A very small company called Charles & Colvard Ltd. (CTHR, Financial) is about to hit an inflection point.
The basic pitch is that there are two different segments. The larger legacy segment is in decline, while the new business segment is growing rapidly, driven by a new high-quality product, new corporate strategy and changing consumer tastes. The growing new business segment will soon make up the majority of revenue and will then start to drive the combined numbers. At that time, the market may finally take notice.
Company history
Over 120 years ago, Nobel Prize-winning chemist Dr. Henri Moissan discovered moissanite (silicon carbide) on a meteorite. Moissan wanted to reproduce the remarkable mineral. That didn’t happen until 100 years later, when researchers from Triangle Park in North Carolina developed a process to create pure silicon carbide. The material propelled advances in semiconductors, LED lighting and extremely hard drilling tools as well as abrasives.
Charles & Colvard focused on turning silicon carbide into jewelry. It took the company about 20 years after the Triangle Park breakthrough to come up with its Forever One quality gemstone (end of 2015). Previously, the company wasn’t able to produce a true colorless grade of moissanite.
Previous generations were slightly colored:
After the invention of Forever One, the company brought in a new CEO and completely changed its business model. Before CEO Suzanne Miglucci arrived at the scene, the company pushed its products into the distribution network. Now, it has changed its method to a pull strategy. It is creating awareness among millennial consumers that they have access to a gemstone of superb quality that is ethically produced. Here’s how the gemstone compares to other types of gemstones, according to company materials:
"Moissanite is comparable to other popular gemstones including diamond, ruby, sapphire and emerald on key characteristics such as hardness, fire and brilliance. On the Brilliance Refractive Index, moissanite is more brilliant than any other gemstone, ranging from 2.65-2.69 on the scale. Its fire dispersion is over 4x greater than any other popular gemstone. On the MOHs hardness scale, moissanite comes in second only to a diamond, measuring at 9.25. In addition, moissanite's durability is excellent, meaning it will survive daily wear and tear."
Balance sheet
The company has a market cap of approximatley $20 million. Tiny companies always have certain vulnerabilities that mega-caps don’t share. In other ways they can be more resilient. Charles & Colvard's balance sheet is extremely sound and is the primary reason I originally got involved with this stock. I’ve included the balance sheet for your convenience below.
Approximately 71% of the inventory is made up of recently created Forever One stones and pieces. Even if we discount the entire inventory by 50%, discount property and equipment entirely, write off half of receivables and all of prepaid expenses, there is still $19 million of value on the asset side of the balance sheet. With $6 million in liabilities, that means there is $13 million of value on the balance sheet.
The company also has a $10 million credit facility. That’s a great sign. Although the company did not tap this facility, it shows banks are willing to lend to the company and perceive it as a healthy entity.
Management
Miglucci previously served as chief marketing officer of ChannelAdvisor Corp. (ECOM) and as senior director at SAP SE (SAP). She is responsible for the shift to the pull marketing strategy and for the e-commerce strategy centered around www.charlescolvard.com.
I’ve held shares since before her arrival and I like the corporate strategy she embarked on. I think she is realizing the turnaround with minimal risk of destroying shareholder value.
You could argue the transition is progressing somewhat slowly. If she would be more aggressive in committing the company's resources to the turnaround, it is possible the company would evolve more rapidly. However, this would almost certainly mean tapping into the credit facility. After that, the company would be only one major setback away from distress. On balance, I’m more than satisfied with her approach.
Valuation
In essence, Charles & Colvard consists of two different businesses selling the same product. The traditional legacy segment is based on push marketing to distributors. The company used to be present at industry events and used its marketing budget to reach this group. Today it is using its marketing budget to drive brand awareness and to set up e-commerce sales channels. The table below from the recent Q-10 clearly shows what is happening under the hood here:
For the quarter, the total year-over-year growth in gross profit came out to something like 15%. For the most part, that still gets eaten by overhead.
Overhead is mostly made up of fixed costs. As gross profits increases, overhead should not increase in any commensurate way.
If we look at gross profit for the traditional segment, it is clearly decreasing, albeit at a modest percentage. Back in 2017, however, this legacy segment made up most of the company's revenue.
At the same time, the new strategy represented by “online channels” is surging by over 50%.
What’s happening here is the company is nearing an inflection point. If online channels continue to grow sales this rapidly, that part of the company is quickly going to dominate the total top line. Soon after it will start to dominate the bottom line too because of the overhead, which mostly consists of fixed costs.
My valuation process in this situation is focused on the downside. Since it is starting from a very small base selling into a huge addressable market, the potential for upside is clearly large.
The downside is more easily quantified. We already know that 71% of the inventory is made up of recently created Forever One stones and pieces. The rest of the inventory is not necessarily worthless. Based on our earlier projections where we discounted the entire inventory by 50%, discounted the property and equipment entirely, wrote off half of receivables and all of prepaid expenses, we arrive at the $19 million of value on the asset side of the balance sheet. With $6 million in liabilities, that means there is $13 million of net value on the balance sheet. Theoretically, if the company were to be liquidated on the spot, we would have a good chance of recovering above 50% of an investment at today’s prices given the entire market cap is only $21 million.
I view the risk-reward proposition as highly asymmetrical. We stand to lose around 50% in a worst-case scenario while the company can easily double in value. If growth of the online channels continues like this, the investment can quickly turn into a multibagger.
Risks
I see two main company-specific risks:
Value trap risk - There is a risk the online sales never really take off and we are stuck with a company and stock price that’s going nowhere. I estimate chances of this happening are low and expect this will still leave me with the option to exit around the current price or while only taking a modest loss.
Competition - There are a number of competitors in the man-made diamond space. For example, there is the silicon valley based Diamond Foundry, which was co-founded by “Blood Diamonds” star Leonardo DiCaprio. Interestingly, this company raised over $100 million. I’m quite happy there are startups like this raising awareness about available man-made alternatives to diamonds.
One competitor who just arrived on the scene is De Beers. It is the world’s leading diamond company and surprised friend and foe by launching LightBox earlier this year. I suspect De Beers launched LightBox in an attempt to kill this nascent and threatening market. They may attempt to cheapen the idea of man-made gemstones by competing in the space and taking a budget approach. If consumers start associating man-made stones with something cheap, it could hurt the growth of the budding market. Here’s an example from LightBox's website to illustrate what I mean:
"Nature created diamonds over a billion years ago. The larger a natural diamond, the rarer it becomes. Each one is unique, like a snowflake. So they are priced individually, often with certificates to describe their character and qualities.
But we can make laboratory-grown diamonds every day of the week. Among the finest you can find. In the color or size we choose. So our pricing is easy, as transparent as our stones."
It is almost as if they don’t want to sell the man-made stones.
They probably don’t want to, but it remains to be seen how much they are able to hurt the man-made market. When De Beers entered the market, it immediately had a strong negative effect on Charles & Colvard’s stock price.
Bottom line
Charles & Colvard is loading up on inventory for the holiday season. This is traditionally a strong season for the retailer. After the holidays, February also tends to be strong due to Valentine's Day.
I expect the online sales channels will continue to show strong growth. Miglucci likes to enter new markets by cheaply setting up online sales channels on third-party-operated websites.
The company also recently signed a strategic retail partnership agreement with Macy’s (M, Financial). Before that, it got upped to a more important partnership level by Walmart (WMT, Financial).
We are entering the first holiday season with these partnerships at this level of engagement. I continue to like the risk-reward here and believe it is an excellent time to invest.Ă‚
Disclosure: Author is long CTHR.
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