<Page>


                        LAZARE KAPLAN INTERNATIONAL INC.

                                      2006
                                  ANNUAL REPORT

                                        1




<Page>


               Lazare Kaplan International Inc. 2006 Annual Report

Lazare Kaplan International Inc. is engaged in the cutting and polishing of
ideal cut diamonds, which it laser inscribes and distributes to quality retail
jewelers internationally under the brand name "Lazare Diamonds(R)" Diamonds,
whatever their size, which are cut and polished by Lazare Kaplan craftsmen, are
finished to precise proportions, bringing out all of the diamond's natural
brilliance, sparkle and fire. In addition, Lazare Kaplan also cuts and polishes
fine make (non-ideal) commercial diamonds and high pressure, high temperature
(HPHT) processed diamonds sold under the Bellataire(R) diamonds brand name.
These stones are sold through wholesalers and distributors and, to a growing
extent, through retail jewelers. Lazare Kaplan is also engaged in the buying and
selling of uncut rough diamonds.

                             American Stock Exchange

  The Company's common stock is traded on the American Stock Exchange under the
                               ticker symbol LKI.

                                    Form 10-K

Upon written request, a copy of the Company's Form 10-K Annual Report without
exhibits for the year ended May 31, 2006 as filed with the Securities and
Exchange Commission, will be made available to stockholders without charge.
Requests should be directed to the Controller, Mr. Ned Cochrane, Lazare Kaplan
International Inc., 19 West 44th Street, New York, New York 10036.

                                 Annual Meeting
                                November 10, 2006
                                     10 A.M.
                                  Sofitel Hotel
                               45 West 44th Street
                          Second floor, Trocadero Room
                            New York, New York 10036

                 Market Prices of Common Stock by Fiscal Quarter

                                                       Fiscal 2006
                                                     ---------------
                                                      High      Low
                                                     ------   ------
            First ................................   $11.65   $ 8.55
            Second ...............................    10.95     8.12
            Third ................................     8.95     7.40
            Fourth ...............................     8.79     7.58

                                                       Fiscal 2005
                                                     ---------------
                                                      High      Low
                                                     ------   ------
            First ................................   $ 8.89   $ 7.25
            Second ...............................    10.40     6.95
            Third ................................    10.98     8.85
            Fourth ...............................    12.55     7.51

As of July 31, 2006 there were 1,716 stockholders of record of the 8,197,134
issued and outstanding shares of the common stock of the Company, including CEDE
& Co. and other institutional holders who held an aggregate of 3,342,915 shares
of common stock as nominees for an undisclosed number of beneficial holders.

                                        2




<Page>


To Our Shareholders:

       The Company's revenue in fiscal year 2006 was $528,045,000 compared to
$421,411,000 in fiscal 2005. Net profit was $1,528,000 in fiscal year 2006
compared to $5,230,000 in fiscal 2005.

       2006 was a challenging year for the Company as well as for the industry
as a whole. The changes in the macroeconomic environment, brought about by the
decision of the Federal Reserve Bank and other Central Bankers to gradually
shift from a stimulative accommodating monetary policy and low interest rates to
a more restrictive posture draining liquidity and raising interest rates, had
its impact on discretionary spending by consumers, dampening their spending
patterns and their willingness to incur further debt. This resulted in more
conservative buying and restocking by our jeweler customers, as well as
industry-wide liquidity issues that require careful and prudent attention from
the Company's management.

       In last year's letter to shareholders we pointed out that while the
structural transformation of the diamond industry from its historic supply-
driven anchor to an increasingly demand-driven business - including the
elimination of the buffer stock regulator and the consequent increase in price
volatility - was progressing well - in fact, better than expected - the new
dispensation taking its place had yet to be tested by a cyclical downturn and
its consequences. While the downturn the industry is now feeling was not
entirely unexpected, as it is part and parcel of the normal business cycle, it
is putting structural strains as well as cyclical strains on the industry.
Pressures previously masked by the benign macroeconomic environment of the last
several years that is coming to an end are now becoming apparent. So far these
structural strains primarily have manifested themselves in the downstream
manufacturing and distribution segments of the pipeline. For some time now,
these segments have suffered from inadequate operating margins and excessive
leverage. While this reality is painful to the companies operating in those
segments, a dysfunctional pipeline will in time affect the other segments of the
business. Although the structural issues are more fundamental in nature the
immediate triggering events were a series of unjustified and excessive price
increases by rough diamond producers driven by cyclical euphoria that could not
be translated into higher prices for polished diamonds and an exceptionally
accommodating lending policy by banks financing the industry pipeline. As the
present situation is unsustainable it is bound to self-correct or require
important structural industry-wide adjustments. All the industry's stakeholders,
i.e., producing countries, mining companies, and banking institutions that
finance the pipeline as well as the manufacturing segments have a vital stake in
how and over what period of time the corrective measures play out. The Company
views these challenging times as a welcome opportunity to recalibrate industry
structures and business plans to better deal with future opportunities. In
summary, the Company is navigating with care and prudence through the shoals
exposed by this cyclical downturn, while it vigorously pursues and builds on
upstream and downstream opportunities aligned with our vision of how the
industry restructuring will eventually evolve.

       The Company continues to receive high marks as a Diamond Trading Company
(DTC) sightholder. As the measurement criteria are aligned with the Company's
historic commitment to global downstream marketing, branding, quality service,
strong balance sheet, best practices and transparency, the Company continues

                                                                               3





<Page>


to receive a high ranking under the DTC's Supplier of Choice (SOC) program. The
Company expects that the SOC program will have to be recalibrated to reflect the
industry wide structural strains, including the changing relationships between
the major producing countries of Botswana, Namibia and South Africa with the
London based DTC, to reflect the more vigorous implementation by these producing
countries of their policies on local beneficiation and employment, as well as
their desire for greater input on how these depleting natural resources are
developed and on the benefits that these countries derive from them. The Company
is well positioned in these countries to participate in and to contribute
constructively to the evolution of these developments.

       The Government of Botswana has granted the Company one of several
licenses it recently issued for setting up cutting and polishing factories in
that country. The issuance of the license was based on a viable multi-year
business plan submitted to and approved by the Government. The Company is in the
process of setting up local management - it has selected retired Ambassador
Alfred Dube as its Managing Director, - acquiring suitable land in the capital
city of Gaborone and drawing up the plans for construction of a state-of-the-art
facility. The Company is aligning the implementation of its investment,
manufacturing and marketing policies with the publicly stated objectives of
Botswana, - the world largest and lowest cost rough diamond producer - to
enhance local beneficiation and, in time, to become the center of gravity for
the diamond industry.

       Good progress continues to be made in implementing the Company's
Cooperation Agreement with NamGem - Namibia's flagship cutting and polishing
plant. The transfer of technical and marketing skills is proceeding apace, and
the trained professional workforce under the effective leadership of a
well-qualified Namibian Managing Director, Eliphas Hawala, is successfully
polishing increasingly larger sizes of diamonds to LKI's demanding quality
standards. In conjunction with the terms of the $25 million financing facility
now in the final stages of negotiations with the US Government's Overseas
Private Investment Corporation (OPIC), the Company is in the process of securing
a long-term supply commitment for suitable rough for NamGem. Under the terms of
its Cooperation Agreement with NamGem, the Company has the option to acquire an
equity holding in NamGem and notice to that effect has been given to the
existing shareholders. The Company is also giving serious consideration to an
expansion of the existing facility - a decision that is linked to commitment of
rough diamond supplies adequate to justify the investment. The Company is
contemplating the creation and marketing of high quality Namibian brand
diamonds, if and when the sourcing of appropriate rough diamonds makes such a
project possible. The Government of Namibia has been, and continues to be, very
supportive of the Company's initiatives, as their prompt and successful
implementation is closely aligned with the Namibian Government's development and
employment policies.

       In South Africa, the agreement with Nozala Investments (Pty.), a broadly
based women's empowerment investment group, is successfully being implemented
under the leadership of its South African Managing Director, Ms. Noluthando
Poswa, and with effective technical and marketing support from the Company.
Nozala is now regularly cutting and polishing large-size rough diamonds (+10.8
carat and larger) to world-class standards. Nozala is in discussion with the
Government of South Africa and with its rough suppliers on expansion of its
operation. An apprentice training program is now in place to prepare for this
planned expansion.

                                                                               4





<Page>


       Following several years of peace, and with the stimulus of higher oil
prices, the Angolan economy is now growing at a rapid rate. Much remains to be
done, but there are visible signs of economic, social and infrastructure
development taking place in Angola. This is a welcome development, and the
Company's in-country activities are growing in scope and importance. They are
widening from our initial Technical Assistance Contract with Sodiam, - the
Angolan Government parastatal legally responsible for marketing Angolan rough
diamonds, - calling for staffing and operating of buying stations and marketing
of a portion of the diamonds produced in the informal sector, to participation
in ventures marketing diamonds produced by the Angolan formal sector and seeking
to secure exploration and mining rights for attractive Kimberlitic prospects.
In addition to these direct investments in the diamond sector of the economy,
the Company is making a substantial investment in Angola's post-war
reconstruction efforts. The Company has taken the lead with US AID and F.A.S.
(a self-standing, not for profit organization funded by the World Bank) in
organizing and funding a multi-year social responsibility program in Lunda
Norte. The work of this consortium will be managed in a transparent and
hands-on manner by a competent N.G.O. familiar with the area, after
consultation with the local population and the Angolan authorities. The
selected projects will focus on reconstruction and on improving the quality
of life of the people in Lunda Norte.

       The Company's operations in Russia, under existing long-term agreement
with A.K. Alrosa, that country's primary diamond producer, continue to be
successfully implemented. With the decision by the Government of the Russian
Federation to increase its shareholding in AK Alrosa to a majority stake, the
termination over the next few years at the behest of the European Competition
Authority of the A.K. Alrosa-DeBeers rough diamond marketing agreement, and
the pending legislation liberalizing the Russian diamond business, the Company
expects to see changes in the way Russia - the world's second largest rough
diamond producer - comes to market with its considerable diamond production. At
the appropriate time and level the Company expects to review and explore the
opportunities that these changes present, taking into account and building on
the successful track record the Company has developed with A.K. Alrosa over the
last decade.

       The Company expects that several, if not all, of the projects in various
stages of implementation will qualify for financing under the Framework
Agreement the Company signed with The Overseas Private Investment Corporation
(OPIC) for financing diamond beneficiation and mining projects in Angola,
Botswana, Namibia, Russia and South Africa.

       In order to be in a position to benefit from these developments, the
Company continues to enhance and build its rough trading capacity and
relationships. As this year's performance indicate rough diamond trading is an
increasingly important self-standing profit center, as well as an optimization
regulator for the rough diamonds the Company selects for production in its
various cutting and polishing operations.

       In order to vigorously pursue greater market share for its premium
quality product the "Lazare Diamond, The World's Most Beautiful Diamond(R)," as
well as the high

                                                                               5





<Page>


quality commercial diamonds now part of the Company's broader product offering,
the Company continues to strengthen and deploy management resources to focus on
a robust hands-on campaign to improve relationships with existing customers by
adding value to our offering, to develop and nurture new markets domestically
and overseas, and to improve the quality and relevance to our customers of our
extensive inventory as well as to improve inventory turns and overall
productivity. Although the present downturn presents operating challenges that,
in all likelihood will be with us for some time, improvements in many areas of
the Company's performance and enhanced productivity are noticeable, and the
Company will continue to drive these measures as hard as possible.

       While continuing to pursue the strategic opportunities outlined at the
outset of this message, management remains focused on its short-term operations
and seeks to improve operating margins, control expenses and achieve a better
return on capital employed. The industry's liquidity problems also call for
vigilant attention, and the Company will continue to manage credit, accounts
receivable and consignment exposures with prudent conservatism.

       The Company has rationalized and simplified its jewelry offering in the
United States and abroad. The Company expects to drive that segment of the
business, as well as accelerate the rollout of LKI boutiques and self-standing
stores - an initiative that has shown considerable success, particularly in
Southeast Asia.

       The Company is implementing its agreement with LJ Superabrasives Holdings
Inc. (who in 2004 acquired an interest in Bellataire(R) operations from General
Electric Company). Progress is being made in the management and marketing areas
while further work needs to be done to augment the sourcing of suitable
material.

       Over many years the Company has made many important scientific and
technical discoveries, on its own and with others, that have commercial
application in different areas of the diamond and diamond-related industries. At
a time when national and corporate comparative advantage is increasingly
knowledge based, the Company views its patent portfolio as a valuable asset of
its shareholders. To protect this asset, the Company recently commenced legal
action against Photoscribe Technologies Inc. for what it believes are
infringements of the Company's patents for diamond laser inscription. The
Company is determined to pursue its case vigorously in the courts and to seek
legally enforceable remedies against Photoscribe and others that are infringing
on what the Company believes to be its intellectual property.

       The Company's manufacturing facility in Puerto Rico, recently refurbished
and re-equipped with the latest state-of-the-art technology, continues to take
the lead in precision diamond polishing that distinguishes the "Lazare Diamond,
The World's Most Beautiful Diamond(R)" from other diamonds. The Puerto Rico
facility and its skilled professional staff also continue to provide the
reservoir of human resources required to implement the expanding number of
manufacturing facilities in Russia, Namibia and other diamond producing
countries.

       In line with the policies of transparency required of publicly listed
corporations and the new legislation, regulations and practices applicable to
the diamond industry, the Management of the Company spends considerable time and
resources on compliance to ensure that best

                                                                               6





<Page>


practices are built into the way it does business. An internal review process is
in place, reinforced by regular educational seminars, and a full-time compliance
officer ensures that everyone employed by the Company is sensitive to these
requirements and that they are reflected in how and with whom the Company does
business. The Company's activities are in compliance with the Kimberley Process
Certification Scheme, the World Diamond Council's System of Warranties and the
provisions of the USA Patriot Act. As a founding member of the UN Global
Compact, it adheres to the GC's ten governing principles. It is also the
Company's policy to encourage its management and employees to participate
in social and development activities that benefit broader society in the
countries where it operates.

       We greatly value the dedication, professionalism and hard work of our
employees in the many countries in which we do business. We respect and
appreciate all you do and how you do it.

/S/Maurice Tempelsman                              /S/Leon Tempelsman

Maurice Tempelsman                                 Leon Tempelsman
Chairman of the Board                              Vice Chairman of the Board

                                                                               7





<Page>


                             Selected Financial Data

<TABLE>
<CAPTION>
----------------------------------------------------------------------------------------------------------------------
(In thousands, except share and per share data)            2006        2005        2004        2003          2002
----------------------------------------------------------------------------------------------------------------------
<S>                                                     <C>         <C>         <C>         <C>           <C>
Net sales                                               $ 528,045   $ 421,411   $ 235,775   $ 203,159     $ 189,548
----------------------------------------------------------------------------------------------------------------------

Income/(loss) before income tax provision/(benefit)
   and cumulative effect of change in accounting
   principle                                            $     766   $   7,870   $   3,273   $   3,256     $  (1,842)
----------------------------------------------------------------------------------------------------------------------

Income/(loss) before cumulative effect of change
   in accounting principle                              $     766   $   7,870   $   2,399   $   2,066     $  (1,226)
----------------------------------------------------------------------------------------------------------------------

Net income/(loss)                                       $   1,528   $   5,230   $   2,399   $   1,094 (2) $  (1,226)
----------------------------------------------------------------------------------------------------------------------

Basic earnings/(loss) per share before cumulative
   effect of change in accounting principle (based on
   the weighted average number of shares)               $    0.18   $    0.62   $    0.28   $    0.24     $   (0.16)
----------------------------------------------------------------------------------------------------------------------

Basic earnings/(loss) per share (based on
   weighted average number of shares)                   $    0.18   $    0.62   $    0.28   $    0.13     $   (0.16)
----------------------------------------------------------------------------------------------------------------------

Diluted earnings/(loss) per share before cumulative
   effect of change in accounting principle (based on
   the weighted average number of shares)               $    0.18   $    0.60   $    0.28   $    0.24     $   (0.16)
----------------------------------------------------------------------------------------------------------------------

Diluted earnings/(loss) per share (based on
   the weighted average number of shares)               $    0.18   $    0.60   $    0.28   $    0.13     $   (0.16)
----------------------------------------------------------------------------------------------------------------------
At May 31:
Total assets                                            $ 263,712   $ 250,284   $ 180,712   $ 160,411     $ 147,987
----------------------------------------------------------------------------------------------------------------------
Long-term debt                                          $  64,176   $  60,000   $  34,726   $  16,756     $  12,089
----------------------------------------------------------------------------------------------------------------------
Working capital                                         $ 143,724   $ 141,556   $ 110,599   $  90,175     $  83,457
----------------------------------------------------------------------------------------------------------------------
Stockholders' equity                                    $  95,796   $  96,305   $  92,416   $  90,207     $ 90,106 (1)
----------------------------------------------------------------------------------------------------------------------
</TABLE>

Note: No cash dividends were declared or paid by the Company during the past
five fiscal years.

(1)   Reflects the effect of the private sale of 1,305,000 shares of common
      stock, consisting of 1,180,000 of previously repurchased treasury shares
      and 125,000 authorized but unissued shares. Proceeds from the sale were
      approximately $11.5 million (net of costs).

(2)   Includes $1.0 million (net of tax) charge for the cumulative effect of a
      change in accounting principle.

                                                                               8




<Page>


                      Management's Discussion and Analysis

      This Annual 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 herein 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, 2006. 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 Annual Report or to reflect the occurrence of other
unanticipated events.

      This discussion and analysis should be read in conjunction with the
Selected Financial Data and the audited consolidated financial statements and
related notes of the Company contained elsewhere in this report. In this
discussion, the years "2006", "2005" and "2004" refer to the fiscal years ended
May 31, 2006, 2005 and 2004, respectively.

Overview

      The Company is engaged in the cutting, polishing and selling of ideally
proportioned diamonds which it markets internationally under the brand name
"Lazare Diamonds(R)". Ideally proportioned diamonds are distinguished from
non-ideal cut ("commercial") diamonds by the symmetrical relationship of their
facets, which optimize the balance of brilliance, sparkle and fire in a polished
diamond. The Company's domestic manufacturing facility, located in Puerto Rico,
is believed by the Company to be the largest diamond cutting facility in the
United States. 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 Company has been a client of the DTC for
approximately 60 years. The Company supplements its rough diamond needs by
secondary market purchases and has entered into relationships with other primary
source suppliers.

      The Company has a technical assistance and cooperation 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 the first fiscal quarter of
2005. During the third fiscal quarter of 2006 the Company's rough buying
operations expanded to include buying in the Angolan formal sector. The Company
is currently negotiating a further expansion and restructuring of its Angolan
operations to include exploration, development and distribution through various
joint ventures.

      The Company has an agreement 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.
Production under this agreement commenced during the third quarter of 2004. The
Company continues its efforts to develop additional sources of rough diamonds,
including potential opportunities in Africa.

      In November of 2004 the Company signed 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

                                                                               9




<Page>


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 the third
fiscal quarter of 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.

      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
high pressure, high temperature (HPHT) process to improve the color of certain
gem diamonds without reducing their all-natural content. POL sells diamonds that
have undergone the HPHT process under the Bellataire(R) 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.

Results of Operations

2006 Compared to 2005

Net Sales

      Net sales in 2006 of $528.0 million were $106.6 million or 25% higher than
net sales in 2005.

      Polished diamond revenues in 2006 were $149.8 million, as compared to
$156.9 million in 2005. This decrease reflects lower sales of branded diamonds
partially offset by increased sales of fine cut commercial diamonds. Factors
leading to the decrease in polished sales include an overall slowing of the U.S.
economy, liquidity concerns throughout the diamond and jewelry distribution
chain, reluctance on the part of U.S. retailers to take stock positions prior to
the start of the 2006 holiday season, and market resistance to price increases
the Company seeks to pass through to customers.

      Rough diamond sales in 2006 were $378.2 million, an increase of $113.8
million over 2005. The increase in rough diamond sales is primarily related to
an increase in the Company's Angolan rough buying and trading operations. This
increase also reflects an increase in the supply of rough diamonds made
available to the Company by other rough diamond producers.

Gross Profit

      During 2006 gross margin on net polished sales was 13.8% compared to 16.2%
in 2005. The decrease in polished gross margin reflects a shift in sales mix
toward lower margin fine cut commercial diamonds, and sales incentives offered
to liquidate slower moving commercial diamond inventory compared to the prior
year.

      Rough gross margin during 2006 was 2.4% compared to 3.5% in the prior
year. The decrease in rough gross margin percentage reflects increased rough
costs and associated fees charged by diamond producers at a time of excess
supply and soft demand from diamond manufacturers.

      As a result of the foregoing, overall gross margin percentage during 2006
was 5.7% compared to 8.2% in 2005.

                                                                              10




<Page>


Selling, General and Administrative Expenses

      Selling, general and administrative expenses for 2006 were $24.8 million,
as compared to $24.5 million for 2005. The increase for 2006 reflects legal,
consulting and other costs associated with the negotiation and implementation of
sourcing and manufacturing operations in Southern Africa. Additionally, the
increase in costs reflects expenses incurred in connection with the
renegotiation of certain agreements relating to the manufacture and distribution
of Bellataire diamonds and the settlement of certain third party obligations
related thereto. Amounts expensed are net of $1.5 million which a third party
has agreed to pay the Company in connection therewith.

Interest Expense

      Interest expense for 2006 was $3.8 million, as compared to $2.4 million
for 2005. This increase primarily reflects increased levels of borrowing and
higher interest rates during 2006. Increased borrowings during 2006 primarily
related to the expansion of rough sourcing in Angola and cutting and polishing
operations in Namibia.

Equity in (income) / loss of joint ventures

      During 2006 the Company entered into several joint venture agreements
relating to sourcing, cutting, polishing, processing and sales of diamonds. The
Company's share of initial operations aggregated a loss of approximately $0.5
million.

Income Tax

      The Company's 2006 income tax benefit reflects its ability to carryforward
certain operating losses for U.S. income tax purposes, offset in part by tax
expense attributable to the repatriation of certain previously untaxed
accumulated foreign earnings. The tax provision for 2005 generally approximated
the U.S. statutory federal income tax rate.

Earnings Per Share

      Basic and fully diluted earnings per share for 2006 were each $0.18. Basic
and fully diluted earnings per share for 2005 were $0.62 and $0.60,
respectively. Basic earnings per share is computed based upon the weighted
average number of common shares outstanding. Diluted earnings per share include
the impact of dilutive stock options.

2005 Compared to 2004

Net Sales

      Net sales in 2005 of $421.4 million were $185.6 million or 79% higher than
net sales in 2004.

      Polished diamond revenues in 2005 were $156.9 million, as compared to
$142.7 million in 2004. The increase in polished sales primarily reflects
increased sales of branded diamonds and jewelry. The increase in branded sales
largely reflects growth of jewelry and loose Lazare Diamonds to both new and
existing Southeast Asia based customers. Factors leading to this increase
include greater brand awareness resulting from increased advertising and an
overall strengthening of regional economies.

      Commencing in the third quarter of fiscal 2004, the Company's sourcing
included material relating to its cooperation agreement with NamGem for the
cutting and polishing of diamonds in Namibia.

      Rough diamond sales in 2005 were $264.5 million, an increase of $171.4
million over 2004. The increase in rough diamond sales is primarily related to
the commencement of Angolan rough buying

                                                                              11




<Page>


and trading operations during the first fiscal quarter of 2005. The 2005
increase also reflects an increase in the supply of rough diamonds made
available to the Company by other rough diamond producers. The increase in
supply from producers reflects, among other things, the Company's competitive
strength and its quality reputation in the industry. The Company's supply of
rough diamonds also increased during 2005 as a result of an increase in its
allocation of stones associated with the Company's cooperation agreement with
NamGem.

Gross Profit

      During 2005 gross margin on net polished sales was 16.2% compared to 15.3%
in 2004. The increase in polished gross margin reflects increased sales of
higher margin branded diamonds and jewelry partially offset by a decrease in
margins earned on increased sales of fine commercial make diamonds (which
typically carry a lower gross margin than branded diamonds). The decline in
gross margin on fine commercial make diamonds reflects increased rough diamond
prices which the Company was unable to fully pass through to customers during
the year.

      Rough gross margin during 2005 was 3.5% compared to 4.6% in the prior
year. The decrease in rough gross margin percentage primarily reflects the
commencement of Angolan rough buying operations which are not expected to
contribute to the Company's rough gross margin during its first year of
operations. Offsetting the dilutive margin impact of Angolan rough sales, the
Company's aggregate rough gross margin from all other sources increased during
2005 reflecting an improvement in the overall market conditions for the
categories of stones the Company trades.

      As a result of the foregoing, overall gross margin percentage during 2005
was 8.2% compared to 11.1% in 2004.

Selling, General and Administrative Expenses

      Selling, general and administrative expenses for 2005 were $24.5 million,
as compared to $22.0 million for 2004. The increase for 2005 reflects increased
advertising, personnel and related costs directed toward expanding sourcing and
supporting the distribution of branded diamonds, jewelry and fine commercial
make polished diamonds.

Interest Expense

      Interest expense for 2005 was $2.4 million, as compared to $0.9 million
for 2004. This increase primarily reflects increased levels of borrowing and
higher interest rates during 2005. Increased borrowings during 2005 primarily
related to the expansion of rough sourcing and cutting and polishing operations.

Income Tax

      The Company's effective tax rate for 2005 was 33.5% as compared to 26.7%
for the prior year. This increase is primarily attributable to an increase in
the percentage of income earned in higher tax rate jurisdictions.

Earnings Per Share

      Basic and fully diluted earnings per share for 2005 were $0.62 and $0.60,
respectively. During 2004 basic and fully diluted earnings per share were each
$0.28. Basic earnings per share is computed based upon the weighted average
number of common shares outstanding. Diluted earnings per share include the
impact of dilutive stock options.

New Accounting Pronouncements

      In December 2004, the Financial Accounting Standards Board (FASB) revised
Statement of Financial Accounting

                                                                              12




<Page>


Standards (SFAS) No. 123 "Share-Based Payment". SFAS No. 123(R) will require the
Company to expense stock options. Adoption is required for the annual reporting
periods beginning after June 15, 2005.

      In July 2006, the Financial Accounting Standards Board (FASB) issued FASB
Interpretation No. 48, Accounting for Uncertainty in Income Taxes (FIN 48),
which clarifies the accounting for uncertainty in tax positions. This
interpretation requires financial statement recognition of the impact of a tax
position if a position is more likely than not of being sustained on audit,
based on the technical merits of the position. Additionally, FIN 48 provides
guidance on measurement, derecognition, classification, accounting in interim
periods and disclosure requirements for uncertain tax positions. The provisions
of FIN 48 will be effective as of the beginning of the Company's fiscal year
2008, with the cumulative effect of the change in accounting principle
recorded as an adjustment to opening retained earnings. The Company is currently
evaluating the impact of FIN 48 on its financial position, results of operations
and cash flows.

Foreign Operations

      International business represents a major portion of the Company's
revenues and profits. All purchases of rough diamonds worldwide are denominated
in U.S. dollars. All of the Company's foreign sales are denominated in U.S.
dollars, with the exception of those sales made by the Company's subsidiary,
Lazare Kaplan Japan Inc., which are denominated in Japanese yen. The functional
currency for Lazare Kaplan Japan is the Japanese yen and, as of May 31, 2006 and
2005, the Company recognized cumulative foreign currency translation adjustments
with regard to the activities of Lazare Kaplan Japan in the amount of $(425,000)
and $(241,000) respectively, which are shown as a component of stockholders'
equity in the accompanying balance sheets.

Liquidity--Capital Resources

      The Company used $33.7 million and $22.5 million of cash flow from
operations in 2006 and 2005, respectively. The Company's usage of cash flow from
operations, funded by an increase in borrowings, was primarily used to expand
inventory sourcing and support increased sales volume.

      The Company's working capital at May 31, 2006, 2005 and 2004 was $143.7
million, $141.6 million and $110.6 million, respectively. The increase in
working capital primarily reflects funding of increased current assets with the
proceeds of debt classified as long-term.

      Fixed asset additions of $1.8 million in 2006 and 2005 primarily reflect
the expansion and upgrading of manufacturing facilities.

      The Company has a long-term unsecured revolving loan agreement. The
agreement provides that the Company may borrow up to $45.0 million (including up
to $1.0 million under letters of credit, $0.7 million issued at May 31, 2006) in
the aggregate through December 1, 2007. The loan term may be extended in
one-year increments commencing November 30, 2006, subject to the consent of the
lending banks. Borrowings under this agreement bear interest at (a) the higher
of the banks base rate or one half of one percent above the Federal Funds
Effective Rate, or (b) 160 basis points above LIBOR. The applicable interest
rate is contingent upon the method of borrowing selected by the Company. The
proceeds of this facility are available for the Company's working capital needs.
The revolving loan agreement contains certain provisions that require, among
other things, (a) maintenance of defined levels of working capital, net worth
and profitability, and (b) limitation on other borrowing levels, investments,
capital expenditures, dividends and the repurchase of treasury shares. As of May
31, 2006 and 2005, the balance outstanding under this facility was $38.0 million
and $33.0 million, respectively.

      During 2004, the Company entered into an additional long-term unsecured,
revolving loan agreement with a bank under which it may borrow up to $30.0
million in the aggregate through December 1, 2007. The loan term may be extended
in one year increments commencing November 30, 2006, subject to the consent of
the bank. Borrowings under this agreement bear interest at (a) the higher of the
banks base rate or one half of one percent above the Federal Funds Effective
Rate, or (b) 160 basis points above LIBOR. The applicable interest rate is
contingent upon the method of borrowing selected by the Company. The proceeds of
this facility are available for working capital purposes. The loan agreement
contains certain provisions that require, among other things, (a) maintenance of
defined levels of working capital, net worth and profitability, (b) limitations
on borrowing levels, investments and capital expenditures and (c) limitations on
dividends and the repurchase of treasury shares. Borrowings under this loan
agreement amounted to $29.2 million at May 31, 2006 and 2005.

      The Company has a $25.0 million and a 45.0 million unsecured, uncommitted
line of credit with a bank. Borrowings under both lines bear interest at a rate
160 basis points above the 90 day LIBOR. As of May 31, 2006 and 2005, the
balance outstanding

                                                                              13




<Page>


under both lines of credit was $40.8 million and $14.5 million, respectively.
Borrowings under these lines are available for the Company's working capital
requirements and are payable on demand.

      A subsidiary of the Company maintains a loan facility which enables it to
borrow up to 520 million Japanese yen (approximately $4.6 million U.S. dollars)
at an interest rate 1% above the Japanese yen LIBOR through November 2007.
Borrowings under the facility are available for working capital purposes. The
Company guarantees repayment of amounts borrowed. Borrowings under the loan are
used in support of its operations in Japan. As of May 31, 2006 the balance
outstanding under this facility was $4.2 million U.S. dollars. There were no
borrowings under this facility at May 31, 2005.

      The Company's long-term facilities do not contain subjective acceleration
clauses or require the Company to utilize a lockbox whereby remittances from the
Company's customers reduce the debt outstanding.

      Long-term debt of $64.2 million outstanding at May 31, 2006 is scheduled
to be repaid in the fiscal year ended May 31, 2008. The Company was in
compliance with its debt covenants at May 31, 2006.

      The following table includes aggregate information about the Company's
contractual obligations including interest as of May 31, 2006 and the periods
in which payments are due. Certain of these amounts are not required to be
included in the Company's consolidated balance sheet (in millions):

--------------------------------------------------------------------
Payments Due by                 Less than    1 - 3    4 - 5   Over 5
     Period            Total      1 year     years    years    years
--------------------------------------------------------------------
Debt                  $ 125.6   $    54.0   $  71.6   $   -   $    -
Operating Leases          9.0         0.8       2.1     1.2      4.9
--------------------------------------------------------------------
Total Contractual
   Cash Obligations   $ 134.6   $    54.8   $  73.7   $ 1.2   $  4.9
====================================================================

      Management believes the Company has the ability to meet its current and
anticipated financing needs for the next twelve months with the facilities in
place and funds from operations.

      Stockholders' equity was $95.8 million at May 31, 2006 as compared to
$96.3 million at May 31, 2005. This decrease primarily reflects current year
earnings offset by $2.0 million of treasury stock purchases. No dividends were
paid to stockholders during the year ended May 31, 2006.

Critical Accounting Policies

      Use of Accounting Estimates-The preparation of financial statements in
conformity with accounting principles generally accepted in the United States
requires management to make certain estimates and assumptions that could affect
the amounts reported in the financial statements and accompanying notes. Actual
results could differ from these estimates.

      Revenue Recognition--The Company recognizes revenue when title and risk of
ownership have passed to the buyer, the earnings process is complete and the
sale price is fixed or determinable. In addition, in certain instances, the
Company may be entitled to receive incremental profits from its customers on the
sale of certain stones. Such profits are recognized as revenue when realized.
Conversely, in certain instances, the Company is obligated to share profits it
realizes on the sale of stones. This additional cost is included in cost of
sales when the related revenue is recognized. When necessary, the Company
provides for estimated returns (where a right to return exists) in the same
period the revenue is recorded. These estimates are based upon historical
analysis, customer agreements and/or currently known factors that arise in the
normal course of business.

      Equity in (income) / loss of joint ventures - The Company utilizes the
equity method of accounting to record its proportionate share of income and
losses from joint ventures.

      Inventories--Inventories, including amounts on consignment with customers,
are stated at the lower of cost or market, using the average cost method. The
Company provides an inventory reserve equal to the difference between the cost
of the inventory and the estimated market value, to ensure inventories are
stated at the lower of cost or market. The determination of market value is
highly subjective as it is based on the relative significance assigned to
various attributes of a diamond, including carat weight, color, clarity and
quality of cut. If actual market conditions are less favorable than those
projected by management, inventory write-downs may be required.

      Allowance for Doubtful Accounts--Accounts receivable are reduced by an
allowance for amounts that may be uncollectible in the future. Estimates are
used in determining the allowance for doubtful accounts and are based on the
Company's ongoing

                                                                              14




<Page>


credit evaluations of customers, customer payment history and account aging.

      Deferred Tax Assets--Deferred income taxes reflect the net tax effects of
(a) temporary differences between the carrying amounts of assets and liabilities
for financial reporting purposes and the amounts used for income tax purposes,
and (b) net operating loss carryforwards. The Company provides a valuation
allowance for the estimated unrecoverable portion of the deferred tax assets.
Factors that the Company considers in assessing the likelihood of future
realization include the forecast of future taxable income and available tax
planning strategies. Realization of the net deferred tax assets is dependent on
generating sufficient taxable income prior to the expiration of net operating
loss carryforwards. Although realization is not assured, management believes it
is more likely than not that the net deferred tax asset will be realized. The
Company will continue to monitor and assess the recoverability of its deferred
tax assets in the future for changes to the tax code, change in statutory tax
rates and the projected level of taxable income.

      Asset Impairment--The Company records impairment losses on long-lived
assets used in operations when events and circumstances indicate that the assets
might be impaired and the undiscounted cash flows estimated to be generated by
the related assets are less than the carrying amounts of those assets. In
assessing the recoverability of the Company's long-lived assets, the Company
makes assumptions in determining estimated future sales, profit margin and
expenses to arrive at estimated future cash flows. If the Company determines,
based upon such measures, that the carrying amount is impaired, the long-lived
asset will be written down to its recoverable value based upon either the
discounted future cash flows or appraised fair value. The fair value of assets
could be different using different estimates and assumptions in these valuation
techniques.

Business Developments

      In March 1999, (in furtherance of a Memorandum of Understanding signed by
Eximbank, ALROSA and the Company) the Company and ALROSA entered into an
agreement to expand their relationship in the cutting, polishing and marketing
of gem diamonds for up to $100 million a year. Under the terms of this
agreement, the Company and ALROSA agreed to refurbish certain diamond cutting
facilities in Russia. At present, the Company's operations in Russia are
consolidated in two facilities, both of which are fully operational.

      During the fourth quarter of 2004 the Company signed a four year technical
assistance and cooperation agreement regarding the purchasing and marketing of
rough diamonds with SODIAM, the government entity responsible for the
development and marketing of diamonds produced in Angola. The Company began
active buying in the Angolan informal sector during the first quarter of fiscal
2005. During the third fiscal quarter of 2006 the Company's rough buying
operations expanded to include buying in the Angolan formal sector. The Company
is currently negotiating a future expansion and restructuring of its Angolan
operations to include exploration, development and distribution through various
joint ventures.

     During the third quarter of 2004 the Company signed a cooperation agreement
with 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 marketing and technical
manufacturing assistance to NamGem. The Company purchases rough diamonds and
supervise's the manufacturing of those deemed suitable to cut and polish. The
Company pays NamGem for manufacturing on a fee for services basis. All rough and
polished diamonds are bought and sold by the Company for its account.

      In November of 2004 the Company signed 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 the
third fiscal quarter of 2006.

      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
high pressure, high temperature (HPHT) process to improve the color of certain
gem diamonds without reducing their all-natural content. The process is
permanent and irreversible and it does not involve

                                                                              15




<Page>


treatments such as irradiation, laser drilling, surface coating or fracture
filling and is conducted before the final cutting and polishing by the Company.
The process will be used only on a select, limited range of natural diamonds
with qualifying colors, sizes and clarities for both round and fancy shapes. The
estimated number of gemstones with characteristics suitable for this process is
a small fraction of the overall diamond market. POL sells only diamonds that
have undergone the HPHT process under the Bellataire(R) brand name. In
connection with this agreement, the Company granted a security interest in POL's
diamond inventory amounting to $13.5 million at May 31, 2006.

      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.

      As a concerned member of the international diamond industry and global
community at large, the Company fully supports and complies with policies which
prohibit the trade in conflict diamonds, prevent money laundering and combat the
financing of terrorism, a position which reflects the Company's leadership in
the industry. The Company fully complies with clean diamond trading and
anti-money laundering legislation adopted by the United States Government such
as the USA Patriot Act and the Clean Diamond Trade Act, and supports relevant
resolutions of concerned regional governments and international organizations
including the OECD and the United Nations. The Company is a founding member of
the United Nations Global Compact which was launched in 2000 to "initiate a
global compact of shared values and principles which will give a human face to
the global market". The Company will continue to join various industry and trade
associations in condemning and combating the trade in illicit diamonds and to
comply fully with World Diamond Congress resolutions for industry
self-regulation in respect of the Kimberley Process Certification Scheme,
including implementation of the prescribed System of Warranties and Code of
Conduct. Furthermore, the Company long ago adopted the highest professional and
ethical standards in every aspect of our business and is fully compliant with
the DTC's recently developed Diamond Best Practices Principles.

Risks and Uncertainties

      The world's sources of rough diamonds are highly concentrated in a limited
number of countries. Varying degrees of political and economic risk exist in
many of these countries. As a consequence, the diamond business is subject to
various sovereign risks beyond the Company's control, such as changes in laws
and policies affecting foreign trade and investment. In addition, the Company is
subject to various political and economic risks, including the instability of
foreign economies and governments, labor disputes, war and civil disturbances
and other risks that could cause production difficulties or stoppages, restrict
the movement of inventory or result in the deprivation or loss of contract
rights or the taking of property by nationalization or expropriation without
fair compensation.

      The Company's business is dependent upon the availability of rough
diamonds. Based upon published reports, the Company believes that more than half
of the world's current diamond output is sold by the Diamond Trading Company
("DTC"), the rough diamond sales arm of the De Beers Group. Although the DTC has
historically been one of the Company's major suppliers of rough diamonds, the
Company has diversified its sources of supply by entering into arrangements with
other primary source suppliers and has been able to supplement its rough diamond
needs by purchasing supplies in the secondary market. While the Company believes
that it has good relationships with its suppliers and that its sources of supply
are sufficient to meet its present and foreseeable needs, the Company's rough
diamond supplies, and therefore, its manufacturing capacity, could be adversely
affected by political and economic developments in producing countries over
which it has no control. While the Company believes that alternative sources of
supply may be available, any significant disruption of the Company's access to
its primary source suppliers could have a material adverse effect on its ability
to purchase rough diamonds.

      In July 2000, the DTC announced significant changes in its approach to
rough diamond marketing. In brief, the DTC stated that it will stop open market
purchases and alter its market control and pricing policies. Henceforth, the DTC
has said it will focus on selling its own mining productions through its
"supplier of choice" marketing programs. These policy changes are intended to
drive consumer demand for diamond jewelry by fostering the development of
efficient distribution networks that stimulate demand, support the emergence of
internationally recognized brands to meet consumer

                                                                              16




<Page>


needs, supply clients with a consistent supply of rough diamonds and encourage
and support additional investment in marketing and advertising programs with the
goal of developing an industry led by advertising and marketing support.

      Further, through its control of the world's diamond output, the DTC could
exert significant control over the pricing of rough and polished diamonds. A
large rapid increase in rough diamond prices could materially adversely affect
the Company's revenue and operating margins if the increased cost of the rough
diamonds could not be passed along to its customers in a timely manner.
Alternatively, any rapid decrease in the price of polished diamonds could have a
material adverse affect on the Company in terms of inventory losses and lower
margins.

      The Company is currently a DTC Sightholder under the Supplier of Choice
Program. The Company believes it is well positioned to benefit from these
changes in the DTC's approach to diamond marketing. However, there can be no
assurance that this policy change will not have a material adverse effect on the
Company's operations.

      In addition, the Company's manufacturing, trading and sourcing operations
abroad are subject to various political and economic risks, including the
instability of foreign economies and governments, labor disputes, war and civil
disturbances and other risks that could cause production difficulties or
stoppages, restrict the movement of inventory or result in the deprivation or
loss of contract rights or the taking of property by nationalization or
expropriation without fair compensation.

      The Company's cooperation arrangement with ALROSA is a significant part of
its operations. The Company believes it is well positioned to benefit from the
reorganization of the diamond industry in Russia. However there can be no
assurance that the resulting change will not have a material adverse effect on
the Company's operations.

                                                                              17




<Page>


                         Consolidated Income Statements

<TABLE>
<CAPTION>
                                                                                     Year ended May 31,
-----------------------------------------------------------------------------------------------------------------
(In thousands, except share and per share data)                                2006         2005         2004
-----------------------------------------------------------------------------------------------------------------
<S>                                                                         <C>          <C>          <C>
Net sales                                                                   $  528,045   $  421,411   $  235,775

Cost of sales                                                                  498,197      386,677      209,631
-----------------------------------------------------------------------------------------------------------------
                                                                                29,848       34,734       26,144
-----------------------------------------------------------------------------------------------------------------

Selling, general and administrative expenses                                    24,759       24,475       21,971
Interest expense                                                                 3,786        2,389          900
Equity in (income) / loss of joint ventures                                        537            -            -
-----------------------------------------------------------------------------------------------------------------
                                                                                29,082       26,864       22,871
-----------------------------------------------------------------------------------------------------------------

Income before income tax provision                                                 766        7,870        3,273
Income tax provison/(benefit)                                                     (762)       2,640          874
-----------------------------------------------------------------------------------------------------------------

NET INCOME                                                                  $    1,528   $    5,230   $    2,399
-----------------------------------------------------------------------------------------------------------------

EARNINGS PER SHARE

Basic earnings per share                                                    $     0.18   $     0.62   $     0.28
-----------------------------------------------------------------------------------------------------------------

Average number of shares outstanding during the period                       8,291,413    8,448,704    8,513,687
-----------------------------------------------------------------------------------------------------------------

Diluted earnings per share                                                  $     0.18   $     0.60   $     0.28
-----------------------------------------------------------------------------------------------------------------

Average number of shares outstanding during the period, assuming dilution    8,569,661    8,653,222    8,599,954
-----------------------------------------------------------------------------------------------------------------
</TABLE>

See notes to consolidated financial statements.

                                       18




<Page>


                           Consolidated Balance Sheets

<TABLE>
<CAPTION>
                                                                                    May 31,
----------------------------------------------------------------------------------------------------
(In thousands, except share data)                                              2006         2005
----------------------------------------------------------------------------------------------------
<S>                                                                         <C>          <C>
Assets
CURRENT ASSETS:
Cash and cash equivalents                                                   $    8,160   $   10,320
Accounts receivable, less allowance for doubtful accounts ($515 and $360
  in 2006 and 2005, respectively)                                               91,403       86,990
Inventories, net:
   Rough stones                                                                 24,746       22,779
   Polished stones                                                             108,368      101,805
                                                                            ------------------------
    Total inventories                                                          133,114      124,584
                                                                            ------------------------
Prepaid expenses and other current assets                                       12,763       11,697
Deferred tax assets-current                                                      2,024        1,944
----------------------------------------------------------------------------------------------------
      TOTAL CURRENT ASSETS                                                     247,464      235,535

Property, plant and equipment, net                                               8,318        7,892
Other assets                                                                       423          855
Deferred tax assets, net                                                         7,507        6,002
----------------------------------------------------------------------------------------------------
                                                                            $  263,712   $  250,284
----------------------------------------------------------------------------------------------------

Liabilities and Stockholders' Equity
CURRENT LIABILITIES:
Accounts payable and other current liabilities                              $   55,771   $   77,241
Current portion of long-term debt and lines of credit                           47,969       16,738
----------------------------------------------------------------------------------------------------
      TOTAL CURRENT LIABILITIES                                                103,740       93,979

Long-term debt                                                                  64,176       60,000
----------------------------------------------------------------------------------------------------
      TOTAL LIABILITIES                                                        167,916      153,979
----------------------------------------------------------------------------------------------------
COMMITMENTS AND CONTINGENCIES
----------------------------------------------------------------------------------------------------
STOCKHOLDERS' EQUITY
  Preferred stock, par value $.01 per share:
    Authorized 1,500,000; no shares outstanding                                      -            -
  Common stock, par value $1 per share:
    Authorized 12,000,000 shares; issued 8,821,345 and 8,802,679 in 2006
      and 2005, respectively                                                     8,821        8,803
  Additional paid-in capital                                                    62,187       62,090
  Cumulative translation adjustment                                               (425)        (241)
  Retained earnings                                                             30,300       28,772
----------------------------------------------------------------------------------------------------
                                                                               100,883       99,424
Less treasury stock, 624,211 and 407,373 shares at cost in 2006 and 2005,
  respectively                                                                  (5,087)      (3,119)
----------------------------------------------------------------------------------------------------
      TOTAL STOCKHOLDERS' EQUITY                                                95,796       96,305
----------------------------------------------------------------------------------------------------
                                                                            $  263,712   $  250,284
----------------------------------------------------------------------------------------------------
</TABLE>

See notes to consolidated financial statements.

                                       19




<Page>


                      Consolidated Statements of Cash Flows

<TABLE>
<CAPTION>
                                                                                     Year ended May 31,
-----------------------------------------------------------------------------------------------------------------
(In thousands)                                                                 2006         2005         2004
-----------------------------------------------------------------------------------------------------------------
<S>                                                                         <C>          <C>          <C>
Cash Flows from Operating Activities:
Net income                                                                  $    1,528   $    5,230   $    2,399
Adjustments to reconcile net income to net cash used in operating
  activities:
     Depreciation and amortization                                               1,310        1,159        1,202
     Provision for uncollectible accounts                                          168           59          (44)
     Compensation expense - noncash                                                  -          329            -
     Deferred income taxes                                                      (1,585)       2,289          659
Changes in operating assets and liabilities:
  Accounts receivable                                                           (4,581)     (25,237)      (4,408)
  Rough and polished inventories                                                (8,530)     (31,207)     (15,140)
  Prepaid expenses and other current assets                                       (944)      (5,779)         206
  Other assets                                                                     413           45          107
  Accounts payable and other current liabilities                               (21,470)      30,564       (6,771)
-----------------------------------------------------------------------------------------------------------------
Net cash used in operating activities                                          (33,691)     (22,548)     (21,790)
-----------------------------------------------------------------------------------------------------------------

Cash Flows from Investing Activities:
Capital expenditures                                                            (1,839)      (1,790)      (2,151)
-----------------------------------------------------------------------------------------------------------------
Net cash used in investing activities                                           (1,839)      (1,790)      (2,151)
-----------------------------------------------------------------------------------------------------------------

Cash Flows from Financing Activities:
Increase in borrowings                                                          35,407       35,119       24,863
Purchase of treasury stock                                                      (1,968)      (1,973)        (212)
Proceeds from exercise of stock options                                            115          258           24
                                                                            -------------------------------------
Net cash provided by financing activities                                       33,554       33,404       24,675
-----------------------------------------------------------------------------------------------------------------

Effect of exchange rate changes on cash                                           (184)          45           (2)
                                                                            -------------------------------------
Net increase/(decrease) in cash and cash equivalents                            (2,160)       9,111          732
Cash and cash equivalents at beginning of year                                  10,320        1,209          477
                                                                            -------------------------------------
Cash and cash equivalents at end of year                                    $    8,160   $   10,320   $    1,209
-----------------------------------------------------------------------------------------------------------------

Supplemental Disclosures of Cash Flow Information:
Cash paid during the year for:
Interest                                                                    $    3,363   $    2,532   $      888
Income taxes                                                                $      508   $      449   $      187
-----------------------------------------------------------------------------------------------------------------
</TABLE>

See notes to consolidated financial statements.

                                       20




<Page>


                 Consolidated Statements of Stockholders' Equity

<TABLE>
<CAPTION>
                                                            Additional    Cumulative                            Total
                                                   Common    Paid-in     Translation   Retained   Treasury   Stockholders'
(In thousands, except share data)                  Stock     Capital      Adjustment   Earnings    Stock        Equity
---------------------------------------------------------------------------------------------------------------------------
<S>                                               <C>       <C>          <C>           <C>        <C>        <C>
Balance, May 31, 2003                             $ 8,707   $   61,575   $      (284)  $ 21,143   $   (934)  $      90,207

Comprehensive income:
   Net income                                           -            -             -      2,399          -           2,399
   Foreign currency translation                         -            -            (2)         -          -              (2)
                                                                                                             --------------
Comprehensive income                                                                                                 2,397
Exercise of stock options, 4,105 shares issued          4           20             -          -          -              24
Purchase of treasury stock, 30,000 shares               -            -             -          -       (212)           (212)
---------------------------------------------------------------------------------------------------------------------------

Balance, May 31, 2004                             $ 8,711   $   61,595   $      (286)  $ 23,542   $ (1,146)  $      92,416

Comprehensive income:
   Net income                                           -            -             -      5,230          -           5,230
   Foreign currency translation                         -            -            45          -          -              45
                                                                                                             --------------
Comprehensive income                                                                                                 5,275
Exercise of stock options, 92,060 shares issued        92          495             -          -          -             587
Purchase of treasury stock, 197,273 shares              -            -             -          -     (1,973)         (1,973)
---------------------------------------------------------------------------------------------------------------------------

Balance, May 31, 2005                             $ 8,803   $   62,090   $      (241)  $ 28,772   $ (3,119)  $      96,305

Comprehensive income:
   Net income                                           -            -             -      1,528          -           1,528
   Foreign currency translation                         -            -          (184)         -          -            (184)
                                                                                                             --------------
Comprehensive income                                                                                                 1,344
Exercise of stock options, 18,666 shares issued        18           97             -          -          -             115
Purchase of treasury stock, 216,838 shares              -            -             -          -     (1,968)         (1,968)
---------------------------------------------------------------------------------------------------------------------------

Balance, May 31, 2006                             $ 8,821   $   62,187   $      (425)  $ 30,300   $ (5,087)  $      95,796
===========================================================================================================================
</TABLE>

See notes to consolidated financial statements.

                                       21




<Page>


                   Notes to Consolidated Financial Statements
                     Years ended May 31, 2005, 2004 and 2003

1. Accounting Policies
--------------------------------------------------------------------------------

a. The Company and its Principles of Consolidation

      The Company and its subsidiaries are engaged in the cutting and polishing
of rough diamonds and selling of both polished and uncut rough diamonds. The
consolidated financial statements include the accounts of the Company and its
wholly-owned subsidiaries. All material intercompany balances and transactions
have been eliminated. In these notes to consolidated financial statements, the
years "2006", "2005" and "2004" refer to the fiscal years ended May 31, 2006,
2005 and 2004, respectively.

b. Use of estimates

      The preparation of financial statements in conformity with accounting
principles generally accepted in the United States requires management to make
certain estimates and assumptions that could affect the amounts reported in the
financial statements and accompanying notes. Actual results could differ from
these estimates.

c. Sales and accounts receivable

Sales arrangements with customers:

      The Company's polished diamond and diamond jewelry customers consist
primarily of wholesale and retail clients. The Company's rough diamond customers
consist primarily of rough diamond cutters. The Company generally ships polished
diamond inventory to customers subject to verification of the diamond
particulars.

      The Company's policy is to recognize revenue when title and risk of
ownership have passed to the buyer, the earnings process is complete and the
sale price is fixed and determinable. Polished diamond sales includes revenue
derived from the sale of polished diamonds and the cutting, polishing and laser
inscription of polished diamonds. In addition, in certain instances, the Company
may be entitled to receive incremental profits from its customers on the sale of
certain stones. Such profits are recognized as revenue when realized. Where the
Company acts as a principal in the sales transaction, takes title to the product
and has risks and rewards of ownership, the gross value of diamonds invoiced is
recorded as sales with the portion of profits allocable to others (where
applicable) included in cost of sales.

      Where the Company believes profitability can be maximized, the Company may
combine, and jointly sell, certain of its diamonds with those of other
wholesalers. In such instances, the Company is obligated to share profits it
realizes on the sale of such stones. Typically, the participating wholesaler is
required to advance funds to the Company equal to their proportional interest in
the underlying diamonds.

      The Company has an arrangement with a diamond producer whereby the Company
sells certain polished diamonds that are cut and polished in Russia. The risk
and rewards of ownership of these diamonds is transferred to the Company upon
delivery to the Company of the diamonds in polished form. Generally, upon
receipt, the Company pays a negotiated base price and the producer receives an
economic interest in future profits associated with the diamonds.

      The Company has a technical cooperation agreement with an entity
responsible for the development and marketing of diamonds produced in Angola.
Pursuant to this agreement the Company has

                                       22




<Page>


established a joint buying and rough diamond trading operation. The Company
takes title to the diamonds upon acquisition in Angola and assumes
responsibility for risk of loss. Sales by the Company are recorded at their
gross invoice value. Profits in excess of operating and rough acquisition costs
as defined are allocated between parties with such costs classified as cost of
sales by the Company.

      The Company's net sales to customers in each of the following regions for
the years ended May 31, 2006, 2005 and 2004 are set forth below:

                                                      ------------------------
                                                      2006      2005      2004
------------------------------------------------------------------------------
United States                                          13%       20%       30%
Far East                                                7%        9%        9%
Europe, Israel & Other                                 80%       71%       61%
------------------------------------------------------------------------------
                                                      100%      100%      100%
                                                      ========================

      No single customer of the Company accounted for 10% or more of the
Company's net sales for the fiscal years ended May 31, 2006, 2005 and 2004.
Where the Company believes profitability can be maximized, the Company may
combine, and jointly sell, certain of its rough stones with those of other
wholesalers. Under certain circumstances, primarily related to foreign sales,
the wholesaler assumes responsibility for billing and collection efforts. While
the ultimate sales are made to multiple third parties the resulting accounts
receivable are aggregated for purposes of determining concentration of credit
risk. Two customers accounted for 15.2% and 11.5% of accounts receivable at May
31, 2006. One customer accounted for 25.9% of accounts receivable at May 31,
2005.

      Accounts receivable are reduced by an allowance for amounts that may be
uncollectible in the future. Estimates are used in determining the allowance for
doubtful accounts and are based on the Company's ongoing credit evaluations of
customers, customer payment history and account aging.

      Credit is extended based on an evaluation of each customer's financial
condition and generally collateral is not required on the Company's receivables

d. Customer rebates

      From time to time the Company has had arrangements whereby it would rebate
to a customer a percentage of certain of its qualifying purchases. The Company
characterizes such rebates as a reduction of sales.

e. Cash and cash equivalents

      The Company considers all highly liquid investments with maturity of three
months or less when purchased to be cash equivalents.

f. Inventories

      Inventories, including amounts on consignment with customers, are stated
at the lower of cost or market, using the average cost method.

g. Property, plant and equipment

      Property, plant and equipment is stated at cost less accumulated
depreciation and amortization. Depreciation and amortization is computed using
the straight-line method over the shorter of asset lives or lease terms.

h. Asset impairments

      The Company records impairment losses on long-lived assets with finite
lives used in operations when events and circumstances indicate that the assets
might be impaired and the undiscounted cash flows estimated to be generated by
the related assets are less than the carrying amounts of those assets. If the
Company determines, based upon such measures, that the carrying amount is
impaired the long-lived asset will be written down to its recoverable value
based upon either the discounted future cash flows or appraised fair value.

i. Foreign currency

      All purchases of rough diamonds worldwide are denominated in U.S. dollars.
All of the Company's foreign sales are denominated in U.S. dollars, with the
exception of those sales made by the Company's subsidiary, Lazare Kaplan Japan,
which are denominated in Japanese yen. The functional currency for Lazare Kaplan
Japan is the Japanese yen and the Company recognizes foreign currency
translation adjustments with regard to the activities of Lazare Kaplan Japan as
a component of stockholders' equity in the accompanying balance sheets.

                                       23




<Page>


j. Advertising and incentive programs

      The Company participates in cooperative advertising arrangements with
customers in order to build brand awareness and product acceptance. Under such
an arrangement a customer is eligible to receive an allowance of up to a
specified percentage of its purchases from the Company if certain qualitative
advertising criteria are met and if specified amounts are spent on qualifying
advertising. The Company characterizes as selling, general and administrative
expense the consideration it pays to customers for cooperative advertising.

      In addition, the Company offers programs whereby certain sales staff
employed by the Company's customers can receive consideration for sales of the
Company's products. The Company characterizes as selling, general and
administrative expense the consideration it pays to the salesperson.

k. Consideration received from vendors

      Periodically, the Company negotiates agreements with vendors to share
certain promotional costs. The Company classifies amounts expended on such
promotions as selling general and administrative expense when incurred.
Similarly, amounts reimbursed by vendors are characterized as a reduction of
selling, general and administrative expense.

      Advertising costs are expensed as incurred and were $2.6, $2.8, and $2.1
million in 2006, 2005 and 2004, respectively.

l. Shipping and handling:

      Shipping and handling costs incurred by the Company to deliver product to
customers, $0.4 million in 2006, $0.3 million in 2005 and 2004, are classified
in the Company's income statement as selling, general and administrative
expense.

m. Equity investments

      The Company utilizes the equity method of accounting to record its
proportionate share of income and losses from joint ventures

n. Income taxes

      The Company provides for income taxes in accordance with Statement of
Financial Accounting Standards No. 109, "Accounting for Income Taxes", whereby
deferred income taxes are determined based upon the enacted income tax rates for
the years in which these taxes are estimated to be payable or recoverable.
Deferred income taxes reflect the net tax effects of (a) temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes, and (b) operating loss
carryforwards. Realization of the net deferred tax assets is dependent on
generating sufficient taxable income prior to the expiration of net operating
loss carryforwards. Although realization is not assured, management believes it
is more likely than not that the net deferred tax asset will be realized. The
amount of the net deferred tax asset considered realizable, however, could be
reduced if estimates of future taxable income during the carryforward period are
reduced.

      The Company and its domestic subsidiaries file a consolidated income tax
return. The Company's foreign subsidiaries are not subject to Federal income
taxes and their provisions for income taxes have been computed based on the
effective tax rates, if any, in the foreign countries.

      Earnings from foreign subsidiaries are intended to be reinvested
indefinitely with the exception of Pegasus Overseas Ltd., a wholly owned
foreign subsidiary, which declared on May 1, 2006 a dividend in the amount of
$8.0 million. The Company provided $0.4 million for U.S. income taxes related
to the dividend.

o. Earnings per share

      The Company computes basic earnings per share based upon the weighted
average number of common shares outstanding, and diluted earnings per share
based upon the weighted average number of common shares outstanding including
the impact of dilutive stock options.

                                       24




<Page>


                                               2006         2005         2004
-----------------------------------------   ------------------------------------

Average number of shares
   outstanding during the period             8,291,413    8,448,704    8,513,687

Effect of dilutive stock options               278,248      204,518       86,267

-----------------------------------------   ------------------------------------
Average number of shares
   outstanding during the period
   assuming dilution                         8,569,661    8,653,222    8,599,954
=========================================   ====================================

Antidilutive options of approximately 601,800, 352,000 and 373,000 were not
included in the computation of diluted earnings per share, for fiscal 2006, 2005
and 2004 respectively because the exercise price of the options were greater
than the average market price of the common shares.

p. Risks and Uncertainties

      The world's sources of rough diamonds are highly concentrated in a limited
number of countries. Varying degrees of political and economic risk exist in
many of these countries. As a consequence, the diamond business is subject to
various sovereign risks beyond the Company's control, such as changes in laws
and policies affecting foreign trade and investment. In addition, the Company is
subject to various political and economic risks, including the instability of
foreign economies and governments, labor disputes, war and civil disturbances
and other risks that could cause production difficulties or stoppages, restrict
the movement of inventory or result in the deprivation or loss of contract
rights or the taking of property by nationalization or expropriation without
fair compensation.

      The Company's business is dependent upon the availability of rough
diamonds. Based upon published reports, the Company believes that more than half
of the world's current diamond output is sold by the Diamond Trading Company
("DTC"), the rough diamond sales arm of the De Beers Group. Although the DTC has
historically been one of the Company's major suppliers of rough diamonds, the
Company has diversified its sources of supply by entering into arrangements with
other primary source suppliers and has been able to supplement its rough diamond
needs by purchasing supplies in the secondary market. While the Company believes
that it has good relationships with its suppliers and that its sources of supply
are sufficient to meet its present and foreseeable needs, the Company's rough
diamond supplies, and therefore, its manufacturing capacity, could be adversely
affected by political and economic developments in producing countries over
which it has no control. While the Company believes that alternative sources of
supply may be available, any significant disruption of the Company's access to
its primary source suppliers could have a material adverse effect on its ability
to purchase rough diamonds.

      In July 2000, the DTC announced significant changes in its approach to
rough diamond marketing. In brief, the DTC stated that it will stop open market
purchases and alter its market control and pricing

                                                     Year ended May 31,
                                            ------------------------------------
                                               2006         2005         2004
                                            ------------------------------------
Net income, as reported                     $    1,528   $    5,230   $    2,399
Add: Compensation expense,                           -          184            -
   net of related taxes
Deduct: Stock-based employee
   compensation expense determined
   under fair value method,
   net of related tax effects                      522          509          329
                                            ------------------------------------

Proforma net income                         $    1,006   $    4,905   $    2,070

Earnings per share as reported:
Basic                                       $     0.18   $     0.62   $     0.28
Diluted                                     $     0.12   $     0.60   $     0.28

Basic and diluted earnings pro forma:
Basic                                       $     0.18   $     0.58   $     0.24
Diluted                                     $     0.12   $     0.57   $     0.24

policies. Henceforth, the DTC has said it will focus on selling its own mining
productions through its "supplier of choice" marketing programs. These policy
changes are intended to drive consumer demand for diamond jewelry by fostering
the development of efficient distribution networks that stimulate demand,
support the emergence of internationally recognized brands to meet consumer
needs, supply clients with a consistent supply of rough diamonds and encourage
and support additional investment in marketing and advertising programs with the
goal of developing an industry led by advertising and marketing support.

      Further, through its control of a significant portion of the world's
diamond output, the DTC could exert significant control over the pricing of
rough and polished diamonds. A large rapid increase in rough diamond prices
could materially adversely affect the Company's revenue and operating margins if
the increased cost of the rough diamonds could not be passed along to its
customers in a timely manner. Alternatively, any rapid decrease in the price of

                                       25




<Page>


rough or polished diamonds could have a material adverse affect on the Company
in terms of inventory losses and lower margins.

      The Company is currently a DTC Sightholder under the Supplier of Choice
Program. The Company believes it is well positioned to benefit from these
changes in the DTC approach to diamond marketing. However, there can be no
assurance that this policy change will not have a material adverse effect on the
Company's operations.

      The Company has an agreement with AK ALROSA of Russia, which is the
largest producer of rough diamonds in Russia. The Company's cooperation
arrangement with ALROSA is a significant part of its operations. Any
interruption in the supply of diamonds from Russia could have a material adverse
effect on the Company's operations.

q. Stock Incentive Plans

      The Company accounts for its stock-based compensation plans using the
intrinsic value method prescribed in Accounting Principles Board Opinion No.25
"Accounting for Stock Issued to Employees" and related interpretations. The
following disclosures are computed as if the Company recorded compensation
expense based on the fair value for stock -based awards or grants.

      In December 2004, the Financial Accounting Standards Board (FASB) revised
Statement of Financial Accounting Standards (SFAS) No. 123 "Share-Based
Payment". SFAS No. 123(R) will require the Company to expense stock options.
Adoption is required for the annual reporting periods beginning after June 15,
2005. The effect of expensing stock options on the Company's results of
operations using the Black-Scholes model is presented in the above table. The
pro forma effects presented above may not be representative of the effects on
reported net income and earnings per share for future periods since options vest
over several years and additional awards may be granted in future periods. The
impact on the Company's financial condition and results of operations of
adopting SFAS No. 123(R) will depend on the number and terms of stock options
granted in future years under the modified prospective method, the amount of
which can not currently be estimated by management.

      During 2005 the Company's Stock Option Committee modified the vesting
period applicable to certain stock options granted in 2004. The effect of this
modification was to accelerate the vesting of options which would have vested on
December 15, 2006 to vest on May 31, 2006. The purpose of accelerating the
vesting of these options was to mitigate the costs associated with adopting SAFS
No 123 (R).

r. Comprehensive Income

      The Company reports "Comprehensive Income" in accordance with Statement of
Financial Accounting Standards No. 130, which requires foreign currency
translation adjustments to be included in other comprehensive income. For the
years ended May 31, 2006, 2005 and 2004, total comprehensive income was $ 1.3,
$5.3, and $2.4 million, respectively.

s. Reclassifications

      Certain prior year amounts have been reclassified to conform to current
year presentation.

t. New Accounting Pronouncements

      In December 2004, the Financial Accounting Standards Board (FASB) revised
Statement of Financial Accounting Standards (SFAS) No. 123 "Share-Based
Payment". SFAS No. 123(R) will require the Company to expense stock options.
Adoption is required for the annual reporting periods beginning after June 15,
2005.

      In July 2006, the Financial Accounting Standards Board (FASB) issued FASB
Interpretation No. 48, Accounting for Uncertainty in Income Taxes (FIN 48),
which clarifies the accounting for uncertainty in tax positions. This
interpretation requires financial statement recognition of the impact of a tax
position if a position is more likely than not of being sustained on audit,
based on the technical merits of the position. Additionally, FIN 48 provides
guidance on measurement, derecognition, classification, accounting in interim
periods and disclosure requirements for uncertain tax positions. The provisions
of FIN 48 will be effective as of the beginning of the Company's fiscal year
2008, with the cumulative effect of the change in accounting principle
recorded as an adjustment to opening retained earnings. The Company is currently
evaluating the impact of FIN 48 on its financial position, results of operations
and cash flows.



2. Property, Plant and Equipment
--------------------------------------------------------------------------------

      Property, plant and equipment consists of (in thousands):

                                                                 May 31,
                                                         -----------------------
                                                            2006         2005
                                                         -----------------------
Land and buildings                                       $    2,115   $    1,470
Leasehold improvements                                        2,633        2,631
Machinery, tools and equipment                                8,775        8,017
Furniture and fixtures                                        1,357        1,337
Computer hardware, software and equipment                     8,257        8,027
--------------------------------------------------------------------------------
                                                             23,137       21,482

Less accumulated depreciation and amortization               14,819       13,590
--------------------------------------------------------------------------------
                                                         $    8,318   $    7,892
                                                         -----------------------
Depreciation and amortization rates:

Buildings                                                            2 to 3.7%

Leasehold improvements                                              3.7 to 20%

Machinery, tools and equipment                                       10 to 25%

Furniture and fixtures                                               10 to 20%

Computer hardware, software and equipment                            10 to 33%

      Depreciation and amortization expense for 2006, 2005 and 2004 was $1.3,
$1.1 and $1.2 million, respectively.

                                       26




<Page>


3. Income Taxes
--------------------------------------------------------------------------------

      The items comprising the Company's net deferred tax assets are as follows
(in thousands):

                                                                  May 31,
                                                           ---------------------
                                                             2006        2005
                                                           ---------------------
Deferred tax assets:
   Operating loss and other carryforwards                  $  8,801    $  7,945
   Other                                                      2,004       1,667
Deferred tax liabilities:
   Depreciation                                              (1,141)     (1,533)
--------------------------------------------------------------------------------
                                                              9,664       8,079
Less: Valuation allowance                                      (133)       (133)
--------------------------------------------------------------------------------
Net deferred tax assets                                    $  9,531    $  7,946
--------------------------------------------------------------------------------

      The income tax provision is comprised of the following (in thousands):

                                                        Year ended May 31,
                                                 -------------------------------
                                                   2006        2005       2004
                                                 -------------------------------
Current:
Federal                                          $    408    $     98   $      4
State and local                                       277         117        165
Foreign                                               138         136         46
--------------------------------------------------------------------------------
                                                      823         351        215
Deferred:
Federal, state and local                           (1,585)      2,289        659
--------------------------------------------------------------------------------
                                                 $   (762)   $  2,640   $    874
                                                 -------------------------------

      Income before income taxes from the Company's domestic and foreign
operations (in thousands):

                                                      Year ended May 31,
                                               ---------------------------------
                                                 2006        2005        2004
                                               ---------------------------------
Domestic                                       $ (4,647)   $  6,008    $  1,951
Foreign                                           5,413       1,862       1,322
                                               ---------------------------------
                                               $    766    $  7,870    $  3,273
                                               ---------------------------------

      The tax provision is different from amounts computed by applying the
Federal income tax rate to the income before taxes as follows (in thousands):

                                               ---------------------------------
                                                 2006        2005        2004
                                               ---------------------------------
Tax provision / (benefit) at statutory rate    $    260    $  2,676    $  1,113
(Decrease) / increase in taxes
   resulting from:
   Differential attributable to
     foreign operations                          (1,724)       (497)       (403)
Tax on repatriated dividends                        408
   State and local taxes,
      net of Federal benefit                        267         443         146
   Permanent items                                   27          18          18
--------------------------------------------------------------------------------
Tax provision                                  $   (762)   $  2,640    $    874
--------------------------------------------------------------------------------

      The Company has available Federal net operating losses to offset future
taxable income which expire as follows (in thousands):

                                                      Net
                                                   Operating
                    Year                            Losses
                    ----------------------------------------
                    2019                               8,690
                    2020                                 298
                    2021                                 120
                    2022                              10,190
                    2023                                  25
                    2026                               2,761
                    ----------------------------------------
                                                   $  22,084
                                                   ---------

      In addition, the Company has New York State and New York City net
operating loss carryforwards of approximately $7.7 million each, expiring from
2021 through 2026.

4. Accounts Payable and Other Current Liabilities
--------------------------------------------------------------------------------

      Accounts payable and other current liabilities consist of (in thousands):

                                                            2006         2005
--------------------------------------------------------------------------------
Accounts payable                                         $    6,608   $    8,040
Advances and other                                           42,458       62,065
Accrued expenses                                              6,705        7,136
--------------------------------------------------------------------------------
                                                         $   55,771   $   77,241
                                                         -----------------------

      Advances and other, primarily relating to the purchase, manufacture and
sale of inventory, includes $22.5 million and $15.4 million payable to two
parties for 2006. For 2005, $40.4 million and $21.6 million was payable to two
parties.

5. Lines of Credit
--------------------------------------------------------------------------------

      The Company has a $25.0 million and a $45.0 million unsecured, uncommitted
line of credit with a

                                       27




<Page>


bank. Borrowings under both lines bear interest at a rate 160 basis points above
the 90 day LIBOR. As of May 31, 2006 and 2005, the balance outstanding under
both lines was $14.5 million and $40.8 million, respectively. Borrowings under
these lines are available for the Company's working capital requirements and are
payable on demand.

      The Company has a long-term unsecured, revolving loan agreement. The
agreement provides that the Company may borrow up to $45.0 million (including up
to $1.0 million under letters of credit) in the aggregate through December 1,
2007. The loan term may be extended in one year increments commencing November
30, 2006, subject to the consent of the lending banks. Borrowings under this
agreement bear interest at (a) the higher of the banks base rate or one half of
one percent above the Federal Funds Effective Rate, or (b) 160 basis points
above LIBOR. The applicable interest rate is contingent upon the method of
borrowing selected by the Company. The proceeds of this facility are available
for working capital purposes. The loan agreement contains certain provisions
that require, among other things, (a) maintenance of defined levels of working
capital, net worth and profitability, (b) limitations on borrowing levels,
investments and capital expenditures and (c) limitations on dividends and the
repurchase of treasury shares. As of May 31, 2006 and 2005, the balance
outstanding under this facility was $38.0 million and $33.0 million,
respectively. In addition, at May 31, 2006 outstanding letters of credit under
this facility amounted to $0.7 million.

      The Company also maintains an additional long-term unsecured, revolving
loan agreement with a bank under which it may borrow up to $30.0 million in the
aggregate through December 1, 2007. The loan term may be extended in one year
increments commencing November 30, 2006, subject to the consent of the bank.
Borrowings under this agreement bear interest at (a) the higher of the banks
base rate or one half of one percent above the Federal Funds Effective Rate, or
(b) 160 basis points above LIBOR. The applicable interest rate is contingent
upon the method of borrowing selected by the Company. The proceeds of this
facility are available for working capital purposes. The loan agreement contains
certain provisions that require, among other things, (a) maintenance of defined
levels of working capital, net worth and profitability, (b) limitations on
borrowing levels, investments and capital expenditures and (c) limitations on
dividends and the repurchase of treasury shares. Borrowings under this loan
agreement amounted to $29.2 million at May 31, 2006 and 2005.

      A subsidiary of the Company maintains a loan facility which enables it to
borrow up to 520 million Japanese yen (approximately $4.6 million U.S. dollars)
at an interest rate 1% above the Japanese yen LIBOR through November 2007.
Borrowings under the facility are available for working capital purposes. The
Company guarantees repayment of amounts borrowed. Borrowings under the loan are
used in support of its operations in Japan. As of May 31, 2006, the balance
outstanding under this facility was $4.2 million U.S. dollars. There were no
borrowings under this facility at May 31, 2005.

      The weighted average interest rate for all outstanding borrowings under
the Company's credit facilities was 5.8% at May 31, 2006.

      Long-term debt of $64.2 million outstanding at May 31, 2006 is scheduled
to be repaid in the fiscal year ended May 31, 2008. The Company was in
compliance with its debt covenants at May 31, 2006.

      The Company guarantees a portion of certain indebtedness ($2.6 million
at May 31, 2006) relating to a joint diamond cutting and polishing operation
in South Africa. The fair value of the guarantee is immaterial.

      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.

6. Stock Incentive Plans
--------------------------------------------------------------------------------

      A Stock Option Incentive Plan was approved by the Board of Directors on
March 11, 1988 (the 1988 Plan). The 1988 Plan has reserved 650,000 shares of the
common stock of the Company for issuance to key employees of the Company and its
subsidiaries. No future grants may be made under the 1988 Plan, although
outstanding options may continue to be exercised.

      A Long-Term Stock Incentive Plan was approved by the Board of Directors on
April 10, 1997 (the 1997 Plan). The 1997 Plan has reserved 1,350,000 shares of
the common stock of the Company for issuance to directors, officers, key
employees and consultants of the Company and its subsidiaries.

                                       28




<Page>


      The purchase price of each share of common stock subject to an incentive
option under each of the plans is not to be less than 100 percent of the fair
market value of the stock on the day preceding the day the option is granted
(110 percent for 10 percent beneficial owners). The Stock Option Committee
determines the period or periods of time during which an option may be exercised
by the participant and the number of shares as to which the option is
exercisable during such period or periods, provided that the option period shall
not extend beyond ten years (five years in the case of 10 percent beneficial
owners) from the date the option is granted.

      The Company does not recognize compensation expense when the exercise
price of the Company's stock options equals the market price of the underlying
stock on the date of the grant. Under Statement of Financial Accounting
Standards No. 123 "Accounting for Stock-Based Compensation", pro forma
information regarding net income and earnings per share is required as if the
Company had accounted for its employee stock options under the fair value method
of the Statement. For purposes of pro forma disclosures, the Company estimated
the fair value of stock options granted in 2005, 2004 and 2003 at the date of
the grant using the Black-Scholes option pricing model. The estimated fair value
of the options is amortized as an expense over the options' vesting period for
the pro forma disclosures.

      The Black-Scholes option valuation model was developed for use in
estimating the fair value of traded options which have no vesting restrictions
and are fully transferable. In addition, option valuation models require the
input of highly subjective assumptions including the expected stock price
volatility. Because the Company's employee stock options have characteristics
significantly different from those traded options, and because changes in the
subjective input assumptions can materially affect the fair value estimate in
management's opinion, the existing models do not necessarily provide a reliable
single measure of the fair value of its employee stock options.

      The following summarizes the assumptions used to estimate the fair value
of stock options granted in each year and certain pro forma information:

                                                              -----------------
                                                                2005      2004
                                                              -----------------
Risk-free interest rate                                          3.85%     2.50%
Expected option life                                          5 years   5 years
Expected volatility                                             30.30%    39.60%
Expected dividends per share                                  $     -   $     -
Weighted average estimated fair value per share
   of options granted at market price                         $  3.09   $  2.96
Weighted average estimated fair value per share
   of options granted above market price                      $  2.48   $  2.49

      No options were granted during 2006. As any options granted in the future
will also be subject to the fair value pro forma calculations, pro forma
adjustments for 2006, 2005 and 2004 may not be indicative of future years.

      A summary of the Plans' activity for each of the three years in the period
ended May 31, 2006 is as follows:

                                                                     Weighted
                             Number of                            average price
                              shares          Option Price          per share
                             --------------------------------------------------
Outstanding - May 31, 2003   1,012,417   $ 4.350   -   $ 14.750     $   8.174
Options expired/cancelled      (56,600)  $ 5.000   -   $ 14.750     $   8.230
Options issued                 208,000   $ 7.000   -   $  8.800     $   8.310
Options exercised               (5,134)  $ 5.125   -   $  6.375     $   5.650
-------------------------------------------------------------------------------
Outstanding - May 31, 2004   1,158,683   $ 4.350   -   $ 14.750     $   8.208
Options expired/cancelled       (9,300)  $ 5.000   -   $ 14.750     $   7.720
Options issued                 360,000   $ 7.770   -   $ 10.560     $   9.310
Options exercised             (169,265)  $ 4.350   -   $ 10.375     $   6.700
-------------------------------------------------------------------------------
Outstanding - May 31, 2005   1,340,118   $ 5.000   -   $ 14.750     $   8.697
-------------------------------------------------------------------------------
Options expired/cancelled      (17,001)  $ 5.480   -   $  8.000     $   6.610
Options issued                       -   $     -   -   $      -     $       -
Options exercised              (18,666)  $ 5.000   -   $  6.550     $   6.230
-------------------------------------------------------------------------------
Outstanding - May 31, 2006   1,304,451   $ 5.000   -   $ 14.750     $   8.697
-------------------------------------------------------------------------------

Exercisable options          1,117,786
---------------------------------------

      In 2005, the Company had cashless exercise of certain options that
generated a compensation expense of $0.3 million.

      The following table summarizes information about stock options at May 31,
2006:

<TABLE>
<CAPTION>
                        Outstanding Stock Options                       Exercisable stock options
---------------------------------------------------------------------   -------------------------
                                        Weighted
                                         average          Weighted                  Weighted
                                        remaining          average                   average
    Range of prices        Shares   contractual life   exercise price    Shares   exercise price
---------------------------------------------------------------------   -------------------------
<C>                       <C>       <C>                <C>              <C>       <C>
$  5.000   -   $  6.550   309,084          4.26           $   5.70      309,084      $  5.70
$  7.000   -   $  8.800   493,567          4.96           $   7.80      386,900      $  7.81
$  9.000   -   $ 10.560   343,300          5.01           $  10.13      263,302      $ 10.14
$ 14.750                  158,500          0.85           $  14.75      158,500      $ 14.75
-------------------------------------------------------------------------------------------------
</TABLE>

                                       29




<Page>


8. Commitments and Contingencies
--------------------------------------------------------------------------------

      Future minimum payments (excluding sub-lease income) under noncancelable
operating leases with initial terms of more than one year consist of the
following at May 31, 2006 (in thousands):

                              Operating
           Year                Leases
      ---------------------------------
               2007                 765
               2008                 789
               2009                 665
               2010                 599
               2011                 623
      Thereafter                  5,567
                              ---------
                              $   9,008
                              ---------

      In June 2003, the Company entered into a lease for office space which
serves as its corporate headquarters. The term of the lease is through September
30, 2019 at an average annual base rental rate of approximately $0.6 million per
year.

      Rental expense, including additional charges paid for increases in real
estate taxes and other escalation charges and credits for the years ended May
31, 2006, 2005, and 2004 was approximately, $1.0 million, $0.9 million and $0.8
million respectively.

As of May 31, 2006 approximately $14.8 million of inventory owned by Pegasus
Overseas Ltd., a wholly owned subsidiary, is subject to a security interest by
a third party.

9. Profit Sharing Plan
--------------------------------------------------------------------------------

      The Company has a profit sharing and retirement plan subject to Section
401(k) of the Internal Revenue Code. The plan covers all full-time employees in
the United States and Puerto Rico who complete at least one year of service.
Participants may contribute up to a defined percentage of their annual
compensation through salary deductions. The Company intends to match employee
contributions in an amount equal to $0.50 for every pretax dollar contributed by
the employee up to 6% of the first $20,000 of compensation, provided the
Company's pretax earnings for the fiscal year that ends in the plan year exceed
$3.5 million. The Company does not anticipate making a contribution for the 2006
plan year. The Company made a matching contribution for the 2005 plan year of
approximately $40,000. The Company did not make a matching contribution during
2004.

                                       30




<Page>


10. Geographic Segment Information
--------------------------------------------------------------------------------

      Revenue, gross profit and income/(loss) before income tax provision and
cumulative effect of change in accounting principles for each of the three years
in the period ended May 31, 2006 and identifiable assets at the end of each of
those years, classified by geographic area, which was determined by where sales
originated from and where identifiable assets are held, were as follows (in
thousands):

<TABLE>
<CAPTION>
                                            North                                  Far
                                           America       Europe       Africa       East     Eliminations   Consolidated
-----------------------------------------------------------------------------------------------------------------------
<S>                                      <C>           <C>          <C>          <C>        <C>            <C>
Year ended May 31, 2006

   Net sales to unaffiliated customers   $   103,914   $  390,599   $   17,196   $ 16,336   $          -   $    528,045
   Transfers between geographic areas        147,120          524      232,498          9       (380,151)             -
                                         -------------------------------------------------------------------------------
Total revenue                            $   251,034   $  391,123   $  249,694   $ 16,345   $   (380,151)  $    528,045
                                         -------------------------------------------------------------------------------
Gross profit                             $    21,281   $    2,593   $    2,174   $  3,785   $         15   $     29,848
                                         -------------------------------------------------------------------------------
Income/(loss) before income taxes        $    (1,382)  $      297   $    1,881   $    (45)  $         15   $        766
                                         -------------------------------------------------------------------------------
Identifiable assets at May 31, 2006      $   167,267   $   58,600   $   29,081   $  8,819   $        (55)  $    263,712
------------------------------------------------------------------------------------------------------------------------
Year ended May 31, 2005

   Net sales to unaffiliated customers   $   108,378   $  295,743   $        -   $ 17,290   $          -   $    421,411
   Transfers between geographic areas        167,634        1,501      113,610         45       (282,790)             -
                                         -------------------------------------------------------------------------------
Total revenue                            $   276,012   $  297,244   $  113,610   $ 17,335   $   (282,790)  $    421,411
                                         -------------------------------------------------------------------------------
Gross profit                             $    28,189   $    2,601   $     (931)  $  4,818   $         57   $     34,734
                                         -------------------------------------------------------------------------------
Income/(loss) before income taxes        $     8,175   $      365   $   (1,231)  $    504   $         57   $      7,870
                                         -------------------------------------------------------------------------------
Identifiable assets at May 31, 2005      $   153,640   $   59,096   $   29,964   $  7,654   $        (70)  $    250,284
------------------------------------------------------------------------------------------------------------------------
Year ended May 31, 2004

   Net sales to unaffiliated customers   $    95,558   $  125,788   $        -   $ 14,429   $          -   $    235,775
   Transfers between geographic areas         40,260        1,459            -          -        (41,719)             -
                                         -------------------------------------------------------------------------------
Total revenue                            $   135,818   $  127,247   $        -   $ 14,429   $    (41,719)  $    235,775
                                         -------------------------------------------------------------------------------
Gross profit                             $    21,692   $    1,735   $     (555)  $  3,334   $        (62)  $     26,144
                                         -------------------------------------------------------------------------------
Income/(loss) before income taxes        $     5,065   $      109   $   (1,333)  $   (506)  $        (62)  $      3,273
                                         -------------------------------------------------------------------------------
Identifiable assets at May 31, 2004      $   163,955   $    6,975   $      729   $  9,180   $       (127)  $    180,712
------------------------------------------------------------------------------------------------------------------------
</TABLE>

Revenue and gross profit for each of the three years in the period ended May 31,
2006 classified by product were as follows (in thousands):

                                     Polished     Rough       Total
          ------------------------------------------------------------
          Year ended May 31, 2006

          Net sales                 $ 149,767   $ 378,278   $ 528,045
                                    ----------------------------------
          Gross profit              $  20,606   $   9,242   $  29,848
          ------------------------------------------------------------
          Year ended May 31, 2005

          Net sales                 $ 156,904   $ 264,507   $ 421,411
                                    ----------------------------------
          Gross profit              $  25,480   $   9,254   $  34,734
          ------------------------------------------------------------
          Year ended May 31, 2004

          Net sales                 $ 142,672   $  93,103   $ 235,775
                                    ----------------------------------
          Gross profit              $  21,854   $   4,290   $  26,144
          ------------------------------------------------------------

                                       31




<Page>


11. Investments in Unconsolidated Joint Ventures
--------------------------------------------------------------------------------

      The Company utilizes the equity method of accounting to record its
proportionate share of income and losses from joint ventures. During 2006 the
Company entered into several joint venture agreements relating to sourcing,
cutting, polishing, processing and sales of diamonds. Combined condensed
financial information concerning the Company's unconsolidated joint venture
activities is as follows: (in thousands)

                                    2006
                                 -----------
Revenues                            128,784
Gross profit                          1,238
Loss before taxes                       633
Net loss                                633

Current assets                       13,154
Non-current assets                      410

Current liabilities                   8,547
Non-current liabilities                   -

12. Sale of Common Stock
--------------------------------------------------------------------------------

      During 2006 and 2005 the Company purchased 216,838 and 197,273 shares,
respectively, of its common stock which was shown as a reduction of
stockholders' equity.

      In February 2002, pursuant to a stock purchase agreement ("SPA"), the
Company sold 1,305,000 shares of its common stock, consisting of 1,180,000 of
previously repurchased treasury shares and 125,000 authorized but unissued
shares, in a private transaction. The SPA provides for, among other things, a
ten-year standstill period whereby the purchaser and its affiliates will not
acquire 24.9% or more of the outstanding shares of common stock, participate in
any proxy disputes or transfer their stock except as provided for in the SPA. In
connection therewith, the purchaser delivered an irrevocable proxy to the
Chairman and President of the Company to vote the 1,180,000 shares, subject to
certain limitations, through February 2010.

      During 2004 the Company purchased approximately $0.3 million of inventory
from an entity affiliated with this investor.

13. 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
2006, 2005 and 2004 were $0.6, $0.5 and $0.5 million, respectively.

      During 2006 and 2005 the Company sold approximately $0.4 and $1.7 million,
respectively, of jewelry to a relative of a non-employee member of the Company's
Board of Directors. During 2004 the Company sold approximately $0.1 million of
jewelry to a non-employee member of the Company's Board of Directors.

14. Quarterly Results of Operations (Unaudited)
--------------------------------------------------------------------------------

       The following is a summary of the results of operations for the years
ended May 31, 2006 and 2005 (in thousands, except per share data):

--------------------------------------------------------------------------
                               First      Second      Third       Fourth
--------------------------------------------------------------------------
2006

Net sales                    $ 138,856   $ 96,275   $ 157,912   $ 135,002
Gross profit                 $   8,982   $  6,054   $   8,909   $   5,903
Net income                   $     908   $   (407)  $     510   $     517
Basic earnings per share     $    0.11   $  (0.05)  $    0.06   $    0.06
Diluted earnings per share   $    0.10   $  (0.05)  $    0.06   $    0.06

2005

Net sales                    $  78,307   $ 93,201   $ 120,013   $ 129,890
Gross profit                 $   9,891   $  8,066   $   7,809   $   8,968
Net income                   $   2,507   $  1,061   $   1,080   $     582
Basic earnings per share     $    0.30   $   0.13   $    0.13   $    0.07
Diluted earnings per share   $    0.29   $   0.12   $    0.12   $    0.07

                                       32




<Page>


             Report of Independent Registered Public Accounting Firm

Board of Directors
Lazare Kaplan International Inc.
New York, NY

      We have audited the accompanying consolidated balance sheet of Lazare
Kaplan International Inc. as of May 31, 2006 and 2005 and the related
consolidated statements of income, stockholders' equity, and cash flows for the
years then ended. These financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.

      We conducted our audits in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those standards require that
we plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. The Company is not
required to have, nor were we engaged to perform, an audit of its internal
control over financial reporting. An audit includes consideration of internal
control over financial reporting as a basis for designing audit procedures that
are appropriate in the circumstances, but not for the purpose of expressing an
opinion on the effectiveness of the Company's internal control over financial
reporting. Accordingly, we express no such opinion. An audit also includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements, assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.

      In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Lazare
Kaplan International Inc. at May 31, 2006, and the results of its operations and
its cash flows for the years then ended in conformity with accounting principles
generally accepted in the United States.

      BDO Seidman, LLP

      New York, NY
      August 17, 2006

                                       33




<Page>


             Report of Independent Registered Public Accounting Firm

   Board of Directors and Stockholders
   Lazare Kaplan International Inc.

      We have audited the accompanying consolidated balance sheet of Lazare
Kaplan International Inc. and subsidiaries as of May 31, 2004 and the related
consolidated statements of income, stockholders' equity, and cash flows for the
year ended May 31, 2004. These financial statements are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.

      We conducted our audit in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those statements require
that we plan and perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement. We were not engaged
to perform an audit of the Company's internal control over financial reporting.
Our audit included consideration of internal control over financial reporting as
a basis for designing audit procedures that are appropriate in the circumstance,
but not for the purposes of expressing an opinion on the effectiveness of the
Company's internal control over financial reporting. Accordingly, we express no
such opinion. An audit also includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements, assessing
the accounting principles used and significant estimates made by management, as
well as evaluating the overall financial statement presentation. We believe that
our audits provide a reasonable basis for our opinion.

      In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position of
Lazare Kaplan International Inc. and subsidiaries at May 31, 2004 and the
consolidated results of their operations and their cash flows for the year ended
May 31, 2004 in conformity with U.S. generally accepted accounting principles.

   Ernst & Young, LLP

New York, New York
August 19, 2004

                                       34




<Page>


                              Corporate Information

<TABLE>
<S>                        <C>                          <C>
Corporate Headquarters     Directors and Officers       Registrar and Transfer Agent

19 West 44th Street        Maurice Tempelsman           Mellon Investor Services
New York, New York 10036   Director;                    44 Wall Street
Telephone (212) 972-9700   Chairman of the Board        6th Floor
                                                        New York, NY 10005
                           Leon Tempelsman
                           Director;                    Counsel
                           Vice Chairman of the Board
                           and President                Warshaw Burstein Cohen
                                                        Schlesinger & Kuh, LLP
                           Lucien Burstein              555 Fifth Avenue
                           Director;                    New York, New York 10017
                           Secretary
                           Of Counsel                   Registered Public Accounting Firm
                           Warshaw Burstein Cohen
                           Schlesinger & Kuh, LLP       BDO Seidman, LLP
                           (attorneys)                  330 Madison Avenue
                                                        New York, New York 10017
                           Myer Feldman
                           Director;
                           Attorney,
                           self-employed

                           Richard A. Berenson
                           Director;
                           Former Managing Partner
                           Berenson & Company, LLP

                           Robert A. Del Genio
                           Director;
                           Co-Founder
                           Conway, Del Genio,
                           Gries & Company, LLC

                           William H. Moryto
                           Vice President and
                           Chief Financial Officer
</TABLE>

                                       35