Charles & Colvard: Leading ‘Made, Not Mined’ Jewelry (NASDAQ:CTHR)

Charles & Colvard (NASDAQ:CTHR) occupies a niche in the making and selling of fine jewelry. Operating on the premise of “made, not mined”, their hallmark product is a lab-grown jewel called moissanite, whose appearance and substance has similarities to diamonds. They also recently started an offering of lab grown diamonds, and all of the precious metal they use is from recycled sources. It is from this premise of sustainability that they push a value proposition to potential clientele. My intent with this article is to underscore recent business results and future growth opportunities, and why now is a great time to establish or add to a position. Bottom line up front: CTHR is a profitable micro-cap that is executing well on a new direct-to-consumer initiative that has reinvigorated growth. Trading below book value, management has wisely initiated a stock buyback program that will support the share price in the short term and drive EPS in the long term as each share becomes proportionally more valuable. Read on to learn why I believe that CTHR has the potentially to double in value over the next one to three years.

Product

Naturally occurring moissanite, or silicon carbide, is extremely rare. It has been found in meteorites, as inclusions in diamonds and other stones, and in only a handful of locations in the upper mantle, namely Wyoming and Russia. However, processes to synthesize artificial silicon carbide had been discovered a few years before it was discovered in its natural form by Henri Moissan, whose name was later used to give the stone it’s now common moniker.

The synthetic mass production of moissanite in single crystal form was developed by Cree Research in 1987, primarily for use in high-performance semi-conductors. Charles & Colvard came along in 1995 to be the first to patent the production and sale of moissanite for gemological applications, with Cree being their primary supplier since then and to this day. Charles & Colvard continues to be the market leader for moissanite jewelry.

Marketability

What makes moissanite appealing as a jewel is several fold.

First, it is extremely durable. Durability for gemstones is measures in two ways: hardness, which is resistance to scratching, and toughness, which is resistance to chipping and cleavage. Moissanite comes second only to diamond when it comes to durability.

Second, moissanite measures exceptionally high in regard to refractivity, or the extent to which the stone reflects light (i.e. the speed at which light passes through the material). When light passes through something other than air, it slows down. Without getting too much into physics, when it slows down it also bends. The extent to which it bends and directs light back to the eye is refractivity, with higher refractivity resulting in more “sparkle”. Moissanite measures higher than diamond on the refractive index, coming in at 2.65 vs. diamond’s 2.42.

Third is dispersion, or the extent to which a substance, in the process of refracting light, separates white light into the rainbow color spectrum. Substances with higher dispersion separate colors more distinctly, which in the industry has come to be known as a gemstones “fire”. Moissanite has higher dispersion than diamond, though the particulars of “fire” is also influenced by how a particular gem is cut.

Fourth, moissanite is extremely affordable. At about $400 a carat, a moissanite gem will cost about 1/10th the price of any diamond with a similar cut. Furthermore, moissanite retains its value better than diamond, retaining 50%-60% of its purchase price in resale vs. 25%-35% for a diamond.

Fifth, moissanite is the environmental and socially conscious choice. It is lab grown, and therefore bypasses all the common concerns related to labor and sourcing for mined gemstones.

In the midst of all these advantages the business proposition of Charles & Colvard is extremely attractive. That being said, the company has been around since 1995. With all the apparent advantages, why are they still a nano-cap? In a word, marketing.

The Message

CTHR dropped significant sums on advertising throughout the 2000’s, albeit it was pretty lumpy from year to year. After the recession of 2008-2009, advertising spend became a lot more level. I haven’t dug deep enough to look at the particulars of any advertising campaigns, but I am tempted to say there may have been a lack of targeted spend owing to the apparent lack of correlation between advertising spend and revenue. For example, in 2005 CTHR spent $9.8 million on advertising and brought in $43.5 million in revenue. The next year, they increased their advertising spend by $1.2 million but brought in $2.8 million less in revenue.

While such could certainly be trumped up to inevitable market vagaries, in context of more recent results the advertising strategies from the mid-2000’s look even more suspect. In the most recent completed fiscal year ended June 2021, CTHR spent less than half as much on advertising than in 2005 but made almost as much revenue, with $4.25 million spent on ads generating $39.2 in revenue. Today’s advertising strategies, which focus on digital efforts, is clearly bearing much more fruit. The messaging this time around may well help them move up the market cap ladder.

Key to their strategy is having a more robust direct-to-consumer presence, led by their flagship website charlesandcolvard.com. The build up of this website and all things related there-to has required considerable investment, but those investments are paying off. The most recent quarter saw a revenue increase of 22% at the website compared to the year ago quarter, and up 34% for the comparable 9-month period. They also recently launched a secondary website called moissaniteoutlet.com back in March of 2021. They explained the strategy behind this web property in the 10-K:

Our website, moissaniteoutlet.com, is an e-commerce shopping destination that caters to the opportunistic and bargain-seeking consumer base for our moissanite products. We believe this new online property allows us to monetize substantially all our raw material and finished goods inventory, thus minimizing product shrinkage and waste. As a unique online shopping destination with a very different product offering strategy, we believe moissaniteoutlet.com rounds out our product offerings with quality discounted jewelry products allowing us to serve a broader range of demographics and consumers.

To completely round out their offering, they are also reaching up the value chain to the more traditional and higher end customers who still want a diamond and are willing to pay for it. Staying true to their made, not mined identity, they now offer a line of lab-grown diamonds under the Caydia label, launched in September of 2020. Trying to get a piece of what they estimate to be a $50 billion addressable market come 2030, their Caydia segment was up 141% for Q3 and 256% fiscal year-to-date. While they unfortunately don’t break down exact dollar amounts in sales for this segment, we do know that growth has been accelerating. Sequential growth for last year’s Q2 over Q1 was 34% but grew by 152% from Q1 to Q2 this year. The lab grown diamond’s premium price point has pulled up their average order value, which has historically been around $1,000 but is up to $1,200 as of the last quarter.

The foray into lab-grown diamonds back in 2020 was prescient. According to an independent industry analyst, lab grown diamond sales increased 80% in February of this year and 63% in March, while mined diamond sales declined. All this was explained in a recent article from CNN business that highlights the recent surge in interest and the likely reasons why.

First, lab grown diamonds are much less expensive, by as much as 73%. Second, Russia’s war in Ukraine and the resulting sanctions from the U.S. has caused supply issues in the diamond market. A Russian company called Alrosa, which is owned in part by the Kremlin, accounts for 28% of global mined diamond output. This company was directly targeted by US sanctions. Third, with recent emphasis on the environment, sustainability, and human rights, people are shying away from mined diamonds that have a history of being connected with child labor and “conflict minerals” whose sale funds war. It’s no wonder that, given all these reasons, the demographic of the typical lab-grown diamond shopper is someone who is under the age of 40 and budget conscious.

Everyone seems to be piling onto the lab-grown train, both as it relates to diamonds and moissanite. Both Signet and Pandora, behemoths in the space, are devoting attention to made, not mined diamonds. Charles & Colvard has significant partnerships with both Macy’s and Warren Buffett’s own Helzberg diamonds, through whom CTHR sells their moissanite jewelry. It seems to be a trend that is here to stay, and CTHR is pulling the right levers to be competitive.

Valuation

In spite of a balance sheet unencumbered by intangibles and the like, CTHR is trading well below book value. In fact, even when adding together only those line items that can reasonably converted into cash quickly (cash, receivables, and inventory) book value per share is still 20% higher than current trading levels!

On a cash flow basis too, CTHR is cheap. A spreadsheet is unnecessary given the simplicity of the argument. CTHR had $6 million in free cash flow in fiscal 2021. Let’s assume that number gets cut in half and they only generate $3 million in FCF each year for the rest of their existence. No growth. At a 12% discount rate, my required rate of return, and taken together with how much cash they currently have on the balance sheet, CTHR is worth $1.41. That is exactly where they are trading right now. Even under dismal assumptions, CTHR is still a good value.

Conclusion

A paragraph in the 10-K perfectly summarizes the Charles & Colvard moissanite value proposition:

With hardness rivaling any mineral on earth, and optical properties exceeding all mined and created gemstones, we believe moissanite is a brilliant jewel that is free from environmental and ethical issues, and capable of disrupting traditional definitions of fine jewelry.

With a new marketing push that is targeting spend in the right places, the word is getting out and CTHR is posting record topline numbers. Yet the stock has lagged their business results significantly. I believe CTHR is severely undervalued, and so does management. They just announced a stock buyback authorization for $5 million, usable through April of 2025. I think this is a fantastic use of cash and will create tons of value for shareholders. I hope they pull the trigger in a big way before the market catches onto their story and sends the share price up. I am buying CTHR, with the full expectation for a 100% return or more within three years.