Business Review

The Business: Adding Value to Diamonds

The Diamond Industry

Diamonds have long been regarded as symbols of love, commitment and eternity. Consistent advertising campaigns by the diamond industry have successfully reinforced these emotions among consumers. Worldwide retail sales of diamond jewellery have been growing consistently for the past 20 years and surpassed US$68 billion in 2006. This buoyant retail market drives a stable industry of mining, processing, certification and trading, on which our Group capitalises.

Unprocessed diamonds go through a series of planning, sawing (cutting), shaping (sometimes, if round, referred to as "bruting"), polishing (faceting) and fine-polishing processes to turn them into retail-ready polished diamonds. Traditionally, the manner in which diamonds were processed into polished ones was done manually by a small group of skilled experts. Historically, this led to diamond processing activity being concentrated, after World War II, in Belgium, Israel and the USA.

We believe Sarin has revolutionised the diamond manufacturing industry by introducing computer-based technology to automate many of the processes of this highly concentrated expertise. This has, in turn, contributed to the migration of the manufacturing to lower-cost areas, primarily India and China. Russia, to a degree, and, more so currently, the southern African countries are also emerging as centres for diamond processing, due to government legislation and investment incentives, requiring domestically mined diamonds to be processed domestically. The diamond cutting industry's turnover was valued at approximately US$19 billion in 2006.

The cost of unprocessed diamonds is extremely high. Hence even single digit percentage yield increases or cost savings translate into significant impact on profits. Thus, the global diamond industry has proven eager to invest in yield-increasing or cost-saving technologies that have been proven to be reliable and efficient.

Similarly, because of the high value of polished diamonds, adhering to the established standards of quality, as measured by a diamond's so-called four Cs (Carat, Colour, Clarity and Cut) is important. The results typically obtained from the manual grading inspection of a diamond often vary, depending on the expert conducting the evaluation. Thus, again, technology has evolved as a major contributor to the industry's grading standardization.

Our Markets

Traditionally, the major diamond manufacturing and trading centres in the world have been in Israel and Belgium. Today, India is by far the leading manufacturing centre, accounting for over 90% of all stones manufactured worldwide (by quantity). China is now the second most important manufacturing centre globally, with many new plants being set up by international players, primarily from Belgium, USA and India. The southern African countries are fast emerging as a major manufacturing centre due to legislation enacted to limit the export of unpolished diamonds and government incentives to develop the domestic polishing industry in these countries.

Sarin has a market presence in both established and emerging diamond manufacturing centres. A key development for us in 2004 was the establishment of Sarin India, our wholly-owned subsidiary. With operations in the key diamond processing centres of Mumbai and Surat, we now have full control over the business direction and marketing of our products in the Indian market.

The emerging diamond manufacturing centres of southern Africa and China represent strategic markets for our products with significant growth potential. Sarin has taken and is taking steps to strengthen its market presence in these emerging markets, with the appointment of an agent in South Africa in 2005 and expansion into Botswana in 2008, the establishment of a subsidiary in Hong Kong in 2006 and the expected establishment of another subsidiary in China in 2008. Over the next few years, we expect our sales and profits from these regions to grow, as we aggressively enhance our market presence therein. We will continue to monitor these and other potential emerging markets closely in order to capitalise on new business opportunities.

Intellectual Property

The products we develop are proprietary in nature. Hence, our ability to remain competitive in the market is dependent, in part, on our ability to protect our proprietary intellectual property in general, and our software in particular. To facilitate the protection of these proprietary intellectual rights, we have registered several patents and trademarks in countries key to our business worldwide and several additional patent and trademark applications are in various registration phases. As is normal, several of our patents and trademarks have been disputed by other, competing, players in the industry.

Objectives

The Group's main objectives for FY2008 and beyond are:

• Adding value to our shareholders by growing our business in terms of sales and profit in the diamond industry;
• Becoming a one-stop-shop for the technological needs of the worldwide diamond industry.

Strategy

To realise these objectives, the Group plans to execute these strategies:

• Incorporate products and services in our offerings that will bring solutions to those facets of the industry not currently addressed by our existing offerings;
• Incorporate products and services in our offerings that generate recurring income - a counter-balance to our existing revenues, which are predominantly from the sale of capital equipment, as has been our traditional business model;
• Distribute our business more evenly between the rough diamond manufacturing and trading industry, which currently accounts for a predominant part of our business, and the polished diamond trading, grading and retail market;
• Expand and strengthen our business in mature markets like India, Europe, and USA, while developing our business in emerging markets like the southern African countries, China, and Russia.

Performance Indicators

Non-financial Indicators

We use the following non-financial indicators to assess our Group's performance year-on-year and against our competition's performance:

Financial Indicators

We use the following financial indicators to assess our Group's performance year-on-year and against our competition's performance:

Operating Review

Opportunities

Market-driven Opportunitie

• As a result of the southern African governments' policies, of increased incentivising domestic diamond polishing activities, there has been and is an ongoing emergence of a major manufacturing centre in that region. This has created more opportunities for the sale of our products to this market. Management believes this trend will continue into FY2008. This may, in the longer term, have a marginal impact on other manufacturing centres (primarily India), as the sourcing of higher-quality rough diamonds becomes more limited.
• Ongoing investments in automation in the diamond manufacturing industry will continue, as the overall drive to increase yield and productivity remains a key concern, even more so as the access to higher-quality rough diamonds becomes more constrained. Emphasis remains focused on investing in yield and productivity enhancing tools and systems. We believe that the DiaExpert Nano system and the Quazer have the potential to realise significant revenues as they directly address this key concern.
• Consumer confidence in diamonds' authenticity and quality is increasingly becoming an issue for jewellery retailers worldwide. This is especially true in the US, which, it is estimated, accounts for nearly 50% of all jewellery sales. Additional marketing efforts will be targeted at the U.S. diamond retail market, to expand sales of our polished diamond grading and branding products DiaScan S+, DiaScribe and Colibri, to this market segment
• Online sales of polished diamonds are growing rapidly and management believes this trend will continue to create a more transparent pricing environment for diamonds at all levels of the trading pipeline. Having secured, as previously reported, an agreement to acquire 23% of IDEX Online, an internationally-recognized operator of a B2B polished diamond traders' network, the Company is closely following the current trends of online diamond trading and indexes, as IDEX Online is well positioned to bring innovative trading tools to our industry and has specific business goals to capitalise on these trends.

Company-driven Opportunities

• As relates to our core family of rough planning products, Sarin has introduced the DiaExpert Nano system for the highthroughput planning and marking of small stones. This is a significant market niche within the diamond manufacturing industry, primarily in India, and was not adequately addressed by the Company until the introduction of this product. We expect to continue enhancing this product, which is aimed at achieving even higher productivity, thus enhancing its value for our customers. Similarly, we intend to introduce new hardware and software enhancements to our rough planning products which will increase the productivity and yield, thus creating a market for upgrades to our installed base of planning products. Finally, for that segment of our customers who need a mobile solution for assessing large stones, we will be introducing later in 2008 a new version of the DiaMobile to handle larger rough goods, to be named the DiaMobile XL.

Company-driven Opportunities (cont'd)

• The Company plans to introduce several software enhancements to the DiaVision software in order to increase its potential benefit to diamond retail chain stores.
• We intend to further enhance our Quazer green laser cutting and shaping product in the coming year with advanced hardware and software aimed at increasing throughput, improving yield and reducing breakage rates. The Company plans to develop a setup station directly linked to our planning systems, to improve the system's performance in general and specifically to increase its productivity (as measured in number of stones processed per hour) which will result in the increased cost-effectiveness of Quazer to our customers when compared to competing products. This, we believe, will create an even better value proposition for our customers with the installed base of our planning systems when choosing the Quazer (and vice versa). Our striving to make the laser itself ever better will continue at our American supplier's facilities in the U.S., as well as at Sarin's research & development centre.
• Sales and marketing efforts in 2008 will continue to focus on retaining our market share in India, while increasing it in emerging markets in the southern African countries and China, as well as in the more established markets, such as Russia and Belgium.

Risk Factors

• The macro-economic outlook in the U.S., still the key market for polished diamonds, remains uncertain, with the possibility of a decrease in growth, or even a recession, a concern. Consumer spending on luxury items would probably be affected by a recession, should one occur.
• Recent currency exchange rate fluctuations may have an adverse effect on our business in the following ways: (a) the strengthening of the Indian Rupee against the U.S. Dollar may impair our Indian customers' profitability and purchasing power; and (b) the strengthening of the New Israeli Shekel against the U.S. Dollar may impact the Group's profitability, as some of its expenses (mostly on human resources) are paid in this currency
• Overall sales of our existing diamond-planning and cut-grading products expanded nicely in 2007 in comparison to those realized in 2006, thus bolstering Management's opinion that market saturation is still not an issue at this time. However, the continued investment in automation and modernisation by diamond manufacturers in India and elsewhere may be affected by global and/or local economic conditions, and thus may impact continued sales of our products to this key sector.
• We may be unable to protect our proprietary technology: Our success and ability to compete are substantially dependent on our proprietary technology. The steps that we have taken to protect our proprietary rights may not be adequate and we might not be able to prevent others from using what we regard as our technology. If we have to resort to legal proceedings to enforce our proprietary rights, the proceedings could be costly and we may not be able to recover our expenses.
• We may be subject to claims by others regarding infringement of their proprietary technology: Litigation over intellectual property rights exists in the industry. In addition to our outstanding legal proceedings, we may in future be subject to other claims.
• There is no assurance that our future plans will be commercially successful: As part of our business plan, we intend to develop new product lines, new products in existing product lines and to expand our marketing and sales efforts in key geographical markets. There is no assurance that such expansion plans will be commercially successful. If we fail to achieve a sufficient level of revenue or if we fail to manage our production costs effectively, we will not be able to recover our costs and our future financial position and performance may be materially and adversely affected.
• The location of the Company in Israel, and the concentration of its research and development and manufacturing activities there, remains a security risk factor.

Financial Review

Cash Flow

The Company's business activities throughout 2007 resulted in a positive cash flow. Sarin opened the fiscal (and calendar) year 2007 with cash reserves and short-term investments of US$ 23.4 million and ended the year with reserves totalling US$ 25.3 million. These reserves are after paying out in excess of US$ 6 million in dividends to its shareholders. This serves as a testament to the financial strength of the Company.

Cash Management and Liquidity

Throughout 2007 the Company maintained cash reserves higher than needed for the financing of ongoing activities. The policy dictated by the Board for the management of these cash surpluses is to invest them in low-risk short-term US Dollar-denominated interest-bearing instruments with high liquidity. A portion of the cash surpluses has thus been invested in short-term dollarlinked interest-bearing bank deposits. Another portion of the reserves has been invested in short-term high-grade bonds and commercial papers, which yielded slightly higher interest rates. Financial instruments held are classified as current assets. When the cash and cash-equivalent balances are analysed and compared to the annual cash requirements needed for the financing of the ongoing business activities of the Company, one finds that the Company has strong liquidity.

Accounting Policies

The financial statements are prepared in accordance with the International Financial Reporting Standards - IFRS, as revised from time to time. A number of new standards, amendments to standards and interpretations are not yet effective for the year ended 31 December 2007, and have not been applied in preparing the financial statements. Refer to Note 2V (New standards and interpretations not yet adopted) of the Financial Statements for complete details.

The financial statements are presented in United States Dollars, rounded to the nearest thousand. Transactions in foreign currencies are translated at the foreign exchange rate ruling at the date of the transaction. Monetary assets and liabilities in foreign currencies are translated into United States Dollars at rates of exchange approximate to those ruling at the balance sheet date. Foreign exchange differences arising on translation are recognized in the income statement. Non-monetary assets and liabilities are measured in terms of historical cost in a foreign currency and are translated using the exchange rate at the date of the transaction.

Revenue from the sale of goods is recognized in the income statements when the significant risks and rewards of ownership have been transferred to the buyer. No revenue is recognized if there are significant uncertainties regarding recovery of the consideration due, associated costs or the possible return of goods, or when the amount of revenue and costs incurred or to be incurred in respect of the transaction cannot be measured reliably. Service revenues from product maintenance contracts and separately priced extended warranty contracts are generally recognized rateably over the contract period.

The financial statements are prepared on the historical cost basis except that short-term investments are stated at their fair value. Items of property, plant and equipment are stated at cost less accumulated depreciation and impairment losses. Depreciation is charged to the income statement on a straight-line basis over the estimated useful life of each part of an item of property, plant and equipment. Know-how is stated at cost less accumulated amortisation and impairment losses.

Expenditure on research activities, undertaken with the prospect of gaining new scientific or technical knowledge and understanding, is recognized in the income statement as an expense as incurred. Inventories are stated at the lower of cost and net realisable value. Net realisable value is the estimated selling price in the ordinary course of business, less the estimated costs of completion and selling expenses. Financial instruments held for trading are classified as current assets and stated at fair value.

The preparation of financial statements, in conformity with the IFRS, requires management to make judgments, estimates and assumptions that affect the application of policies and reported amounts of assets and liabilities, income and expenses. The estimates and associated assumptions are based on historical experience and various other factors that are believed to be reasonable under the circumstances. The results of these forms the basis of making the judgments about carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates. The estimates and underlying assumptions are reviewed on an ongoing basis. Revisions to accounting estimates are recognized in the period in which the estimate is revised, if the revision affects only that period, or in the period of the revision and future periods, if the revision affects both current and future periods.

The accounting policies set out in our yearly financial reports have been applied consistently to all periods presented in these consolidated financial statements. The accounting policies have been applied consistently to all Group entities. The financial statements of subsidiaries are included in the consolidated financial statements from the date that control commences until the date that control ceases. Intra-group balances and any unrealised gains and losses or income and expenses arising from intra-group transactions, are eliminated in preparing the consolidated financial statements.

For more information on our accounting policies and related explanations, please refer to our Consolidated Financial Reports.

Shareholder Return

Sarin is a profitable company. During 2007 the Company earned US$ 8.0 million, equivalent to basic earnings per share of US$ 0.032.

The Group's dividend policy provides for the distribution of at least 38% of its net earnings as a dividend to its shareholders. For 2007 the Company has paid (in September and December 2007) interim dividends totalling US$ 0.0165 per share, totalling US$ 4.2 million.