Charles & Colvard: Deep Value And Potential Acquisition Target

Investment Summary

Charles & Colvard (NASDAQ:CTHR) (hereto “CTHR”, “Charles & Colvard”, or “the company”), is a small business out of North Carolina that manufactures and sells top-grade moissanite and lab grown diamonds both direct to consumer and through retail partners Macy’s and Helzberg Diamonds. The company experienced a transformational turnaround in 2020 when new CEO Don O’Connell took the helm, moving the company into the lab grown diamond space and shifting focus away from bulk distributor of loose stones to direct-to-consumer of finished jewelry. One should consider that CTHR has transformed themselves as of 2020 and comparisons to prior periods should be made with this in mind.

This article will review potential levers for value for the company – for more information on the company itself, please refer to earlier articles by Seeking Alpha peers Kevin Mackie and BOOX Research here and here. The article assigns a Buy rating to CTHR, though prospective investors should be aware that this is an illiquid microcap and to manage their risks appropriately.

State of Current Affairs

CTHR, under new leadership, has grown top-line sales from $29.19 million to $43.09 million and operating income from $(0.45) million to $3.07 million from FY2020 to FY2022. While top-line sales have grown substantially, it has come on the back of a significant rise in SG&A costs – particularly due to marketing – to drive top-of-funnel sales and increase brand awareness. This has led to bottom-line growth stalling, and the company’s latest Q1 results reported break-even.

The company currently has no debt, with adjusted* book value of $28 million against a current market cap of $25 million, $11.6 million of which are cash assets. In fact, with a total current asset value of $31.65 million and total liabilities of $9.37 million, the net current asset value of the company is $22 million, nearly at Net-Net value to its current market cap of $25 million.

*Adjusted Book Value: The author has completely removed deferred tax assets of $6.15 million and “long-term assets” of $24.54 million from the book value of the company. The company describes in their 10-K that “long-term assets” are largely surplus raw material goods that they are contracted to purchase from their supplier, as well as work-in-process goods which we will consider to be illiquid.

Growth and Acquisition Value

We strongly believe that ESG-trends in the diamond industry, and lab grown diamonds and alternative gemstones, in particular, will continue to capture market share, especially given that Millennial and Gen-Z consumers continue to grow into the primary target consortium. An overview of this viewpoint is presented here in an analysis of Brilliant Earth (BRLT). Research suggests that this category is projected to grow at a 9.4% CAGR between 2020 and 2030, reaching $49.9 billion. In the traditional diamond category, one immediately thinks of Tiffany’s (OTCPK:LVMUY) when it comes to top-of-the-line luxury jewelry brands. However, the lab diamond space does not evoke a similar statement; the majority of lab grown diamond merchandise is aggregated in vast inventory catalogues in the manner of BRLT and James Allen (SIG).

CTHR has an opportunity to distinguish itself and fill the luxury lab grown diamond space, capturing the high end of this category. Signet Jewelers and Brilliant Earth themselves have stated their intention to focus on addressing the middle-market category. Simply growing at the lab grown diamond industry rate would suggest CTHR reaches a top-line of around $105 million. Using the low end of operating margin, the past two years of 7% would lead to operating income of around $7 million. A modest P/E of 10 places the company at $2.25 per share, or 10% CAGR out to 2030 for a total 165% return.

While the previous scenario seems like a reasonable investment over the next 8 years, the company is rife with marketing and execution risk. This isn’t to say that the company is in danger of suddenly burning cash and going out of business; rather, the concern is for the company to continue its perennial behavior of treading water and going nowhere. This risk is exemplified by searching online for lab grown diamonds at various magazine outlets such as Brides, Vogue, and Forbes and seeing callouts to Brilliant Earth, James Allen, and others, but no recent mentions of Charles & Colvard. In fact, we even visited some Helzberg Diamond locations, CTHR’s retail partner for its Forever One moissanite products, and the staff – presumably experts on the industry – were oblivious to the fact that Charles & Colvard even sold lab diamonds.

While, in theory, CTHR has plenty of growth runway given the much faster pace of growth in the lab grown space within the jewelry industry, we believe a more prudent approach to unlocking value is to pursue a sale of the company. The luxury space is a fantastic industry, evidenced by such high-quality companies as Ferrari (RACE), Louis Vuitton (OTCPK:LVMUY), and Estée Lauder (EL) – an industry that is resilient in recessions due to its customer base typically being least impacted by macroeconomic conditions. This is perhaps one big reason that private equity firms like the industry. For example, Blue Nile was owned by Bain Capital before being sold to Signet Jewelers; JK Findings was acquired by Latitude 27 Capital in 2020; and Pedemonte Group was sold to Louis Vuitton from equity firm Equinox just last month.

Blue Nile is said to have generated $740 million in sales, and Bain Capital sold the company for $360 million at a P/S multiple of 2x. Signet also disclosed that Blue Nile was not profitable and that it would not be accretive to Signet earnings until Q4 2024. In contrast, CTHR is actually profitable with an enterprise value of only $17 million and generating sales of $40 million in the trailing twelve-month period. Using Blue Nile’s sale multiple as a baseline, this would put CTHR’s price tag at $80 million enterprise value plus $2 million of net cash (after removing all liabilities), or $82 million (i.e., around $2.7 per share) which would be immediately accretive to an acquirer.

Charles & Colvard’s products resonate with its customer base given its 100% lab grown ESG focus; its primary issue is lack of marketing and brand awareness, which the current management is attempting to address on their own with an increase in SG&A. Unfortunately, we simply do not believe the company has the financial capacity to compete on marketing with the likes of BRLT, SIG, LVMUY, and others in a ruthless commodity business. Instead, we believe this can be solved with the financial backing of private equity.

Alternatively, a sale to either BRLT or SIG would provide either company with a luxury collection brand line in the lab grown space, which neither currently has. The acquisition would immediately stretch their middle-grown product offering both upward and downward. The upward stretch is due to the lab grown Caydia diamond line while the downward stretch is due to the Forever One moissanite product line, which comes in at lower average order values than diamonds. For BRLT, the last reported average order value is $3013, and for SIG, their higher-end James Allen banner holds around $2500 in average transaction value. Scanning the signature collection of CTHR’s Caydia lab diamond products results in an average product value of around $4100. Finally, since neither BRLT nor SIG carry moissanite products, the acquisition would provide additional product diversity to their lineups, particularly in the lower middle end of the product catalogue. The moissanite product addition would enable either BRLT or SIG to better compete and increase market share in the value portion of the market against the likes of Pandora Jewelry (PANDY).

Our last article covered the fragmentation of the industry and the flurry of consolidation occurring, spearheaded by Signet, which we believe will continue. Given that the current management of CTHR has been recently appointed, there is unlikely to be an entrenchment issue and a potential sale may materialize if the company fails to gain marketing traction. Apart from Signet, we believe CTHR makes more sense being acquired by BRLT, as it is entirely aligned with BRLT’s ESG strategy, would grow new verticals in their product offering, and would add an additional showroom to BRLT’s expanding geographical footprint.

In conclusion, we believe a sale of Charles & Colvard and to either BRLT or SIG – both of whom have the balance sheet to pursue such an immediately accretive acquisition – makes sense to all parties and would be the best way to unlock value for CTHR shareholders given its struggle to market and grow brand awareness.

Risks and Final Word

While the rest of this article already covered some of the risks, we should note that the company does not appear to be in any financial distress given the state of their balance sheet and virtually no liabilities. Financial liquidity is not an issue for the company given they hold $11.6 million in cash and broke even in the worst quarter of their fiscal year. Consider also that the inventory of a jewelry company comprises gold, silver, platinum, and diamonds, all precious metals and commodities that hold their value and can often be considered fungible to cash, giving CTHR an additional $12.09 million in inventory of buffer.

Management themselves seem confident in the state of the company’s finances and outlook given recent insider buying over the past year as well as a newly issued buyback program of $5 million. Instead, the primary risk is the low liquidity of the stock itself with only 30 million shares outstanding and a lack of coverage or interest, which, coupled with general market sentiment, has caused the share price to drift lower and lead to a warning of delisting from the NASDAQ exchange.

Between the share buyback program, the company currently trading at near Net-Net valuation of $22 million, and the company being profitable on a GAAP pretax income basis since 2020, the risk of delisting appears to be driven more by lack of share volume than an existential threat to the company itself. We assign a Buy rating to the company on the basis of being near Net-Net valuation, maintaining a solid balance sheet and sustainable business model, and being a potential take-over candidate for BRLT, SIG, or private equity. However, prospective investors should be astutely aware of the lack of liquidity, and only consider this company if they are comfortable being involved in the microcap space. As always, the reader is encouraged to do their own due diligence, and that is doubly important for the case considered here.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.