Description

Charles & Colvard (CTHR) is your classic "cigar butt!" It has been around a long time with many good years and some bad years. It was originally known as the exclusive supplier of Moissanite diamond jewelry. It had a poor second (fourth calendar year) quarter with sales well below expectations. Sales were down 24% in the quarter. Online sales represented 84% of total sales versus 76% last year. (Sequentially sales were substantially higher, but the second quarter was the traditional strong Christmas quarter.) Net loss was $.09 per share versus $.03 loss per share last year. The second quarter was challenging for the entire industry as sales were down 6% for the industry. Lab-grown diamonds put substantial pressure on industry pricing. It clearly shows that the Company needs to put more resources in lab-grown diamonds and move away from its distributor model of loose stones. The Company is now moving to a direct distribution model forging relationship with retailers. The impact of these actions, outlined below, should become evident over the next few quarters. 

Why should we be interested in this Company? Well, it's selling at less than 40% of classic Net Current Assets (NCA)  when we value long term jewelry inventory at 50% of book.  Even if you value long term inventory, which is substantially made up of 14K gold, at zero, the shares sell for 60% of NCA. NCA is essentially cash and jewelry inventory which can be easily liquidated at book! We have a market cap of $9 million, over $11 million in cash, almost $25 million jewelry inventory and no debt!

How much gold is in in the inventory? (I am sure you are asking.)  Of the $25 million in inventory, $17 million is finished products and of that 60% is 14 K gold, or about $10 million of gold! Valuing the diamonds at zero that still gives us cash and gold of over $20 million which is double the market value.

The real issue is, can they turn this business around? Management certainly thinks so and is putting their money where their mouth is! Management has been  an active buyer of the shares over the past few months, with numerous Form 4 filings.. The CEO, O'Connell, bought 30,000 shares at $.34 on February 22nd,  and 15,000 shares at $.37 on March 5th. As of March 5th O'Connell owned a total of 720,450 shares with a market value of only $216K but all purchased at prices substantially above the current price. Board member Sykes has been even more active than the CEO. In a 13D filing on March 26 he disclosed a 6.1% ownership in the Company of 1.844 million shares and additional purchases occurred after the 13D filing. As it turns out this is just a portion of Mr. Sykes holdings. In a Proxy just recently filed he disclosed a total position 3.35 million shares or 11% of the outstanding shares, CEO O'Connell disclosed a position of 1.32 million shares for a 4.4% share in the Company. In total management holds almost 7.5 million shares representing almost 25% of the outstanding shares.

That's the good news. The bad news is they are about to execute the dreaded, deadly reverse split in May which almost always leads to a drop in the share price. The question is should we buy the shares now or wait until the reverse split and get them cheaper? I would buy a small position now and buy more post-split.

The opportunity for the Company to return to profitability lies in the transition from Moissanite diamonds to man-made diamonds. They believe they have an excellent opportunity for success here. From our standpoint, we just need for them to stop the cash burn and break even to more than likely double our investment. Management is laser focused on reducing and eliminating the cash burn. Cash burn was only $1.7 million this quarter versus $2.7 million last year.

Before moving on, let's answer the obvious question: What is Moissanite? Moissanite is made of silicon carbide and is synthesized in the factory. It's properties are very similar to a diamond. In terms of sparkle,though, it sparkles more than a diamond, giving it more fire. It is not as hard as a diamond but it sells for less than 10% the price of a diamond. It has never caught on, but has maintained a small niche market, that was once dominated by CTHR.

What actions is the Company taking to take advantage of the demand for man-made diamonds?

1) Launched MADE Shopping, The Company's new owned multimedia network.

2) Launched madeshopping.com to support the multimedia network

3) Launched two strategic drop shipping partnerships with Fred Meyer Jewelers and the Army and Air Force Exchange

4) Introduced Caydia lab grown diamond jewelry at select Helzberg Diamond Stores

5) Expanded chalesandcolvard.com assortment to include 126 new Moissanite and lab grown styles

6) Debuted lab grown diamond jewelry to be drop-shipped with Amazon, eBay, Walmart.com and other vendors.

7) Participated in numerous promotional events including in Raleigh magazine, TODAY.com, theknot.com, brides.com, Insider.com, JCkoline.com, MarieClaire.com and The National Breast cancer Foundation.

All the above is interesting but what gives the Company credibility and gives me some confidence in the investment is its relationship with Helzberg Diamonds, a Berkshire Hathaway Company. As noted above, It markets a line of Moissanite Diamonds and a an exclusive line of man-made diamonds through Helzberg. There is a significant push to buy "made and not mined" diamonds. Given the belief that minors are exploiting the various countries where they mine diamonds, factory made diamonds have caught on. They a significantly cheaper than mined diamonds and identical to mined diamonds in every way! The Helzberg channel could end up making all the difference for CTHR.

In summary, we have a management team that's "all-in" in a  turnaround for the Company, relationships with reputable companies like Helzberg and a valuation that is extremely compelling. We are getting this Company certainly for less than 50% than current liquidation value. The chance of success look good.

Catalyst

1) Sales of Man-made diamonds continue to expand.

2) The Company is successful in developing its new distribution channels.