realizing the fruits of its labor. After spending many years making intelligent strategic sourcing decisions, cutting costs and focusing on high quality product the company has begun to strongly benefit from the robust demand in all its markets. In this month’s earnings conference call Mr. Tempelsman asserted that we have returned to an inflationary environment in diamonds as DTC announced it fourth price increase in rough diamond prices in the past year. Shortages have appeared in rough diamonds and especially in the large diamonds the company specializes in. In short, given that the company is not merely a distributor of diamonds, but a strong sourcer of diamonds through its operations in Russia and Africa it can now directly benefit from the industry’s new found pricing power.


In the first fiscal quarter of 2005 ending in August the company reported EPS of $.30 per share, an extremely strong quarter for a company that had earned no more than $.11 for any quarter in the past five years. In its most recent quarter ending in November it reported EPS of only about $.13 per share. This drop is earnings resulted from the start up of the company’s Angolan operations during the quarter. As the sales ramped up the company was unable fully absorb the overhead costs of the facility. CFO, Bill Moryto, expects that over the next six months or so as the facility’s volume ramps up to full capacity, it should be able to completely absorb its overhead and should realize its full margin. The company looks to be on track to realize close to $1 in EPS in its current fiscal year even with the Angolan ramp up. At its current price the company sells for about ten times it current earnings with strong expectations for even higher earnings next year.

Company management, headed up by Chairman, Maurice Tempelsman (Yes, this is the same Tempelsman that had a relationship with Jacqueline Kennedy Onasis), based on my experience with them over the past five years, has always been very conservative in their expectations and statements. This is why I am very encouraged by the company’s recent statements. Their recent enthusiasm for the industry environment and the company’s competitive position and prospects has been palpable.


Balance Sheet

If the attractive market conditions, strong market position and low multiple were not enough to make this an attractive investment, then the company’s valuation relative to it strong asset base and conservative balance sheet should do it. As of August 31, the company had $197 million of current assets which included $116 million of diamond inventory. Current liabilities were $85 million which included $34 million of maturing long term debt. In addition, the company had $33 million of long term debt which was classified as such. This translates to over $9 of net working capital per share which is about equal to the stock price!

Uncovered

The company’s compelling valuation is explained to some extent by the fact that it is currently totally uncovered and completely off the Wall Street radar screen. The only piece of research on the company I have ever seen is a research report written by Bear Stearns in April 1999. The report correctly predicted the company’s current advantageous market situation but unfortunately, like much Street research, it was five years too early! The lack of Wall Street interest is explained significantly by the LKI’s limited float. Father and son, Maurice and Leon Tempelsman, hold 62% of the shares.

To further add to the story and confirm the bullishness of management, the company bought back over 62,500 shares of its stock during the latest quarter at about $9.50 per share.

Summary

In summary, we have a well-positioned and strategically managed company in an industry with excellent market conditions and prospects selling for about ten times earnings and at net current assets. In the current market environment, I find this story extremely compelling.

Catalyst

- Discovery of the story by Wall Street
- Continued company share buybacks
- Strong earnings performance over the next few years driven by excellent market conditions