CHARLES & COLVARD LTD CTHR
May 13, 2019 - 3:42pm EST by
niceonice
2019 2020
Price: 1.91 EPS 0.10 0.14
Shares Out. (in M): 22 P/E 19 13.5
Market Cap (in $M): 42 P/FCF 0 0
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 38 TEV/EBIT 0 0

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  • atrocious accounting
 

Description

First, a disclaimer: the stock has run quite a bit after its most recent earnings and since I first started writing this idea up. I still like it at under $2/share.

 

Charles and Colvard is a retailer of moissanite, a lab-created gemstone similar in appearance to a diamond. The company’s marketing materials state that their moissanite is second only to a diamond on the MOHs hardness scale, measuring out at 9.25 (vs. diamond at 10), but actually scores higher on the Brilliance Refractive Index (BRI) at 2.65-2.69 vs diamond at 2.42 (https://www.charlesandcolvard.com/customer-care/moissanite-faq/). In fact, moissanite is just silicon carbide, which has various industrial/manufacturing and consumer applications from abrasives and cutting tools to bullet-proof vests and LEDs.

The company sells loose gemstones and finished jewelry through various brick-and-mortar retail partners and direct-to-consumer through their website, where they target millennial consumers, selling the product as a more affordable, sustainable, and conflict-free product. Their most popular high-end moissanite (“Forever One”), which launched in late 2015, and has been featured in several media outlets, where diamond shoppers couldn’t distinguish between the diamond and CTHR’s stone, which sells for around 35-50% of the price. Here’s the segment on the Today Show from 2017: https://www.today.com/video/can-you-tell-which-is-a-real-diamond-and-which-is-a-cheaper-gemstone-875990595743.

While the story sounds all well-and-good—a diamond lookalike that’s going to have a huge TAM for cost-conscious consumers, this nano-cap has been around forever, and it’s had its share of hype cycles and slip-ups. But I believe they’ve finally addressed most of the old baggage, and that the company is at an inflection point, just announcing a second straight quarter (the two most important of the year—the Christmas and Valentine’s Day quarters) last Thursday of solid growth and profitability. Although the stock rocketed up more than 30% on Friday, the company has grown their online sales over 25% yoy in the six months of the year that matter the most, continues to expand gross margin while managing operating expenses exceptionally well, and still trades around 13x what I think are very doable earnings going forward. There isn’t any official sell-side coverage, either, which I expect will change in the coming quarters, which should also attract some buyers for the stock. I view it as a pretty cheap option—at this price, and with their current balance sheet, I don’t think there’s much downside, but it could payoff big if they continue to execute their brand strategy and are able to capture a larger audience for their product.

 

Brief History

While the moissanite on charlesandcolvard.com competes with a traditional diamond today, it wasn’t always that way. The company has been public for quite a while, but in the past, it had trouble getting all of the color out of the moissanite, so it had a yellowy tinge to it and was sold at a lower price point. While they did have a spark of success in the 2011-2013 timeframe, as they began pushing their product to bored housewives on Jewelry Television (JTV), that success was short-lived as consumers shifted away from TV Home Shopping to internet shopping. From 2011 to 2014 the company’s sales increased by 60%, but opex more than doubled.

The company also had gotten involved in various low-margin (read: low-quality) tangential businesses and sales outlets that didn’t pan out very well. Most recently, in 1Q 2016, they divested their interest in Lulu Avenue, a multi-level-marketing business contingent on recruiting middle-aged women to sell other middle-aged women cheap costume jewelry. While in the beginning of its launch, it provided sales growth, it never really caught on, and a lot of those sales dollars went to the “Style Advisors” who were pushing the jewelry. The divestiture of the chronically unprofitable business basically amounted to an assumption of assets/liabilities.

In late 2015 (right around the time Forever One was launched) the current CEO, Suzanne Miglucci, came in from a marketing background at ChannelAdvisor and SAP. The hire was the first major position filled by someone who didn’t come from the diamond or jewelry industry, which I think has been an asset in the new direct-to-consumer world. The old guard of CEOs were more focused on selling moissanite as a cheap alternative to diamond in the traditional diamond retailing channels, and while the company does still get significant contribution from partners like Helzberg, Suzanne has brought a new marketing vision, selling moissanite on its own merits as a beautiful gemstone in a high-margin, high-quality, online, branded format. In the past few years, she’s reallocated the marketing resources to newer, targeted online ad campaigns more relevant to a millennial audience through social media (influencers, facebook, etc.), and revamped the website to be prettier and easier to use. She also brings a much-needed female vision to the company, which has begun to pay off.

Valuation

Due to the nature of the jewelry business, having long-term inventory on hand or at retail partners’ stores, the company has most of its balance sheet tied up in inventory. One of the lingering concerns of investors has been that much of this inventory was the older, more yellowy moissanite, which could potentially be more difficult to sell at a reasonable margin, especially given the newer Forever One line. At year-end 2016, the legacy inventory represented just over 50% of the $28 million of inventory on the balance sheet. As of 3/31/19, CTHR had about $34 million of inventory, and the legacy inventory had been reduced to less than ¼ of the total inventory. The increased inventory has been in large part due to expanded case space at Helzberg as well as interest from other retailers. With the stock at $1.85/share, around a $40 million market cap, it’s trading at just 1.1x book.

On the earnings side, for the trailing 9 months, CTHR has earned $0.10/share. However, that doesn’t include the most seasonally challenged June quarter (Q4), in which they lost $0.03/share in 2018. I think that if they execute well, they could get to breakeven in this year’s Q4, keeping them at $0.10 for the year. The mix should continue to improve as well with online, which has grown at a very impressive clip (and has just eclipsed the 50% of total revenue mark) becomes an even larger part of the business. If they can keep this current pace of revenue growth and disciplined opex, I see the company getting to at least $3 million of operating income (which approximates EPS since they have no debt and a $25 mil NOL) in F2020. This comes out to around $0.14/share, or 13x earnings, ex-cash, for a business growing revenue in the high-teens.

Risks

-          It’s not a diamond, and doesn’t carry the same mystique, so moissanite might not hold its value the same way over time.

-          A small addressable market could lead to overestimation of growth runway and unfruitful spending, as was the case in the 2011-2013 timeframe.

-          Cree is currently an exclusive manufacturing partner, and while the agreement was extended recently, there could be pricing/exclusivity disagreements down the line.

-          While there’s no major competition currently for moissanite, there are some cheaper Chinese manufacturers (who can’t get the stone as brilliant/colorless as CTHR), that could eventually improve their technology and cause pricing pressure.

 

 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

-          Strong December and March quarters

-          Pick-up in sell-side interest 

-          International sales, which used to be more important in the early days, became a bright spot in the last quarter, and could portend extra growth upside

 

 

    sort by    

    Description

    First, a disclaimer: the stock has run quite a bit after its most recent earnings and since I first started writing this idea up. I still like it at under $2/share.

     

    Charles and Colvard is a retailer of moissanite, a lab-created gemstone similar in appearance to a diamond. The company’s marketing materials state that their moissanite is second only to a diamond on the MOHs hardness scale, measuring out at 9.25 (vs. diamond at 10), but actually scores higher on the Brilliance Refractive Index (BRI) at 2.65-2.69 vs diamond at 2.42 (https://www.charlesandcolvard.com/customer-care/moissanite-faq/). In fact, moissanite is just silicon carbide, which has various industrial/manufacturing and consumer applications from abrasives and cutting tools to bullet-proof vests and LEDs.

    The company sells loose gemstones and finished jewelry through various brick-and-mortar retail partners and direct-to-consumer through their website, where they target millennial consumers, selling the product as a more affordable, sustainable, and conflict-free product. Their most popular high-end moissanite (“Forever One”), which launched in late 2015, and has been featured in several media outlets, where diamond shoppers couldn’t distinguish between the diamond and CTHR’s stone, which sells for around 35-50% of the price. Here’s the segment on the Today Show from 2017: https://www.today.com/video/can-you-tell-which-is-a-real-diamond-and-which-is-a-cheaper-gemstone-875990595743.

    While the story sounds all well-and-good—a diamond lookalike that’s going to have a huge TAM for cost-conscious consumers, this nano-cap has been around forever, and it’s had its share of hype cycles and slip-ups. But I believe they’ve finally addressed most of the old baggage, and that the company is at an inflection point, just announcing a second straight quarter (the two most important of the year—the Christmas and Valentine’s Day quarters) last Thursday of solid growth and profitability. Although the stock rocketed up more than 30% on Friday, the company has grown their online sales over 25% yoy in the six months of the year that matter the most, continues to expand gross margin while managing operating expenses exceptionally well, and still trades around 13x what I think are very doable earnings going forward. There isn’t any official sell-side coverage, either, which I expect will change in the coming quarters, which should also attract some buyers for the stock. I view it as a pretty cheap option—at this price, and with their current balance sheet, I don’t think there’s much downside, but it could payoff big if they continue to execute their brand strategy and are able to capture a larger audience for their product.

     

    Brief History

    While the moissanite on charlesandcolvard.com competes with a traditional diamond today, it wasn’t always that way. The company has been public for quite a while, but in the past, it had trouble getting all of the color out of the moissanite, so it had a yellowy tinge to it and was sold at a lower price point. While they did have a spark of success in the 2011-2013 timeframe, as they began pushing their product to bored housewives on Jewelry Television (JTV), that success was short-lived as consumers shifted away from TV Home Shopping to internet shopping. From 2011 to 2014 the company’s sales increased by 60%, but opex more than doubled.

    The company also had gotten involved in various low-margin (read: low-quality) tangential businesses and sales outlets that didn’t pan out very well. Most recently, in 1Q 2016, they divested their interest in Lulu Avenue, a multi-level-marketing business contingent on recruiting middle-aged women to sell other middle-aged women cheap costume jewelry. While in the beginning of its launch, it provided sales growth, it never really caught on, and a lot of those sales dollars went to the “Style Advisors” who were pushing the jewelry. The divestiture of the chronically unprofitable business basically amounted to an assumption of assets/liabilities.

    In late 2015 (right around the time Forever One was launched) the current CEO, Suzanne Miglucci, came in from a marketing background at ChannelAdvisor and SAP. The hire was the first major position filled by someone who didn’t come from the diamond or jewelry industry, which I think has been an asset in the new direct-to-consumer world. The old guard of CEOs were more focused on selling moissanite as a cheap alternative to diamond in the traditional diamond retailing channels, and while the company does still get significant contribution from partners like Helzberg, Suzanne has brought a new marketing vision, selling moissanite on its own merits as a beautiful gemstone in a high-margin, high-quality, online, branded format. In the past few years, she’s reallocated the marketing resources to newer, targeted online ad campaigns more relevant to a millennial audience through social media (influencers, facebook, etc.), and revamped the website to be prettier and easier to use. She also brings a much-needed female vision to the company, which has begun to pay off.

    Valuation

    Due to the nature of the jewelry business, having long-term inventory on hand or at retail partners’ stores, the company has most of its balance sheet tied up in inventory. One of the lingering concerns of investors has been that much of this inventory was the older, more yellowy moissanite, which could potentially be more difficult to sell at a reasonable margin, especially given the newer Forever One line. At year-end 2016, the legacy inventory represented just over 50% of the $28 million of inventory on the balance sheet. As of 3/31/19, CTHR had about $34 million of inventory, and the legacy inventory had been reduced to less than ¼ of the total inventory. The increased inventory has been in large part due to expanded case space at Helzberg as well as interest from other retailers. With the stock at $1.85/share, around a $40 million market cap, it’s trading at just 1.1x book.

    On the earnings side, for the trailing 9 months, CTHR has earned $0.10/share. However, that doesn’t include the most seasonally challenged June quarter (Q4), in which they lost $0.03/share in 2018. I think that if they execute well, they could get to breakeven in this year’s Q4, keeping them at $0.10 for the year. The mix should continue to improve as well with online, which has grown at a very impressive clip (and has just eclipsed the 50% of total revenue mark) becomes an even larger part of the business. If they can keep this current pace of revenue growth and disciplined opex, I see the company getting to at least $3 million of operating income (which approximates EPS since they have no debt and a $25 mil NOL) in F2020. This comes out to around $0.14/share, or 13x earnings, ex-cash, for a business growing revenue in the high-teens.

    Risks

    -          It’s not a diamond, and doesn’t carry the same mystique, so moissanite might not hold its value the same way over time.

    -          A small addressable market could lead to overestimation of growth runway and unfruitful spending, as was the case in the 2011-2013 timeframe.

    -          Cree is currently an exclusive manufacturing partner, and while the agreement was extended recently, there could be pricing/exclusivity disagreements down the line.

    -          While there’s no major competition currently for moissanite, there are some cheaper Chinese manufacturers (who can’t get the stone as brilliant/colorless as CTHR), that could eventually improve their technology and cause pricing pressure.

     

     

    I do not hold a position with the issuer such as employment, directorship, or consultancy.
    I and/or others I advise hold a material investment in the issuer's securities.

    Catalyst

    -          Strong December and March quarters

    -          Pick-up in sell-side interest 

    -          International sales, which used to be more important in the early days, became a bright spot in the last quarter, and could portend extra growth upside

     

     

    Messages


    SubjectRe: De Beers
    Entry05/13/2019 05:35 PM
    Memberniceonice

    Certainly the pricing strategy they've taken is aggressive and concerning for margins on lab-created diamonds (and therefore eventually moissanite), but the last two quarters were the best in a long time margin-wise for CTHR while lab-created diamond pricing was apparetly getting crushed. I don't know where it shakes out long-term, and I don't have a good reference point or model for cost/carat for synthetic diamond (if you do, I'd love to see). 

    I do buy the company's party line at least a little bit in that as big companies promote lab-created stones, it brings a degree of credibility and awareness to the whole sub-industry, and awareness is probably the company's biggest hurdle at this point in time. But I do think they downplay the possibility for any long-term margin pressure.


    SubjectRe: Re: De Beers
    Entry05/14/2019 05:18 AM
    MemberHarden

    big companies promote lab-created stones, it brings a degree of credibility and awarenes

    I agree and think the silicon valley startups with a similar goal are a positive. As long as the category grows that trumps the competition element. 

    I worry a bit more about De Beers agenda. Perhaps I'm being to cynical but I sometimes fear De Beers is trying to damage the category (by cheapening the product). 


    SubjectRe: competition
    Entry05/15/2019 03:38 PM
    Memberniceonice

    Correct, they do not have exclusivity on the gemstone. However, to my knowledge they by far are the best at getting the color out of it. And like I said in the comments yesterday, I do somewhat believe the company's line that more competition brings credibility and awareness, which expands the market, and the size of the market is the biggest hurdle at this point. 

    The direct to consumer business is more valuable because you can go to their site and they can better tell the story on a webpage than a staff member at the local jewlery store. They are in Helzberg (https://www.helzberg.com/category/collections/charles-colvard-moissanite.do), Macy's (https://www.macys.com/shop/jewelry-watches/all-fine-jewelry/Brand/Charles%20%26%20Colvard?id=65993), and a handful of other retailers, but I think the major growth opportunity for them today is online through charlesandcolvard.com. 

    True, not many have heard of it. I think some of the reason for that is that the technology improvements CTHR made to make it colorless are relatively recent, and I don't think the company had done a good job in building a brand before this CEO got there. It's also probably because the market just hasn't been very big. Part of the bet the company is making is that the younger generation will find the value proposition more appealing that those in the past--if I'm in my 20s, maybe I care more about saving a couple thousand dollars (that I can spend on an experience rather than an object) on my engagement ring for something that I know is conflict-free, is just as durable, and looks just as pretty as a diamand than I do paying up for something just because it's rarer. In the long run, if the company does have sustainable value, it will be in how they manage their brand. 


    SubjectRe: offering?
    Entry06/11/2019 09:42 AM
    Memberniceonice

    We participated in the offering. They plan to embark on a more aggressive online marketing campaign because they have seen very high ROIs on the relatively small amount they've spent thus far. 


    SubjectRe: Re: Re: offering?
    Entry06/14/2019 04:25 PM
    Memberniceonice

    I dont wan't to share much in regards to offering details other than I think there was decent institutional support, especially given the size of the company.

    Guidance was a little weaker than expected, but I'm more concerned with how the money-making quarters shake out. 

    Company wasn't comfortable taking on a large debt obligation given the newness of their profitability. 

    Good points on the compensation metrics. I think growth is definitely the priority, but I don't think they plan on through all the cash right away to do so--more trying to accelerate growth while maintaining marginal profitability for the near future. 

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