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First Quarter Financial Statement And Dividend Announcement 2017

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Consolidated Statements of Comprehensive Income for the (US$'000):

Statement of Financial Position as at (US$'000):


* No par value

Review of Performance

Overview

The Group reported in Q1 2017 revenues of US$ 16.3 million, profit from operations of US$ 3.2 million, and net profit of US$ 2.5 million, as compared to revenues of US$ 15.5 million, profit from operations of US$ 3.7 million, and net profit of US$ 3.0 million in Q1 2016, and as compared to revenues of US$ 18.9 million, profit from operations of US$ 6.3 million and net profit of US$ 5.0 million in Q4 2016.

The year-over-year improvement in our revenues was primarily due to increased diamond manufacturing equipment sales, as well as due to increased recurring revenues. Nevertheless, net profit declined on higher operating expenses, as detailed below. The sequential quarterly decline in revenues was primarily due to fewer Galaxy™ deliveries following the cessation of the 2016 promotion of the Meteor™ under attractive introductory terms, which are no longer offered, and revised pricing of the Solaris ™' ongoing use fees. Operating expenses, were further impacted by an approximate 5% decline of the US$ versus the NIS in Israel, where most of our compensation expenses are incurred.

With deliveries in Q1 2017 of 17 Galaxy™ family systems to customers, comprising 11 ofthe Meteor™ small stone machines, five Solaris™ machines and one Galaxy™ system, the Group had an installed base of 316 Galaxy™ family systems as of March 31,2017. Overall recurring revenues for Q1 2017 (including Galaxy™-related, Quazer™ services, polished diamond related ("Trade") services, annual maintenance contracts, and spare parts, etc.) represented approximately 42% of our overall revenue. Overall Trade revenues from our polished diamond line of products and services, the Sarine Profile™ and its various components (Sarine Light™, Sarine Loupe™, Sarine Connect™, etc.), represented about 2% of our overall revenue for Q1 2017, but we continue to expect to double this ratio as the year unfolds, as new customers buy in to the paradigm, existing customers continue to expand their programs, and the number of stones processed increases.

Balance Sheet and Cash Flow Highlights

As at March 31, 2017, cash and cash equivalents and short-term investments (bank deposits) ("Cash Balances") increased to US$ 40.9 million as compared to US$ 38.0 million as of December 31, 2016. The increase in Cash Balances was primarily due to the Group's operating results and lower trade receivables, offset by lower payables and increased fixed assets, primarily due to the Group's recently completed new facilities in Surat India.

Revenues

Revenues for Q1 2017 increased to US$ 16.3 million as compared to revenues of US$ 15.5 million in Q1 2016, but decreased as compared to US$ 18.9 million in Q4 2016. The increase in revenues on a year-over-year basis was primarily due to increased diamond manufacturing equipment sales and increased recurring revenues, mainly in India. The sequential quarterly decrease in revenues especially in India was primarily due to fewer Galaxy™ deliveries, as noted above.

Cost of sales and gross profit

Cost of sales for Q1 2017 increased to US$ 5.2 million as compared to US$ 5.0 million for Q1 2016, but decreased as compared to US$ 5.3 million in Q4 2016, with gross profit margins of 68% in Q1 2017 virtually flat versus Q1 2016, but lower than the 72% reported in Q4 2016. The year-over-year increase in the cost of sales was due primarily to higher sales volumes in Q1 2017 as compared to Q1 2016. The decrease in cost of sales on a sequential basis and the lower gross profit margin were primarily due to lower sales volumes and product mix.

Research and development expenses

Research and development expenses for Q1 2017 increased to US$ 3.0 million as compared to US$ 2.6 million in Q1 2016, and US$ 2.7 million in Q4 2016. The increase in research and development on year-over-year and sequential bases was primarily due to higher employee-related and outsource expenses. The increase in employee related expenses was also impacted by an approximate 5% devaluation in the US dollar versus the NIS. The Group continues to focus its research and development expenditures on the development of future growth products and services.

Sales and marketing expenses

Sales and marketing expenses for Q1 2017 increased to US$ 3.5 million as compared to US$ 3.1 million in Q1 2016 and was virtually flat with Q4 2016. Sales and marketing expenses increased on a year-over-year basis on increased marketing, advertising and business development expenses as well as increased sales expenses in the Asia Pacific region, with the expansion of our staff in line with the continued successful rollout of our Trade offerings.

General and administrative expenses

General and administrative expenses for Q1 2017 increased to US$ 1.4 million as compared to US$ 1.1 million in Q1 2016, and as compared to US$ 1.1 million in Q4 2016. The increase in general and administrative expenses on a year-over-year and sequential bases was primarily due to higher third-party professional fees, mainly related to IP protection in India, as well as higher non-cash incentive based compensation expenses.

Profit from operations

Profit from operations for Q1 2017 decreased to US$ 3.2 million as compared to US$ 3.7 million in Q1 2016 and US$ 6.3 million in Q4 2016. The decrease in profit from operations on a year-over-year basis was due to higher operating expenses, offset somewhat by increased revenues. The decrease in profit from operations on a sequential basis was primarily due to lower sales and somewhat higher operating expenses, as detailed above.

Net finance (expense) income

Net finance expense for Q1 2017 was US$ 19,000 as compared to net finance income of US$146,000 in Q1 2016 and net finance expense of US$2,000 in Q4 2016. Net finance expense in Q1 2017 was primarily due to exchange rate differences associated with our NIS-linked payables.

Income tax expense

The Group recorded an income tax expense of US$ 0.7 million for Q1 2017 as compared to an expense of US$ 0.9 million for Q1 2016 and an expense of US$ 1.3 million in Q4 2016. The decrease in income tax expense was primarily due to lower pre-tax profitability, as discussed above.

Profit for the period

Net profit for Q1 2017 decreased to $2.5 million as compared to US$ 3.0 million in Q1 2016 and US$ 5.0 million in Q4 2016. The decrease in net profit on a year-over-year basis was due to higher operating expenses, offset somewhat by increased revenues. The decrease in net profit on a sequential basis was primarily due to lower sales and somewhat higher operating expenses, as detailed above.

Commentary

We expect the following industry trends to continue influencing our business:

  1. Fundamental global economic indicators continue to be overall positive, though geopolitical uncertainties in North Korea, Syria and Europe (Brexit) persist.

  2. In all retail diamond markets, save for the domestic market in India, end consumer demand remains robust. In the second most important market, China, general and retailer-specific indicators show consumer demand for luxury items, in general, and diamond jewellery specifically, expanding after a two year hiatus.

  3. De Beers' and other major producers' sales of rough diamonds in the first quarter of 2017 were higher than in 2016, with prices steady, indicating continued overall positive industry sentiment. The producers leveraged this sentiment to sell into the industry pipeline quantities of rough stones, which had been stockpiled during the problematic second half of 2015. The issue as to whether too many rough stones are entering the midstream needs to be closely monitored. Otherwise, an imbalance between rough stones entering and polished stones leaving the midstream may develop, as has happened in the past, creating inventory, pricing and liquidity issues.

  4. There are no significant polished diamond pricing or inventory issues at this time, though an imbalance, as noted in the previous paragraph, may be developing.

  5. The trends noted above, positive macroeconomics, continued positive consumer demand for polished diamonds in almost all markets, a robust supply of rough diamonds at favourable prices and no inventory overhang (under proper balancing of rough bought and polished sold) should underpin continued normal industry activity in 2017.

  6. With respect to those parties in India, who we suspect are operating an inclusion mapping service centre in Surat, India and who we believe to be offering for sale systems akin to our Solaris and Meteor systems, we believe that they are infringing upon our patented technology for inclusion mapping in rough diamonds, as well as infringing on our copyright of our Advisor™ rough diamond planning software. We intend to leverage and seek remedies for the infringement of the patent granted us in India for our unique diamond inclusion scanning technology, as well as our copyrights of the Advisor™ planning software, which without infringing upon the latter we believe the inclusion mapping results could not be gainfully utilised. These remedies will be enforced against those who unlawfully compete with us by violating our IP rights, by making, selling, renting, buying, using or using the output from infringing products and pirated software. To the degree possible and prudent, we will announce more details relating to our actions when they have actually been initiated. In addition, we will also leverage our market position and the pending release of upcoming innovations to the planning process and other facets of the diamond manufacturing and wholesale/retail sales processes, to further protect the company against such unlawful activities.

  7. As forecast in full year 2016 report, in Q1 2017 we delivered fewer systems than in Q4 2016, primarily due to termination of the Meteor™ promotion and change in pricing of the Solaris ™ ongoing use fees, which took effect as of 1 January 2017. We sold 17 Galaxy™ family systems, comprising 11 Meteor™ small-stone systems, 5 Solaris™ systems, and one Galaxy™, and the Group had an installed base of 316 inclusion mapping systems as of 31 March 2017.

  8. Sales programs utilising Sarine Profile™ by retailers primarily in the Asia Pacific (APAC) region, and to a lesser extent in the U.S, continue to expand. Programs with retailers in the U.S. are gaining momentum slower than those in the AP AC region due to various factors, including the average quality of stones sold and other corporate and consumer cultural issues. In the AP AC region we have had a series of significant successes this quarter. Two new chains in Japan have joined our customer list, K-Uno which has, as announced, for the first time in Japan, adopted the full Sarine Profile ™ and Sadamatsu, which has launched the unique Wish Upon a Star diamond using Sarine light performance, as well as a large buyers' group in Australia, Leading Edge Group. Talks are continuing with other major chains. We intend to double the number of stones scanned for the Sarine Profile™ in 2017 and expect its contribution to overall Group sales to be around 5% this year.

  9. Our new technology for the automated, objective and consistent mapping and identification of a polished diamond's inclusions and the subsequent derivation of its Clarity grade continues in large-scale testing in India, and is on track for commercialisation in Q3 2017. Likewise for the Color grading technology, which is being tested in parallel. These technologies address the US$500 million annual 4Cs grading market, which currently generates an estimated 7 million reports a year for stones typically a fifth of a carat and up, at prices ranging from US$50 to US$100 a carat. We believe that by introducing a cost-effective, consistent and reliable automated solution, the addressable market can be expanded down to polished diamonds of a tenth of a carat and up, effectively increasing the total addressable market value by 50% to US$ 750 million annually. We are considering various commercialisation avenues, all based on a recurring revenue model per each stone graded, as is the norm in the industry today. Customers could be from across the entire diamond industry value chain. Large manufacturers could adopt self-certification, especially for the smaller stones, as enabled by our technology. Existing gemmological laboratories may see value in adopting an objective consistent automated grading paradigm, a goal announced last year by the IIDGR lab (DeBeers' diamond lab), or at least utilising the initial phase of the process – the comprehensive plotting of the inclusions in the polished diamond. Large chain retailers with existing in-house gem labs may similarly utilise the technology. Finally, yet importantly, as this may be the most immediate avenue of commercialisation open to the Group, retail customers, who have already chosen or who choose to implement the Sarine Profile™, may, to reduce overhead and cost, prefer to also acquire the 4Cs data from us.

  10. The Allegro™ system's planning optimisation algorithms and shaping/polishing hardware is undergoing re-evaluation, with the help of the engineering consultants, who were involved in the original system's design and implementation, in order to fully assess its commercial potential.

  11. We will focus our research and development initiatives on the following objectives:

    • Polished diamond trade systems:
      • Expansion of our operational infrastructure for Sarine Profile™;
      • Continued enhancement of Sarine Profile ™ in order to provide additional capabilities for customer programs, as required, including additional shapes - current work continues on supporting less ubiquitous shapes, such as Ovals, Pears, Marquises and Hearts, as well as newly derived customerproprietary modified shapes, more customer-generated marketing information (videos), etc.
      • Enhancement of Sarine Profile™ to support the display of jewellery pieces and not just loose polished diamonds. As retail businesses display set jewellery by far more often than loose stones, this will significantly broaden the appeal and applicability of Sarine Profile ™.
      • Development of the software infrastructure for the Clarity and Color grading capabilities currently in testing, including process management, data security, etc.
      • Initial assessment of available technologies and possible enhancements to the solutions for the authentication of a polished diamond being of natural source and untreated, especially as applicable to the high-speed screening of very small polished diamonds (so called "melee").

    • Manufacturing products: Overall ongoing improvements to our Advisor™ rough planning software continue to enhance its capabilities and productivity along with refined IP protection. Advisor™ 7.0, with significant new value-added capabilities, including light performance simulation and evaluation, is scheduled for Q2 2017, ahead of schedule.