Description

Charles & Colvard is a jewelry supplier and online retailer that specializes in moissanite gemstones and jewelry. After surprising the market last year with strong growth that only represent half measures in terms of marketing investment, shares have settled at a level that still overly discounts the profitable growth runway ahead. If holiday results come in strong on the back of full-court marketing investment, and management has given us reasons to believe they will, it could change the narrative and rerate the shares.

Background

For more background on the company and moissanite, please read this earlier VIC posting. We will skip over much of the history, customer value proposition and other information that was covered there. https://valueinvestorsclub.com/idea/CHARLES_andamp%3B_COLVARD_LTD/0497901829

Despite reporting 4 consecutive quarters of revenue growth in the low to high teens and an upgraded gross margin profile, shares have drifted down from its recent peak in the mid-2’s and have been unable to hold onto gains after multiple positive earnings surprises. The share illiquidity, tiny market cap and general skepticism of the sector (retail? jewelry? uggh!) are likely culprits. 

In addition, the company exhibits high seasonality, with Q2 (Dec 31, including holidays) and Q3 (Mar 31, including Valentine’s Day) contributing the lion’s share of annual results. Understandably, investors are not entirely wrong to discount shoulder season results. 

Trading patterns also suggest short-termism into and post-earnings, with little reason to hold shares between reports, especially if you’re someone like #5 holder Rentech. There is some institutional ownership, but it is likely that retail, algos and the odd micro-cap fund set the marginal price.

This may all change with the reporting of Q2’s holiday season results on February 6. If results represent another stair step in growth as we believe they should, it may be the catalyst that rerates the shares strongly to the upside and with more finality. We see 30% to 100% near-term upside, and the potential for much greater appreciation. If the company does demonstrate exceptional results for the holiday season, it also likely sets up H2 FY2020 and FY2021 for a continuation of higher growth. From a trading perspective, investors will then have a reason to hold through Q3 and thereafter to see sustained higher growth unfold.

We see medium-term upside of at least +100% from here. They need only catch the attention of a few small funds and institutions. If they get lucky and catch on with the millenial zeitgeist, it could be worth a lot more.

On the other hand, if they don’t get it right this holiday season, it is still cheap at 0.9x book and a cashed up balance sheet. They still have a large growth runway both in terms of untapped channels, as well as just doing basic retailing blocking & tackling better.

The Setup:

C&C already has a profitable niche business with positive FCF, a strong balance sheet (no debt, lots of cash) and high operating leverage. The main debate is whether lack of awareness is the only factor holding back much greater sales growth. Thus, this investment boils down to whether you believe management’s claims that it can 1.) sustainably deliver 2-8x ROI on advertising spend, 2.) enough demand exists for the company to grow revenue in excess of 20%+ for the foreseeable future by upping the marketing spend and 3.) its brand and offering is defensible against alternatives. 

Management has invested incrementally but conservatively in marketing over the past year and thus far has been able to demonstrate several quarters of good growth by tweaking their spend while opening new distribution channels. However, all of that has been market testing as a lead up to the holiday season ramp up. Nearly all of their incremental marketing efforts will be focused on their Online channel, which represents sales through their own website and which represent their highest margin sales.

They began priming the pump in Q1 (last quarter) with additional “top of funnel” marketing - ie. spend that does not necessarily convert into immediate sales, but is meant to build awareness. Much of their foundational work has revolved around influencers (JWoww, streamers, others), podcasts, videos, media placements and tapping other social media. Some early signs this is working as of Q1: +75% increase in their email database QoQ (albeit off a small base), 300% increase in YouTube subscribers YoY, 200% increase in YouTube clickthroughs YoY. 

This shifted into high gear during Q2 with a blitz of targeted email, display, social and paid search - all meant to convert prospects to sales. We observe this has continued into Q3 in anticipation of Valentine’s Day. 

It is surprising how nascent some of their programs are compared to any established retailer, which may be a reflection of their more historically wholesale legacy (selling through 3rd parties) and bad capital allocation decisions in the past. Examples include: an email database was not previously a priority, they have just begun to offer an installment option, and they had made limited effort to re-engage existing customers previously despite a high repeat buyer contribution (28% of all sales), international retailing still in infancy.

So, while the ultimate market potential is unknown, what is clear is that there has been consumer demand for their product despite a mostly second rate effort at playing retailer. So, what could the business look like once they start doing what is just basic blocking and tackling to other retailers?

Signpost #1: Web Traffic

Website traffic improved +50% YoY in Q1, and Q2 data suggests further increases on the order of another ~30% sequentially.

Engagement metrics are also promising: since mid-year 2019, page views per visit are up ~50% as is total time spent browsing on the C&C website.

Source: Similarweb, Alexa. Caution: web data is notoriously unreliable.

Signpost #2: Inventory Build

C&C increased their inventory sequentially by the largest amount ever ($2.3 mm) in Q1. A direct comparison with prior years’ Q1 inventory needs to be adjusted - inventory must be separated into New (highest grade, highest price Forever One) and Legacy (yellowish tinted inventory of Forever Classic and Forever Brilliant in runoff). Given that Q1 2019 inventory of $30.9 mm was ~72%/28% New/Legacy and Q1 2020 inventory of $36 was ~81%/19% New/Legacy, one can roughly infer that they increased their New inventory by $6.9 mm or 31% YoY. Of this, only $900k was consignment inventory placed at Helzberg. New inventory sells at vastly higher gross margins vs. Legacy (3-5x per carat), meaning that the embedded revenue potential per inventory unit is much higher. 

Signpost #3 Industry Datapoints

Credit card data on jewelry sales is also strong-ish this season with +2% comps in the jewelry category and +9% for the online jewelry category. Signet and Richemont, among others, reported better than expected results. Given significant sales go through their B&M partner Helzberg and some international sales through physical distributors and online marketplaces, these datapoints suggest a supportive industry backdrop. 

Signpost #4 Modeling Ad Spend ROI

As for projecting upcoming holiday results, below is a bottoms-up build based on management’s guidance on advertising ROI and spending levels. It will almost certainly be wrong, but should be directionally correct.

- C&C did $10.1 mm in revenue in their year-ago Q2 2019 quarter, of which $4.7 was Traditional and $5.4 was Online.

- They estimate a 2x-8x return on every advertising dollar spent. In their recent quarters, they claim to have averaged a 4x average return on ad spend, but expect ROI in the lower end for Q2 given more of their current marketing is focused on attracting new customers whom will have lower conversion.

- They increased YoY S&M spend by +37.5% or $600k in Q1, of which $400k was targeted online ad spend. This implies a potentially > 50% increase in ad budget, as total S&M spend of $2.2 mm includes many fixed line items. Management targeted much of this incremental spend to “top of funnel” investment that did not convert in Q1, but which they expect to retarget in Q2.

- Management anticipates Q2 ad spend to increase in a similar proportion to Q1. We estimate an incremental ~$1 mm ad spend for Q2. Management indicates they can throttle ad spend in real time based on campaign results, so the total spend could be higher or lower.

- The expansion of Helzberg display case placement helped to improve YoY Traditional sales by 30% and 10% over the past two Qs. (Note that there is some potential for revenue timing differences because of different accounting treatment for consignment vs. asset sales at brick & mortar. Also, it can be lumpy due to periodic distributor buys.)

- Crudely putting this all together, $4.7 mm Traditional revenue per prior year x conservative 10% growth = $5.2 mm + $5.4 mm Online per last year carried forward + $1 mm new ad spend x 2x return on ad spend ⇒ $12.6 mm Base Case revenue

- The Base Case may be overly conservative for a few reasons, namely that there is some unconverted awareness marketing from Q1, marketing ROI at 2x is probably too punitive (discussed later) and there should be greater marketing efficiency with existing channels for no reason other than repeat buying. Adjusting the numbers to add half of the Q1 ad spend converting in Q2, moving the overall incremental ROI at 3x, plus a 10% increase in the “base” $5.4 mm prior year Online sales due to better mining their existing customer base ⇒ $14.71 mm Upside Case revenue.

While it is hard to precisely judge how the company will perform, we believe they have set themselves up for a quarter that should exceed implied market expectations. 

- It is reasonable to believe they can at least beat the 1 analyst estimate out there at $11.7 mm, and which would represent ~25% YoY growth the Base Case and ~45% YoY growth in the Upside Case. We suspect the market is anchored to a mid-teens growth rate currently, at which the company is still undervalued - but we care about relative expectations more for our catalyst.

- C&C GMs have been in the mid to high 40% range over the past year, with higher ranges captured in quarters with greater Online growth (eg. 49% in Q1). With online sales expected to make up approximately 60%+ of revenues in Q2 and C&C Online sales at 60%+ margins, it would not be unreasonable to see overall margins of greater than 50%. However, we use 50% GMs here for conservatism.

- At these revenue levels, one could expect EPS of $0.07 in the Base Case to $0.11 in the Upside Case for Q2 vs. the sole analyst at $0.04

(A note on empty calories: our base case assumes a 2x ROI on ad spend, which is pretty weak if considered in the context of average GMs of 50% - essentially, expensing $1 of ad money to get $1 of GM. Of course, C&C website GMs are in excess of 60%+, but if C&C is marketing effectively, they will have to deliver higher ad ROI than 2x to be doing a good job. They should be able to do so, as compared to our estimates, given management has indicated to us that a significant portion of their incremental spend will be still targeting existing customers at 4-8x ROI not just new customers at 2-4x ROI.)

Valuation

So what is it worth? If C&C can credibly support >20% topline growth and demonstrate strong operating leverage, a 15x P/E multiple seems like a reasonable place to start. There aren't a lot of high growth primarily online retailers that are actually making money. What’s the right comp? It’s not Signet at 6x with flat to declining topline. Maybe it is closer to Ulta at 20x with 9% topline growth but a stronger moat? Lululemon at 40x and 20% growth? There are lots of brand-only moat retailers with single digit growth between 10x-20x. Who knows? It’s a microcap, so it will be what it will be. 

Applying this multiple to a range of $0.13 Base Case FY2020 EPS to $0.20 in Upside Case gets us to $1.95 (+30%) to $3.00 (+100%). For comparison, they earned $0.10 in FY2019 EPS vs. -$0.08 in FY2018. The Roth analyst has $2.50 PT on $0.08 EPS, though the analyst doesn’t mean much here. If you give them credit for the $0.42 of cash on the balance sheet, and you should since they will be growing cash despite increasing WC, then things look even better. 

This is a consumer discretionary business and a micro cap, so results could be way off for any number of reasons. What is particularly hard to estimate is the level of foreign marketplace sales (think Amazon Japan) affecting Online, and lumpy stocking purchases by both domestic and international distributors which can flatter or punish comps in any given quarter. 

It is an illiquid microcap, so it could trade anywhere if they fall on their face. Looking at the real downside, though, the balance sheet cash and inventory (if fully valued) together are worth where they trade today - so long as the marketplace value of their offering do not fall apart, there’s pretty good valuation support at 0.9x book. 

Other Debates 

These are some key debates which will have an impact on perception and valuation, many of which will not likely be settled anytime soon:

- What is the actual TAM?

- Are synthetic diamonds a real threat?

- Will moissanite be commoditized? 

Regardless, C&C is so small and niche today as to be unlikely to have tapped out even a miniscule % of whatever its actual TAM is. So long as investors can see a multi-year runway of double digit revenue growth runway ahead with reasonable marketing spend, translating into even higher EPS growth and substantial FCF, the debates may not matter that much in the medium term.

On the flip side, there is also optionality that moissanite is swept up by the social consciousness movement and the millennial anti-materialism shift. It certainly feels like the right place and the right time for it to become a fad. Interestingly, Moissanite had a brief moment in the sun at the end of 2017 / early 2018, steadily increasing its share of the market since (albeit off of a tiny base). 

Risks:

- Poor execution - merchandising, targeting, promotional cadence

- Opacity of international and B&M sales

- Lumpiness in recognition of certain distributor sales can affect results significantly

- Traditional segment still has exposure to mall weakness

- Price competition for limited category spend from synthetic diamonds, other gemstones and other moisssanite

Other Information:

Average customer: It is worth noting that C&C is not selling low priced fashion jewelry as one might initially assume. Their largest category by far is engagement rings and their average order value is $1k (actually climbing to $1.1k recently, although will be lower over holidays due to seasonal discounting). 

Industry: The below report highlights that moissanite represents roughly 2% of the engagement ring market, is now the most popular diamond alternative gemstone, and has apparently doubled its share since 2017. As the jewelry industry is about as honest and transparent as … say healthcare, lending, or education … we’ve also seen self-serving reports that seem to vastly overstate these figures, but this survey appears directionally credible. https://instoremag.com/the-truth-about-how-modern-couples-shop-for-engagement-rings/

Management: You won’t find the most credentialed management teams in micro-cap land, but we like the team here. The CEO is high energy and dynamic, without being overly promotional. The CFO gets the job done, though does not present well in person. Importantly, they have made an improved effort to develop their relationship with investors and to respond to questions/feedback. Their bonus is predicated on hitting revenue, GM and EBITDA goals - this has served shareholders well so far. Our sense is, if they don’t hit their #s, it is because they miscalculated, not because they’re hyping the story.

Balance Sheet: Directors and management participated in the June 2019 equity financing @ $1.60 and have been periodic buyers since. They raised about $9 million as a war chest to fund their growth. They do not intend to pursue M&A, and have reserved this cash to fuel their growth, as they have seen a high ROI on their various initiatives. In any given year, they should generate positive FCF, other than inventory building in certain quarters or accelerated quarter-ahead marketing. They have federal and state NOLs which should obviate taxes for at least the next several years.

Catalyst

Q2 earnings results

Q3 earnings results