Lazare Kaplan International (LKI) appears to be a highly undervalued franchise that derives little benefit from being a public company. I wrote up LKI on VIC about one year ago when the stock was undervalued and the opportunities for the company looked excellent. Today, impacted by some short term volatility in the rough diamond market, the shares have become extremely undervalued and the company’s prospects have only improved.
LKI is a major worldwide player in the sourcing, cutting, polishing and marketing of ideally proportioned diamonds. With its significant diamond sourcing arrangements in Russia, Angola, South Africa and other areas, the company is also a significant trader in the wholesale rough diamond market. The company is no “spring chicken” in the diamond market as it traces its roots to 1903. To get an overview of the company’s business I refer you to last year’s write up on the company. The critical point to take out of last year’s summary is the excellent sourcing arrangements the company has developed across the world. Over the past year, these sourcing arrangements have continued to improve. Angola has now been operating since the first fiscal quarter of 2005 and is now producing diamonds at prices competitive in the world market. With only a few more quarters of significant amortization costs, this operation should turn solidly profitable. South Africa became a DTC site (Diamond Trading Company) for LKI this month, which allows the company to beginning sourcing diamonds from this area.
At today’s price of $7.65, on a fully diluted basis, the shares trade at about a 17% discount to its net working capital and at a 25% discount to its conservative tangible book value. The share price gives no value to the company’s significant brand equity and sourcing and distribution infrastructure. What explains the significant undervaluation?
Earnings for the six months ending November 30, 2005 were only $.06 per share with a ($.05) loss for the most recent three month period. After a strong fiscal 2005, the market expected significantly better earnings in fiscal 2006. After the company disappointed investors the shares were destroyed. Is there a fundamental problem with the company? No, the company was hit with significant volatility in the rough diamond market. During the past six months rough diamond prices increased significantly due to speculative purchases unrelated to underlying demand. The company correctly sensing that this was a speculative bubble, that would ultimately deflate, significantly decreased its rough purchases. Unfortunately, needing to maintain its infrastructure and keep its partners content, it had to continue a base level of purchases. When, as anticipated, rough prices collapsed the company had to sell some rough diamonds at a loss. The result was a negative margin for rough sales in the second fiscal quarter. At this point the market has stablelized and equilibrium has been achieved. The company anticipates normal rough purchasing during the rest of the year with good margins.
On the more important polished diamond front, the increase in rough prices during the period could not be passed on to the polished market resulting in a margin squeeze. The company thus had lower polished margins during the past six months. Again, with rough prices now lower and stable, this margin pressure has been relieved. The company anticipates improved polished margins in the coming quarters.
There are some critical facts to consider about the last six months. First, these events were not company-specific. They were macro market events. Second, diamond prices and margins are now at equilibrium and favorable for the company. Third, with its extensive network and market experience, the company anticipates and manages around these events extremely well. Remember, there is no hedging mechanism in the diamond market. The company continues to emphasize that its competitors tend to be highly leveraged and not in a position to weather this volatility as well as the company. Increased volatility in the future may hurt the company in the short term, but in the long term it should only serve to improve the company’s competitive position as competitors are forced “to fold up their tents”. Finally, demand for polished diamonds remains solid. The US demand is good. Japan is recovering nicely and the future for India and China sales looks promising.
The other critical factor in the company’s valuation is the illiquidity of the shares. The Tempelsman (father Maurice is the company chairman and son Leon is the CEO.) family controls about 60% of the shares. Management as a whole accounts for 65% of the outstanding shares. In addition, twenty five percent of the shares are held by the Fifth Avenue Group (a passive investor that is in the diamond retail business). This leaves a float of only 10% of the outstanding shares! This means only about 800,000 of the company’s 8.3 million outstanding shares are in the float. To make matters worse, Dimensional Fund Advisors holds 500,000 shares. If one removes these shares from the float, only about 300,000 shares are left to trade. Thus, any small amount of selling or buying has an exaggerated impact on the price. Finally, the company has been consistently buying back shares, further reducing the float. Why is a company with such a miniscule float public? Recently, when provided with the logic of going private, management did not dispute the reasoning. The truth is that LKI has absolutely no reason to remain public. The current undervaluation combined with its bright outlook may provide the impetus for management to take the company private.
In summary, we have a unique franchise in the diamond market that is selling well below its liquidation value. The valuation is explained by some short term market conditions and the stock’s illiquidity. The impetus is now very strong for management to take this company, which has only 10% of its shares in the float, private. The cost of going private at $12 a share would only be about $10 million, which the company could easily fund.