Summary of LAZARE KAPLAN INTERNATIONAL INC

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Introduction

This quarterly report contains, in addition to historical information, certain forward-looking statements that involve significant risks and uncertainties. Such forward-looking statements are based on management's belief as well as assumptions made by, and information currently available to, management pursuant to the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995. The Company's actual results could differ materially from those expressed in or implied by the forward-looking statements contained herein. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in "Liquidity - Capital Resources" and in Item 1 - "Description of Business" and elsewhere in the Company's Annual Report on Form 10-K for the fiscal year ended May 31, 2008. The Company undertakes no obligation to release publicly the result of any revisions to these forward-looking statements that may be made to reflect events or circumstances after the date of this quarterly report or to reflect the occurrence of other unanticipated events.

Overview

The Company is engaged in the cutting, polishing and selling of branded and non-branded ("commercial") diamonds. The Company's premier product line is comprised of ideally proportioned diamonds which it markets internationally under the brand name "Lazare Diamonds®". Ideally proportioned diamonds are distinguished from non-ideal cut diamonds by the symmetrical relationship of their facets, which optimize the balance of brilliance, sparkle and fire in a polished diamond. The Company owns and operates a domestic manufacturing facility located in Puerto Rico. In addition, through various cooperative agreements, the Company cuts and polishes commercial diamonds which it markets to wholesalers, distributors and retail jewelers. Rough stones purchased by the Company are either selected for manufacturing or resold as rough diamonds in the marketplace.

The Company's overall revenues are, in part, dependent upon the availability of rough diamonds, the world's known sources of which are highly concentrated. The Diamond Trading Company ("DTC") is the world's largest rough diamond selling organization. The DTC periodically appoints clients - known as "Sightholders" - who are among the world's leading diamantaires, and are carefully chosen for their ability to add value to the diamonds sold by the DTC. The Company has been a client of the DTC for approximately 60 years. The Company was recently re-appointed as a Sightholder. The Company supplements its rough diamond needs by secondary market purchases and has entered into relationships with other primary source suppliers.

The Company has an agreement regarding the purchasing and marketing of rough diamonds with Sociedade de Comercializacao de Diamantes de Angola SARL ("SODIAM"), the government entity responsible for development and marketing of diamonds produced in Angola. Informal sector rough diamond buying from this operation commenced during fiscal 2005. During fiscal 2006, the Company's rough buying operations expanded to include buying in the Angolan formal sector. Angolan formal sector operations are currently conducted by separate joint venture companies. The Company is currently negotiating a further expansion and restructuring of its Angolan operations which includes exploration and development through various additional joint ventures.

The Company has a ten year agreement signed in March 1999 with AK ALROSA of Russia, which is the largest producer of rough diamonds in Russia. Under the terms of this agreement, the Company sells polished diamonds that are cut in facilities jointly managed and supervised by the Company and ALROSA personnel. The proceeds from the sale of these polished diamonds, after deduction of rough diamond cost, generally are shared equally with ALROSA.

The Company has signed a strategic cooperation agreement with NamGem Diamond Manufacturing Company (PTY) Ltd. ("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, the Company provides technical manufacturing assistance and supervises the manufacture of the Company's rough diamonds deemed suitable to cut and polish.

During September 2006, the Company and the Overseas Private Investment Corporation, an independent agency of the United States Government ("OPIC") signed a commitment letter pursuant to which OPIC committed to provide approximately $25 million of long-term financing in support of the acquisition of certain rough diamonds to be cut and polished in Namibia. Pursuant thereto, a subsidiary of the Company and OPIC subsequently entered into a financing agreement. The Company is currently in negotiations with third parties regarding changes to its existing Namibian operations. Pending a satisfactory outcome of these negotiations and subject to various conditions precedent under the financing agreement, the Company anticipates initial borrowing under the facility to commence during fiscal 2009.

The Company has an agreement with Nozala Investments (Pty) Ltd., a broadly based women's empowerment investment group, for cooperation in South Africa's diamond sector. The agreement contemplates diamond mining, cutting, polishing, and distribution. The joint venture is in line with the South African Government's recently announced program to promote new entrants and investment in the domestic diamond sector, increasing the sector's contribution to economic development. Cutting and polishing activities which concentrate on local sources of rough diamond supply commenced during fiscal 2006.

In February 2006, Lazare Kaplan Botswana (Pty) Ltd., a wholly owned subsidiary, was granted a license from the Government of Botswana to cut and polish diamonds in that country. The Company is currently constructing a new cutting facility in Gaborone, Botswana.

The Company continues its efforts to develop additional sources of rough diamonds, including potential opportunities in Africa.

Through February 2009, the Company's wholly-owned subsidiary, Pegasus Overseas Ltd. ("POL") has an exclusive agreement with Diamond Innovations Inc. ("DI") under which POL will market natural diamonds that have undergone a new high pressure, high temperature (HPHT) process to improve the color of certain gem diamonds without reducing their all-natural content. POL only sells and markets diamonds that have undergone the HPHT process under the Bellataire® brand name.

In November 2005, the Company (including certain of its subsidiaries) amended certain terms of its agreement with DI relating to the sourcing, manufacture and marketing of Bellataire diamonds. The amendment and related agreements seek to increase the sales and profitability of Bellataire diamonds by more closely aligning the economic interests of the parties through shared management of product sourcing, manufacturing and marketing as well as the sharing of related costs.

While the Company believes that its success in maintaining quantities and qualities of polished inventory that best meet its customers' needs is achieved through its ability to fully integrate its diverse rough and polished diamond sources, any significant disruption of the Company's access to its primary source suppliers could have a material adverse effect on the Company.

The financial market crisis and economic downturn has disrupted credit and equity markets worldwide and led to deterioration in the global economic environment, a general tightening of credit, lower levels of liquidity and discretionary spending, and increases in the rates of default and bankruptcy. During the fiscal quarter ended November 30, 2008 rough and polished diamond sales slowed significantly as customers focused on selling owned inventory and preserving liquidity in response to the global economic downturn. As a result, some diamond producers have reduced mining activity or begun to stockpile inventory. In the current economic environment, some of the Company's customers may experience difficulty in paying for previously purchased products.

At November 30, 2008, the Company had a net aggregated exposure to a group of affiliated and / or associated companies amounting to approximately $34.0 million. In addition, the Company guaranties a portion of debt relating to a joint rough trading venture ($20.5 million at November 30, 2008) in which one of the affiliated companies is a principal operating partner. The Company's aggregate exposure consists primarily of accounts receivables, inventory and advances offset by advances and investments funded by such companies. At November 30, 2008 certain of the affiliated companies and certain third party customers were experiencing liquidity difficulty in the current economic environment. As a result, certain receivables and joint venture funding for which these companies are responsible were past due. The Company is continuing to work with the affiliated companies and their management to alleviate the situation.

Results of Operations

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 diamond jewelry purchases are ultimately dependant on the availability of consumer discretionary spending. Uncertainties regarding future economic prospects and a decline in consumer confidence during the current fiscal quarter translated into lower purchases and sales by diamond retailers, wholesalers and producers in most sectors of the diamond and jewelry industry.

Net Sales

Net sales for the three and six months ended November 30, 2008 were $41.3 million and $119.6 million, respectively, as compared to $90.5 million and $193.1 million for the prior year periods.

Polished diamond revenue for the three and six months ended November 30, 2008 were $20.2 million and $61.1 million, respectively, as compared to $43.0 million and $76.9 million for the prior year periods. The current quarter and year to date decrease reflects lower sales of both branded diamonds and fine cut commercial diamonds. Polished diamond sales have been significantly impacted by the worsening economic conditions, and the reluctance of customers to take inventory positions in response to liquidity concerns.

Rough diamond sales were $21.1 million and $58.5 million for the three and six months ended November 30, 2008, as compared to $47.5 million and $116.2 million for the comparable prior year periods. The decrease in rough diamond sales primarily reflects reduced sourcing activities as the Company sought to preserve liquidity and declined to purchase rough diamonds it considered overpriced in light of current market conditions.

Gross Profit

Gross Margin on net polished sales for the three and six months ended November 30, 2008 were 6.5% and 10.7%, respectively, as compared to 9.5% and 10.6% for the prior year periods. The decrease in polished gross margin during the current quarter primarily reflects lower margins on the sales of both branded and fine cut commercial diamonds. The decline in gross margin reflects the liquidation of slower moving diamonds and diamond jewelry items at reduced prices, the expensing of unabsorbed manufacturing overhead costs and credits issued in connection with the return of certain inventory.

Rough diamond gross margin for the three and six months ended November 30, 2008 was (3.0%) and 1.0%, respectively, as compared to 4.8% and 5.6% in the comparable prior year periods. The decrease in rough gross margin reflects trading losses incurred by the Company as falling demand resulted in decreased prices for rough. In addition, rough margin reflects the expensing of unabsorbed sourcing costs associated with the Company's informal sector rough buying operation.

Selling, General and Administrative Expenses

Selling, general and administrative expenses for the three and six months ended November 30, 2008 were $6.6 million and $13.5 million, respectively, as compared to $6.9 million and $13.2 million for the prior year periods. The decrease for the current quarter and year-to-date period reflects decreased legal, advertising and compensation expense partially offset by costs associated with the expansion of manufacturing operations in Southern Africa.

Equity in Income of Joint Ventures

The Company is an equity owner in several joint venture companies relating to sourcing, cutting, polishing, processing and sales of diamonds. The Company's combined share of income from these joint venture operations for the three and six months ended November 30, 2008 was $0.9 million and $3.4 million, respectively, as compared to $2.5 million and $2.6 million for the comparable prior year periods. Reduced joint venture earnings during the fiscal quarter ended November 30, 2008 primarily reflects lower levels of operating activity attributable to the effects of the global economic downturn in the diamond industry.

Interest Expense

Net interest expense for the three and six months ended November 30, 2008 was $0.9 million and $1.3 million, respectively, as compared to $1.5 million and $3.0 million in the comparable prior year periods. The decrease for the three and six months ended November 30, 2008 reflects lower interest rates and net borrowing levels compared to the comparable prior year period.

Income Tax

The Company's effective tax rate for the three and six months ended November 30, 2008 was 36.3% and 37.4%, respectively, as compared to 24.6% and 26.2% for the prior year periods. The increase is primarily attributable to an increase in the percentage of income / loss applicable to higher tax rate jurisdictions.

Liquidity and Capital Resources

The Company used $1.9 million of cash flow from operations for the six months ended November 30, 2008, as compared to generating $21.8 million in the prior year.

The primary sources and uses of operating cash flow by the Company relate to the purchase and sale of diamonds.

Rough diamond buying operations commonly involve the commitment of significant monies for opportunistic purchases of groups of diamonds. Rough trading requires accumulation, sorting and aggregation of purchases for resale, generally in large volume transactions. The timing of sales depends on many factors, including the Company's ability to source adequate quantities of similar categories of diamonds, the balance of supply and demand in the broader market, the availability of financial liquidity and confidence on the part of customers and consumers in the normal operation of the broader economy.

By comparison, polished diamond operations involve a substantially longer holding period during which the Company manufactures grades and sells individual diamonds to customers, generally in transactions involving a relatively small number of diamonds.

Payment for rough diamonds sourced directly from producers is generally required to be made at, or prior to, title transfer. Open market purchases of both rough and polished diamonds, which the Company uses to supplement its inventories, are generally paid for over time base on negotiated terms.

As a result of the foregoing, the Company's cash flow and changes in operating assets and liabilities can vary significantly between fiscal periods depending on the source, mix and timing of diamonds the Company purchases changes in the availability of credit and macroeconomic shifts in consumer confidence and spending patterns.

For the six months ended November 30, 2008 changes in accounts receivable generated $13.2 million of cash from operations as compared to $25.5 million for the comparable prior year period. The decrease in accounts receivable primarily reflects the impact of lower sales during the current period.

For the six months ended November 30, 2008 changes in inventory levels used $15.9 million of net cash flows as compared to a use of $1.6 million for the comparable prior year period. Increased inventory levels reflect higher levels of both rough and polished diamonds, primarily attributable to reduced sales volume.

For the six months ended November 30, 2008 changes in accounts payable and other current liabilities generated $8.9 million of cash flow as compared to a usage of $5.8 million during the comparable prior year period. The increase in accounts payable and other current liabilities primarily reflects the timing of payments by the Company.

The Company's working capital at November 30, 2008 was $99.8 million as compared to $108.6 million at May 31, 2008.

The Company maintains long-term unsecured, committed, revolving credit facilities that it utilizes for general working capital purposes in the amount of $35.0 million. In addition, the Company has a 520 million Yen denominated facility (approximately $5.0 million U.S. dollars) that is used in support of its operations in Japan. The Company's long-term facilities do not contain subjective acceleration clauses or require the Company to utilize a lock box whereby remittances from the Company's customers reduce the debt outstanding.

The Company also maintains an additional $80.0 million of uncommitted lines of credit that are used to finance rough inventory transactions and other working capital needs.

A majority owned subsidiary of the Company also maintains $3.0 million line of credit relating to a joint diamond cutting and polishing operation in South Africa. The balance outstanding as of November 30, 2008 was approximately $1.7 million with a portion of this debt (approximately $0.7 million) guaranteed by the Company's partner.

The Company also guarantees a portion of debt related to a joint rough trading operation ($20.5 million at November 30, 2008). The fair value of the guarantees is immaterial.

Long-term debt includes the portion of borrowings which the Company has the intention to refinance on a long-term basis.

Stockholders' equity was $97.8 million at November 30, 2008 as compared to $100.6 million at May 31, 2008. No dividends were paid to stockholders during the six months ended November 30, 2008.

The Company believes that it has the ability to meet its anticipated financing needs for at least the next twelve months.

New Pronouncements

In September 2006 the FASB issued SFAS No. 157, "Fair Value Measurements," which establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. SFAS No. 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Effective June 1, 2008 the Company adopted SFAS No. 157, with the exception of all non-financial assets and liabilities, except those items recognized or disclosed at fair value on an annual or more frequently recurring basis, which will be effective for years beginning after November 15, 2008. The impact of adopting SFAS No. 157 on the Company's financial position, results of operations and cash flows was immaterial.

Effective June 1, 2008, the Company adopted SFAS No. 159, "The Fair Value Option for Financial Asset and Financial Liability: Including an amendment of FASB Statement No. 115" ("SFAS No. 159"). The standard permits all entities to elect to measure certain financial instruments and other items at fair value with changes in fair value reported in earnings. The impact of adopting SFAS No. 159 on the Company's financial position, results of operations and cash flows was immaterial.

Transactions with related parties

A member of the Company's Board of Directors is of counsel to a law firm which serves as counsel to the Company. Amounts paid to the law firm during the three and six months ended November 30, 2008 were $0.1 million and $0.2 million, for each respective year.