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Third Quarter Results Financial Statement And Related Announcement 2016

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Third Quarter Financial ended 30 September 2016

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

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


* No par value
** Retrospective application regarding initial application of Amendment to IAS 27: Equity Method in Seperate Financial Statements

Review of Performance

Overview

The Group's revenues and operating performance continue to show significant improvement on a year-over-year basis in Q3 2016 and for the nine months ended September 30, 2016. The Group reported in Q3 2016 revenues of US$ 17.3 million, profit from operations of US$ 4.5 million, and net profit of US$ 4.0 million, as compared to revenues in Q3 2015 of US$ 9.5 million, loss from operations of US$ 0.7 million and a net loss of US$ 1.4 million. The Group reported for the nine months ended September 30, 2016 revenues of US$ 53.6 million, profit from operations of US$ 14.9 million and net profit of US$ l3.0 million versus revenues of US$ 36.1 million, profit from operations of US$ 3.5 million and net profit of US$ 2.1 million.

The continued improvement in our business, as further elaborated on in section 10, was primarily due to positive macroeconomics, continued positive and renewed consumer demand for polished diamonds in key markets, a robust supply of rough diamonds at economically viable prices and no inventory overhang.

Despite overall positive sentiment a degree of uncertainty did hang over the industry midstream activity in anticipation of the key Hong Kong Jewellery & Gem Fair show in the second half of September. As the show evidenced markedly improved sentiment and business activity (buyers from China indicated stronger demand for polished diamonds, including larger stones up to 5 carats in weight), sentiment and manufacturing improved further at the tail end of the quarter.

With record deliveries in Q3 2016 of 22 Galaxy™ family systems (21 to customers and one additional Galaxy™ Ultra to our Indian service centre due to continued strong demand for these high-end services), comprising twelve of the new Meteor™ small stone machines, seven Solaris™ machines two Galaxy™ Ultra systems and one Galaxy™ system, up from 20 in Q2 2016 and only one system in Q3 2015, the Group had an installed base of275 Galaxy™ family systems as of September 30, 2016. Overall recurring revenues for the nine months ended September 30, 2016 (including Galaxy™-related, Quazer services, annual maintenance contracts, etc.) represented about 40% of our overall revenue.

Balance Sheet and Cash Flow Highlights

As at September 30, 2016, cash and cash equivalents and short-term investments (bank deposits) ("Cash Balances") increased to US$ 34.9 million as compared to US$ 32.6 million as of December 31,2015. The increase in Cash Balances was primarily due to the Group's improved operating results, lower inventory levels and higher payables, offset by the payment of US$ 12.2 million in dividends in 2016 – the US$ 5.2 million final dividend paid in Q2 2016 for the fiscal year 2015 and the US$ 7.0 million interim H1 2016 dividend paid in September 2016, the US$ 1.2 million purchase in Q2 2016 of DiaMining's app-based point of sale technology for diamonds, gemstones and jewellery (resulting in an equivalent increase in intangible assets), higher trade receivables (on higher recurring revenues and credit to certain customers) and increased fixed assets, primarily due to the Group's soon to be completed construction of its new facilities in Surat India.

Revenues

Revenues in Q3 2016 were US$ 17.3 million, as compared to US$ 9.5 million in Q3 2015 and as compared to US$ 20.9 million in Q2 2016. Revenues for the nine months ended September 30, 2016 were US$ 53.6 million as compared to US$ 36.1 million for the comparable period in 2015. The increase in revenues on a year-over-year basis in most geographies, but mainly in India, was primarily due to increased diamond manufacturing equipment sales, including Galaxy™ family systems, as well as due to increased recurring revenues, as noted above. On a sequential basis, there was a certain decline in revenues, due to uncertainty leading up to the key Hong Kong Jewellery & Gem Fair show in September, as noted above.

Cost of sales and gross profit

Cost of sales for Q3 2016 was US$ 5.4 million as compared to US$ 3.5 million for Q3 2015 and US$ 6.4 million in Q2 2016, with gross profit margins of 69% in Q3 2016 as in Q2 2016 and versus 63% in Q3 2015. Cost of sales for the nine months ended September 30, 2016 increased to US$ 16.9 million as compared to US$ 11.6 million for the comparable period in 2015, with gross profit margins of 68% for the respective periods. The year over year and quarterly variances in the cost of sales were linked to the relevant increase or decrease in sales volumes.

Research and development expenses

Research and development expenses in Q3 2016 of US$ 2.8 million were virtually flat with US$ 2.6 million in Q3 2015 and US$ 2.7 miIlion in Q2 2016. For the nine months ended September 30, 2016, research and development expenses of US$ 8.1 were virtually flat with US$ 8.0 million for the comparable period in 2015. The Group continues to focus its research and development expenditures on the development of future growth products and services, primarily as related to its new polished diamond offerings, as expanded upon in Section 10.

Sales and marketing expenses

Sales and marketing expenses for Q3 2016 were US$ 3.3 million, virtually flat with Q3 2015 and down from US$ 3.7 million in Q2 2016. Sales and marketing expenses for the nine months ended September 30, 2016 increased by a modest 3% to US$ 10.1 million versus US$ 9.8 million for the comparable period in 2015. The increase in sales and marketing expenses on a year-over-basis was primarily due to higher sales commissions and incentive-based compensation. The sequential decrease in sales and marketing expenses for Q3 2016 as compared to Q2 2016 was primarily due to lower expenses associated with trade shows.

General and administrative expenses

General and administrative expenses for Q3 2016 were US$ 1.1 million as compared to US$ 0.8 million in Q3 2015 and US$ 1.3 milIion in Q2 2016. General and administrative expenses for the nine months ended September 30, 2016 increased to US$ 3.5 million versus US$ 3.1 million for the comparable period in 2015. The increase in general and administrative expenses on a year-over year basis was due to higher incentive-based compensation (versus negative incentive based compensation in Q3 2015). The sequential decrease in quarterly general and administrative expenses was primarily due to lower legal expenses in Q3 2016.

Profit (loss) from operations

Profit from operations for Q3 2016 was US$ 4.5 million as compared to a loss from operations of US$ 0.7 million in Q3 2015 and profit from operations of US$ 6.7 million in Q2 2016. Profit from operations for the nine months ended September 30, 2016 increased to US$ 14.9 miIlion versus US$ 3.5 million for the comparable period in 2015. The increase in profit from operations on a year-over-year basis was primarily due to increased revenues, as detailed above. The decrease in profit from operations on a sequential basis was primarily due to lower revenues, as detailed above.

Net finance income (expense)

Net finance income for Q3 2016 was US$ 0.4 million as compared to an expense US$ 0.2 miIlion in Q3 2015. Net finance income for the nine months ended September 30, 2016 was US$ 0.8 million versus an expense US$ 0.2 million for the comparable period in 2015. Net finance income in Q3 2016 was primarily due to a reversal of US$ 0.4 miIlion in interest charges relating to prior period tax assessments under dispute in India.

Income tax expense

The statutory corporate tax rate in Israel in FY2016 decreased to 25% (from 26.5% in FY2015). The Group's effective tax rate is a blend of the statutory tax rate in Israel reduced by substantial tax benefits, in accordance with tax directives enacted in Israel as of 2011, accorded to our export-oriented revenue mix (taxed at between 9%-16%), offset by the higher statutory tax rate in India (34%).

Income tax expense was US$ 0.9 million for Q3 2016 as compared to an expense ofUS$ 0.5 million for Q3 2015. Income tax expense was US$ 2.7 million for the nine months ended September 30, 2016 versus US$ 1.2 million for the comparable period in 2015. The increase in income tax expense was primarily due to higher pre-tax profitability, as discussed above.

Profit for the period

Net profit for Q3 2016 was US$ 4.0 million as compared to a net loss of US$ 1.4 million in Q3 2015 and net profit US$ 6.0 million in Q2 2016. Net profit for the nine months ended September 30, 2016 increased to US$ 13.0 million versus US$ 2.1 million for the comparable period in 2015. The increase in net profit was primarily due to increased revenues, 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.

  2. In the U.S., still the largest single market for polished diamonds, diamond jewellery sales continue to indicate a positive trend. At the key Hong Kong Jewellery & Gem Fair in the second half of September, sentiment was markedly improved, business was more robust and buyers from China were more active with stronger demand for polished diamonds, including larger stones up to 5 carats in weight. This renewed stronger demand from China, which became manifest at the show (too late to mitigate a degree of uncertainty which prevailed for much of Q3 regarding the market in China), has had a positive effect on the overall industry sentiment and should positively influence activity going into the last quarter of 2016 and the first quarter of 2017 through to the Chinese New Year.

  3. During the third quarter of the year rough diamond sales continued to show a marked recovery over 2015. Even with sights realising volumes less than those in the first six months of the year, DeBeers reported sales 77% higher than in the corresponding period of 2015 . We expect rough diamond sales and the consequent polishing activity to continue robustly for the rest of the year, as concerns regarding the demand in China have been mitigated somewhat, as mentioned above, and there are no significant negatives impairing profitability throughout the diamond industry value chain.

  4. There are no known polished diamond inventory issues of substance at this time.

  5. The trends noted above, positive macroeconomics, continued positive and renewed consumer demand for polished diamonds in key markets, a robust supply of rough diamonds at economically viable prices and no inventory overhang, should underpin continued healthy industry activity, and, by extension, Group sales.

  6. With deliveries in Q3 2016 of a new record 22 Gaiaxy™ family systems, 21 to customers and one additional Gaiaxy™ Ultra to our service centre in Surat, comprising twelve Meteor™ systems, seven Solaris™ systems, one Galaxy™ and two Galaxy™ Ultra systems, the Group had an installed base of 275 Galaxy™ family systems as of 30 September 2016. We have now delivered a record 60 systems in the first nine months of 2016 and expect to expand substantially upon the previous annual record of 48 deliveries realised in 2014. To the best of our knowledge, there have been no material developments from potential competitors to date.

  7. Sales programs utilising the Sarine Profile™ by leading retailers in the U.S and the Asia Pacific (APAC) region continue to expand with Meidie of China and Mariage, Verite (also under Maharaja brand) and Grace Fujimi (also under Garden brand) from Japan having adopted the Sarine Profile™ oflate. We are seeing significant growth in the volume of stones processed monthly. Additional programs with retailers in the U.S. and Australia are launching in Q4, with stones already being scanned and their personnel trained in preparation for these launches.

  8. The Allegro™ system has demonstrated clear benefit using optimal yield and cut perfection as the criteria in the production of high-end stones by sophisticated manufacturers. Additional software has been written to enable the AllegroTM to also compete favourably with lower-end manufacturing of standard sized stones, where the emphasis is on given dimensions with maximal weight and less focus on cut perfection. The new software version has completed testing in Israel and will now be installed at the Jaipur service centre after the Divali holiday, to demonstrate its benefits to Indian manufacturers of standard sized stones. This has been the major issue holding back more widespread adoption of the Allegro™ in India. We are continuing to plan for rollout in additional territories, Thailand initially, in 2017.

  9. We continue to focus our research and development initiatives on the following projects:

    • Polished diamond trade systems:
      • Expansion of our operational infrastructure for the Sarine Profile™;
      • Enhancement of our Sarine Profile™ in order to provide additional capabilities for customer programs, as required, mainly additional shapes – current work is on Oval shaped diamonds to be followed by Pear and Heart shapes (having concluded work on Radiant, Cushion, Ascher, Princess, Emerald and other program-specific shapes, such as Shining House's octagon).
      • Integration of the recently acquired Sarine Connect™ (previously known as DiaMining) technology to enhance our Sarine Profile™ with significantly better in-store capabilities, as well as advanced inventory management functionalities.
      • Enhancement of the Sarine Profile™ integrated with the Sarine Connect™ to support the display of jewellery pieces and not just loose polished diamonds. As retail businesses showcase set jewellery by far more often than loose stones, this will significantly broaden the appeal and applicability of the Sarine Profile™. Furthermore, it will allow a retail business to showcase all their inventory on one unified platform, not only the high-end programs with high-quality diamonds, for which the Sarine Profile™ is increasingly becoming the preferred sales vehicle, but also the more ubiquitous jewellery lines.
      • As recently reported (10 November 2016), the development of new hardware and services complementary to our Sarine LightTM and Sarine Loupe™ platforms has reached the advanced high-volume testing phase. The key development has been a very sophisticated device, which provides automated, objective and consistent Clarity grading with in-grade sub-sorting capabilities, as well.
      • A second platform which has been developed, is a system which performs automated, objective and consistent Colour grading.

    • Manufacturing products: Overall ongoing improvements to our Advisor™ rough planning software continue to enhance its capabilities and productivity along with refined IP protection. We have completed development of the ability to predict the planned polished diamond's light performance during its planning stage. We are now working on the capability to plan a polished diamond to meet desired light performance grades in general (e.g., Ultimate) or specific grades of specific subparameters of light performance (e.g., ultimate Fire). Completion of the integration of these new capabilities with the Advisor™ and our faceting quality control software (the Instructor™), so as to allow manufacturers to incorporate light performance into their manufacturing criteria and develop enhanced Cuts based on light performance as well as proportions and symmetry, will be released in Advisor™ 7.0, scheduled for mid-2017.

    • Non-diamond gemstones: See paragraph [h] above.