Charles & Colvard (CTHR): Value Analysis
Charles & Colvard, a small jewelry company with a strong balance sheet, presents a fascinating case for retail value investors. With a unique focus on lab-grown moissanite for conscientious millennials, the company’s growth potential is clouded by uncertain earnings, especially amid COVID-19’s economic impact. This analysis dives into CTHR’s valuation, liquidation value, and potential risks, providing insight into whether this undervalued gem could be worth the investment. Read on to explore if Charles & Colvard’s stability can outweigh its challenges.
Overview
Today I'll cover a small company that operates in the jewelry industry, Charles & Colvard.
Here some traits:
- EV/EBITDA = 2.96
- P/TB = 0.41
- Net Cash per Share = $0.20 (~28% of current share price)
- P/E = 8.6
- Future earnings are uncertain due to COVID-19
- A hidden asset in a form of tax loss carryforwards
Business
My understanding statement of the business:
The company is a small, transitioning towards online sales, producer, and retailer of moissanite jewels, oriented to conscientious millennial females in US.
Product
Charles & Colvard produces and sells loose moissanite jewels and finished jewelry. Moissanite is a rare mineral, a gemstone with characteristics very similar to diamond. The company uses lab-created moissanite and it markets the products as "beautiful and conscientious luxury". The most popular product is Forever One jewelry line.
The products are sold in 2 segments:
- Online (website, e-commerce outlets, marketplaces, etc.)
- Traditional (domestic and international distributors, retail customers)
Customers
From 10-K (2019):
Our consumer audience is in transition. Prior to our product brand re-launch in 2016, our audience largely comprised Baby Boomers and Generation X – which we consider an older set of consumers. Today, our market research, which is based on charlesandcolvard.com customer analytics, indicates that more than half of our audience comprises Millennial and emerging Gen-Z consumers.
In this interview Suzanne Miglucci, CEO describes the target audience as follows:
She is millenial. ... She is worried about socially and ethically created, ethically conscious gemstone or product.
Industry
Jewelry production and retailing.
Form
Corporation.
Geography
Headquarters: Raleigh, North Carolina, US.
Operations: North Carolina, US.
Customers: US accounts for 87% of net sales.
Status
Since Suzanne Miglucci was appointed as CEO, the company started the transformation from traditional distribution channels towards online sales. So far this strategy pays out and the company managed to become profitable after years of losses.
Management
I have not found any red flags in the proxy statement.
Compensations:
| Name | Title | Total Compensation |
|---|---|---|
| Suzanne Miglucci | CEO | $462,926 |
| Clint J. Pete | CFO | $297,453 |
| Don O’Connell | COO | $339,805 |
Insider ownership:
| Name | Shares | Percentage | Value |
|---|---|---|---|
| Ollin B. Sykes | 1,641,595 | 5.7% | 1.1M |
| Neal I. Goldman | 845,242 | 2.9% | 549.4K |
| Suzanne Miglucci | 828,104 | 2.9% | 538.3K |
| Anne M. Butler | 534,574 | 1.8% | 347.5K |
| Don O’Connell | 358,053 | 1.2% | 232.7K |
| Clint Pete | 269,341 | 0.9% | 175.1K |
| Jaqui Lividini | 235,730 | 0.8% | 153.2K |
| Benedetta Casamento | 195,569 | 0.7% | 127.1K |
| Total | 4,837,878 | 16.7% | 3.1M |
Note: value is calculated with price per share = $0.65.
Management has some skin in the game: ownership of CEO, CFO and COO is about their total annual compensation.
Recent insiders transactions:
| Date | Value | Name | Shares |
|---|---|---|---|
| 17 Sep 19 | $10,050 | Suzanne Miglucci | 7,500 |
| 17 Jun 19 | $7,587 | Don O'Connell | 4,968 |
| 13 Jun 19 | $74,400 | Benedetta Casamento | 46,500 |
| 13 Jun 19 | $24,800 | Jaqui Lividini | 15,500 |
In summer directors bought some amount of shares, but this should not be seen as a pure positive signal. It was rather a supportive signal for the public offering of 6.25M new shares:
In June 2019, as described above, we successfully completed an underwritten public offering of 6,250,000 shares of our common stock at a price of $1.60 per share, which, together with the partial exercise of the underwriters’ over-allotment option for an additional 630,500 shares in July, resulted in net proceeds of approximately $9.99 million, net of underwriting discount and fees and expenses.
Valuation
Liquidation Value
| Balance Sheet | Pct (low) | Value (low) | Pct (base) | Value (base) | Pct (high) | Value (high) | |
|---|---|---|---|---|---|---|---|
| Cash and cash equivalents | 12.7M | 95% | 12.1M | 100% | 12.7M | 100% | 12.7M |
| Restricted Cash | 656.9K | 95% | 624.0K | 100% | 656.9K | 100% | 656.9K |
| Receivable | 3.1M | 70% | 2.2M | 80% | 2.5M | 90% | 2.8M |
| Prepaid expenses | 1.4M | 5% | 69.4K | 10% | 138.9K | 15% | 208.3K |
| Inventory (current) | 10.7M | 30% | 3.2M | 40% | 4.3M | 50% | 5.3M |
| Inventory (long-term) | 25.1M | 30% | 7.5M | 40% | 10.0M | 50% | 12.5M |
| Property and equipment | 1.1M | 10% | 111.3K | 20% | 222.5K | 30% | 333.8K |
| Total Liabilities | -7452.6K | 100% | -7452.6K | 100% | -7452.6K | 100% | -7452.6K |
| Liquidation Value | 18.3M | 23.0M | 27.1M | ||||
| Shares outstanding | 29.0M | ||||||
| Liquidation Value per share | $0.63 | $0.80 | $0.94 |
Liquidation value per share lays in a range $0.63 - $0.94.
Share Price: P/E method
Since the company has excessive cash I use the following formula to determine a fair share price:
fair price = net cash + future earnings value
Let's calculate net cash per share:
net cash = total cash - total liabilities = $13.34M - $7.45M = $5.89M
net cash per share = $5.89M / 29M = $0.20
To calculate earnings value we need EPS and P/E.
EPS (TTM) = $0.08
P/E = 13
future earnings value per share = EPS * P/E = $0.8 * 13 = $1.04
Notes:
- EPS (TTM) is not reliable. A more proper approach would be using averaged EPS over a long period (10 years), but since the company changed the strategy and started selling products online, it hasn't built a reliable earnings record yet.
- P/E = 13 is gut feeling obtained from observing historical P/E of CTHR and its competitors. Some analysts suggest P/E=20 for the jewelry industry, but I do not see how it can be justified.
Now we can get a fair price:
fair share price = $0.20 + $1.04 = $1.34
P/E model is very naive and relies on the following assumptions:
- P/E = 13 is correct. I feel more or less certain about it
- All future earnings will replicate earnings of the last 12 months. This just can not be true.
During the COVID-19 pandemic, the company is very likely to care losses because consumer confidence deteriorates: unemployment rates have skyrocketed and people do not feel like spending their savings on luxury.
However, we have $1.34 the as the upper limit for the fair share price, even though we know the real share price is likely to be lower.
Share Price: Discounted Future Earnings Method
They are high chances that in 2020 (and maybe 2021) sales will deteriorate, and the company may encounter losses.
It would be fair to represent this in the model. To get a feeling of how strong impact could be let's take a look revenue and earnings of Charles & Colvard and competitors (Tiffany, Signet Jewelers) during 2008-2009 recession.
Sales of Tiffany and Signet Jewelers declined insignificantly, while Charles & Colvard fell from $40M in 2006 to $8M in 2009.
It makes me think, that there is something more attributed to CTHR sales decline than the recession. However, I was not able to confirm it by looking at 10-K for 2009:
The global economic recession resulted in a significant slowdown in the retail environment, with the impact on the jewelry industry particularly severe.
In 2008 CTHR had losses of $6.1M what is about a fifth of sales volume a year before. In 2009 losses were $3.6M.
If we apply similar mechanics to today's situation we get:
2020 EPS = -$0.23
2021 EPS = -$0.12
So let's assume the company will take the losses in 2020 and 2021 and in 2022 EPS will recover and stay flat further.
With 10% of the discount rate we get the value of the future earnings equals $0.31:
| Year | EPS | PV |
|---|---|---|
| 2020 | -$0.23 | -$0.23 |
| 2021 | -$0.12 | -$0.12 |
| Perpetuity | $0.80 | $0.66 |
| Total | $0.31 |
With other discount rates:
| Discount Rate | Future Earnings Value |
|---|---|
| 10% | $0.31 |
| 12% | $0.18 |
| 15% | $0.05 |
If we take $0.31 as future earnings value, we get fair share price equals $0.51:
share price = net cash per share + future earnings per share = $0.20 + $0.31 = $0.51
$0.51 is below liquidation value.
Let's summarize what we've got so far:
- $0.20 - net cash per share
- $0.51 - fair share price if the deteriorating consumer confidence will significantly hit the sales in 2020-2021 like it was in 2008-2009.
- $0.63 - $0.93 - liquidation value range
- $1.34 - fair share price that could be if the pandemic was not there
The range of numbers just illustrates that the models work as long as the inputs are correct.
However, I conclude that regardless of all uncertainties laying ahead at price $0.33 per share CTHR becomes a good buy for me ($0.51 with 35% Margin Of Safety).
Risks
Competition
Here some quotes from 10-K that describes competition:
Our moissanite jewels compete with fine gemstones such as ruby, sapphire, emerald, and tanzanite as well as with mined diamonds
The worldwide market for large, uncut, high-quality mined diamonds is significantly consolidated and controlled by the De Beers Group of Companies, or De Beers, (headquartered in South Africa), Alrosa (Russia), Rio Tinto (Australia), and BHP (Canada). These companies have a major impact on the worldwide supply and pricing of mined diamonds at both the wholesale and retail levels.
With current moissanite pricing averaging approximately 5% of mined diamond gemstones and approximately 10% of lab-created diamond, we believe that for the foreseeable future we will continue to be able to address an underserved segment of the market.
However, we are seeing a grade of moissanite material reaching the market that exhibits a lower color rating and/or lesser cut, clarity and polish standard compared to our Forever OneTM gemstone.
Supply Agreement with Cree
The company has an exclusive supply agreement with Cree (CREE) that expires on June 25, 2023. The ability to prolong the agreement is in many ways crucial for the company.
Covid-19 Pandemic
As it was already covered in the Valuation section, deteriorating consumer confidence may result in significant losses for the company.
From 8-K filing:
The Company continues to receive and fulfill customer orders, however, the Company has recently seen a negative impact on traffic to the Company’s e-commerce site, given consumer concerns and changes related to COVID-19.
However, in another 8-K filing we see that the company is taking serious cost-saving measures, in particular:
- CEO, CFO and COO reduce their base salary by 25%, 15% and 15% respectively for ~2.5 months. This should result in approximately $185K saved.
- 50% of employees are furloughed
- Salary reduction for all employees
Notes
Here are some company traits that are worth paying attention to.
Tax Loss Carry Forwards
Since the company experienced a lot of losses in the past, it will not pay taxes for the next $23M of the income.
As of June 30, 2019 and June 30, 2018, we also had federal tax net operating loss carryforwards of approximately $23.39 million and $26.28 million, respectively, expiring between 2030 and 2037, which can be used to offset against future federal taxable income;
This may be seen as hidden assets that are not present on the balance sheet.
With current Earning Before Tax (TTM) of ~$2.5M, assuming earnings stay flat, the company will avoid taxes for the next 9 years. That is a lot.
Seasonality
Sales in the retail jewelry industry are typically seasonal due to increased consumer purchases during the calendar year-end holiday season.
Data confirms that the strongest revenue is generated in 4th calendar quarter:
Cash Flow
Free Cash Flow is lagging behind Net Income.
It may look suspicious at first glance but makes total sense considering that the company is in a growing phase.
Takeover Target?
With current EV/EBITDA = 2.96, the company may be very attractive as a takeover target for the bigger players in the market.
Summary
Charles & Colvard is a small company that has a strong balance sheet, but it may encounter losses in the nearest future because of the COVID-19 pandemic. The fair share price is highly dependent on how big those losses will be, so it's not possible to determine an accurate share price.
Please let me know what do you think about the analysis and the company itself in the comments below. If you consider investing in Charles & Colvard do not forget to perform your own due diligence. Thank you for reading.