As of August 4, 2014, there were 20,357,333 shares of the registrant’s common stock, no par value per share, outstanding.

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Basis of Presentation and Principles of Consolidation - The accompanying unaudited condensed consolidated financial statements included in this Quarterly Report on Form 10-Q have been prepared in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for interim financial information. However, certain information or footnote disclosures normally included in complete financial statements prepared in accordance with U.S. GAAP have been condensed, or omitted, pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”). In the opinion of the Company’s management, the unaudited statements in this Quarterly Report on Form 10-Q include all normal and recurring adjustments necessary for the fair statement of the results for the interim periods presented. The results for the three and six months ended June 30, 2014 are not necessarily indicative of the results to be expected for the fiscal year ending December 31, 2014.

The condensed consolidated financial statements as of and for the three and six months ended June 30, 2014 and 2013 included in this Quarterly Report on Form 10-Q are unaudited. The balance sheet as of December 31, 2013 is derived from the audited financial statements as of that date. The accompanying statements should be read in conjunction with the audited financial statements and related notes, together with Management’s Discussion and Analysis of Financial Condition and Results of Operations, contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013 filed with the SEC on March 27, 2014 (the “2013 Annual Report”).

 

The accompanying condensed consolidated financial statements as of and for the three and six months ended June 30, 2014 and 2013 include the accounts of the Company and its wholly owned subsidiaries Moissanite.com, LLC, formed in 2011; Charles & Colvard Direct, LLC, formed in 2011; and Charles & Colvard (HK) Ltd., the Company’s Hong Kong subsidiary that became a dormant entity in the second quarter of 2009 and the operations of which ceased in 2008. All intercompany accounts have been eliminated.

 

Significant Accounting Policies - In the opinion of the Company’s management, the significant accounting policies used for the three and six months ended June 30, 2014 are consistent with those used for the year ended December 31, 2013. Accordingly, please refer to the 2013 Annual Report for the Company’s significant accounting policies.

Use of Estimates - The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. The most significant estimates impacting the Company’s condensed consolidated financial statements relate to valuation and classification of inventories, accounts receivable reserves, deferred tax assets, uncertain tax positions, stock compensation expense, and cooperative advertising. Actual results could differ materially from those estimates.

 

Reclassifications - Certain amounts in the prior year’s condensed consolidated financial statements have been reclassified to conform to the current year presentation.

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The Company’s net inventories by product line maintained in the parent entity’s wholesale distribution segment are as follows:

 

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The Company evaluates assets and liabilities subject to fair value measurements on a recurring and non-recurring basis to determine the appropriate level to classify them for each reporting period. This determination requires significant judgments to be made by management of the Company. The instruments identified as subject to fair value measurements on a recurring basis are cash and cash equivalents, trade accounts receivable, trade accounts payable, and accrued expenses. All instruments are reflected in the consolidated balance sheets at carrying value, which approximates fair value due to the short-term nature of these instruments.

The Company’s total inventories, net of reserves, consisted of the following as of June 30, 2014 and December 31, 2013:

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As of each reporting date, the Company’s management considers new evidence, both positive and negative, that could impact its view with regard to future realization of deferred tax assets.  The Company’s management determined that sufficient positive evidence existed as of March 31, 2014 and December 31, 2013 to conclude that it is more likely than not that deferred tax assets of $4.15 million and $4.04 million, respectively, were realizable.  A valuation allowance remained at March 31, 2014 and December 31, 2013 against certain deferred tax assets relating to state net operating loss carryforwards from the Company’s e-commerce and home party operating subsidiaries due to the timing uncertainty of when the subsidiaries will generate cumulative positive taxable income to utilize the associated deferred tax assets. A valuation allowance also remained at March 31, 2014 and December 31, 2013 against certain deferred tax assets relating to investment loss carryforwards because the Company does not anticipate it will generate sufficient investment income to utilize the carryforwards.  The Company also previously considered various strategic alternatives, resulting in management determining that a valuation allowance was not necessary at that time.  During the three months ended June 30, 2014, the Company’s management determined that such alternatives were no longer in the best interest of the Company.  Accordingly, the Company’s management concluded that the positive evidence was no longer sufficient to offset available negative evidence, primarily as a result of the pre-tax operating loss for the three and six months ended June 30, 2014.   As a result, management concluded that it was uncertain that the Company would have sufficient future taxable income to utilize its deferred tax assets, and therefore, the Company established a valuation allowance against its deferred tax assets, resulting in a tax expense of $4.15 million and $4.05 million for the three and six months ended June 30, 2014, respectively.  During the three and six months ended June 30, 2014, the Company also recognized approximately $6,000 of income tax expense for estimated tax, penalties, and interest associated with uncertain tax positions.

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In March 2004, the Company entered into a seven-year lease, beginning in August 2004, for approximately 16,500 square feet of mixed-use space from an unaffiliated third party at a base cost with escalations throughout the lease term plus additional common-area expenses based on the Company’s proportionate share of the lessor’s operating costs. The lease provided for two rent holidays, during which no rent was payable, and a moving allowance. In January 2011, the Company amended the lease effective January 1, 2011 to extend the term through January 2017 in exchange for a reduced rental rate and 50% rent abatement in the first 12 months of the extended term.  The amended lease includes 3% annual rent escalations and a one-time option to terminate the lease effective as of July 31, 2014. The Company exercised this right to terminate the lease by giving notice to the lessor prior to October 31, 2013.  The cost to terminate the lease effective July 31, 2014 was approximately $112,000, which the Company paid at the time notice was given to terminate the lease.  This amount reflects all unamortized lease transaction costs, including, without limitation, all rent abated since January 1, 2011, plus two months’ rent at the current rental rate.  On December 9, 2013, the Company entered into a Lease Agreement, as amended on December 23, 2013 and April 15, 2014 (the “Lease Agreement”), for a new corporate headquarters, which occupies approximately 36,350 square feet of office, storage, and light manufacturing space. The Company took possession of the leased property on May 23, 2014 once certain improvements to the leased space were completed.  These improvements and other lease signing and moving incentives offered by the landlord totaled approximately $550,000 and $73,000, respectively, which will be amortized over the life of the lease.  Included in the Lease Agreement is a seven-month rent abatement period expected to begin June 2014 through December 2014.

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Consolidated net sales were $7.84 million for the three months ended June 30, 2014 compared to $6.51 million for the three months ended June 30, 2013, an increase of $1.33 million, or 20%. Consolidated net sales were $13.91 million for the six months ended June 30, 2014 compared to $13.02 million for the six months ended June 30, 2013, an increase of $892,000, or 7%.  The improvement in consolidated net sales for the three and six months ended June 30, 2013 was due primarily to an increase in loose jewel sales to our existing domestic wholesale customer base resulting from an effort to reduce inventories of older standard grade finished gemstones, sales of our new whiter Forever Brilliant^® moissanite jewel and the growth of our wholesale customers’ moissanite finished jewelry lines with styles that include both Forever Brilliant^® and our loose jewel standard grades, and the growth in sales of our direct-to-consumer businesses, Moissanite.com and Lulu Avenue^®, which collectively increased 59% to $992,000 and 72% to $1.91 million during the three and six months ended June 30, 2014, respectively. We anticipate orders and related sales of loose moissanite jewels and finished jewelry featuring moissanite in both our wholesale distribution segment and direct-to-consumer distribution segment will improve as we execute our growth strategies.

 

Sales of loose jewels represented 51% and 55% of total consolidated net sales for the three and six months ended June 30, 2014, respectively, compared to 63% and 65% of total consolidated net sales for the corresponding periods of the prior year. For the three months ended June 30, 2014, loose jewel sales were $4.01 million compared to $4.08 million for the corresponding period of the prior year, a decrease of $65,000, or 2%. For the six months ended June 30, 2014, loose jewel sales were $7.69 million compared to $8.42 million for the corresponding period of the prior year, a decrease of $732,000, or 9%. The slight decrease for the three months ended June 30, 2014 was primarily due to a focus to reduce inventory of slower moving standard grade loose jewels through existing distribution channels. The decrease for the six months ended June 30, 2014 was primarily attributable to a decrease in loose jewel sales to two of our larger international wholesale customers, offset in part by increased sales to two of our larger domestic wholesale customers.  Overall sales orders from some of our larger international customers were lower in the first six months of 2014 compared to the same period in 2013, due to economic and market conditions facing these larger international customers.   We believe the economic and market conditions will improve in our international markets.

 

Sales of finished jewelry represented 49% and 45% of total consolidated net sales for the three and six months ended June 30, 2014, respectively, compared to 37% and 35% of total consolidated net sales for the corresponding periods of the prior year. For the three months ended June 30, 2014, finished jewelry sales were $3.83 million compared to $2.44 million for the corresponding period of the prior year, an increase of $1.39 million, or 57%. For the six months ended June 30, 2014, finished jewelry sales were $6.22 million compared to $4.59 million for the corresponding period of the prior year, an increase of $1.62 million, or 35%. These increases were primarily attributable to our ongoing expansion into the finished jewelry business, primarily through the growth of our e-commerce and home party businesses in our direct-to-consumer distribution segment.

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The decrease in sales and marketing expenses for the six months ended June 30, 2014 compared to the same period in 2013 was primarily due to a $428,000 net decrease in advertising expenses;  a $167,000 net decrease in professional services related to the reduction of temporary personnel, consulting services, and the maintenance of software platforms for our direct-to-consumer e-commerce and home party lines of business; a $77,000 decrease in recruiting fees; and an $8,000 decrease in travel due to fewer international sales trips.  These decreases were partially offset by increases of $247,000 in net compensation expenses; a $10,000 increase in office-related expenses; and a $10,000 increase in depreciation expense related to the Moissanite.com and Lulu Avenue^® e-commerce websites direct sales platforms.  The decrease in advertising expenses comprises a $305,000 decrease in cooperative advertising; a $99,000 decrease in agency and other media spending; and a decrease in Internet marketing of $44,000 primarily due to greater efficiencies gained in paid search advertising in support of our Moissanite.com e-commerce website.  These decreases in advertising expenses were partially offset by an increase of $20,000 in print media expenses to develop and promote brand awareness campaigns.  The decrease in cooperative advertising expenses resulted primarily from the decrease in sales of loose jewels to our international customers, compared to the same period in the prior year and management’s decision to offer sales discounts in lieu of cooperative advertising assistance.

 

Compensation costs for the six months ended June 30, 2014 compared to the same period in 2013 increased primarily from an increase in commissions of $180,000 for sales to specific customers under which commission plans of sales representatives are based; a $170,000 increase in salaries and related employee benefits; and a $35,000 increase in severance.  These increases were partially offset by a decrease in bonus expense of $137,000; and a $1,000 decrease in stock-based compensation costs.

We expect our total sales and marketing expenses will increase as sales increase, but the rate of growth should slow and become a lower percentage of sales as expenses more variable in nature, such as advertising and commissions, increase as part of our strategy to build sales; but fixed expenses remain relatively constant.  While employee compensation costs may fluctuate from period to period as we continue to build a more efficient and productive sales organization, we expect that these costs will become more fixed in nature over time.

 

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The increase in general and administrative expenses for the six months ended June 30, 2014 compared to the same period in 2013 was primarily due to a $744,000 increase in bad debt expense associated with our allowance for doubtful accounts reserve policy, and for which we placed a full reserve against one customer account that is in dispute and has become past due; a $406,000 increase in professional services; a $268,000 net increase in compensation expense; an $89,000 increase in depreciation and amortization expense; a $32,000 increase in office-related expenses; an increase of $30,000 for moving the corporate headquarters to its new leased space; and a $24,000 increase in business and franchise taxes.  Professional services increased primarily due to an increase in legal fees of $254,000; investor and public relations expenses increase of $96,000; a $32,000 increase in audit and tax services; and an increase of $24,000 in consulting and other professional services.  Compensation expenses increased primarily as a result of an increase in salaries and related employee benefits in the aggregate of $280,000; and an increase in stock-based compensation expense of $52,000; offset partially by a decrease in bonus expense of $64,000.  These increases were offset in part by a $32,000 decrease in travel-related expenses associated with investor, customer, and supplier meetings; and a $2,000 decrease in board compensation.

 

Research and Development

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As of each reporting date, management considers new evidence, both positive and negative, that could impact its view with regard to future realization of deferred tax assets. Management determined that sufficient positive evidence existed as of March 31, 2014 and December 31, 2013 to conclude that it is more likely than not that deferred tax assets of $4.15 million and $4.04 million, respectively, were realizable.  A valuation allowance remained at March 31, 2014 and December 31, 2013 against certain deferred tax assets relating to state net operating loss carryforwards from our e-commerce and home party operating subsidiaries due to the timing uncertainty of when the subsidiaries will generate cumulative positive taxable income to utilize the associated deferred tax assets. A valuation allowance also remained at March 31, 2014 and December 31, 2013 against certain deferred tax assets relating to investment loss carryforwards because management does not anticipate we will generate sufficient investment income to utilize the carryforwards.  Management also previously considered various strategic alternatives, resulting in management determining that a valuation allowance was not necessary at that time.  During the three months ended June 30, 2014, management determined that such strategic alternatives were no longer in our best interest.  Accordingly, management concluded that the positive evidence was no longer sufficient to offset available negative evidence, primarily as a result of the pre-tax operating loss for the three and six months ended June 30, 2014.   As a result, management concluded that it was uncertain that we would have sufficient future taxable income to utilize our deferred tax assets, and therefore, we established a valuation allowance against our deferred tax assets, resulting in a tax expense of $4.15 million and $4.05 million for the three and six months ended June 30, 2014, respectively.  During the three and six months ended June 30, 2014, we also recognized approximately $6,000 of income tax expense for estimated tax, penalties, and interest associated with uncertain tax positions.

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During the six months ended June 30, 2014, $1.81 million of cash was provided by operations. The primary drivers of positive cash flow were a decrease in trade accounts receivable of $2.59 million, a decrease in inventory of $869,000, and an increase in accrued liabilities of $662,000.  These factors were partially offset by our loss of $7.26 million that included $5.35 million of non-cash expenses, an increase in prepaid expenses of $395,000 and a decrease in accounts payable of $11,000.  Accounts receivable decreased primarily as a result of collection efforts during the first six months of 2014 on higher sales made in the fourth quarter of 2013, offset in part by extended wholesale customer payment terms that we offer from time to time that may not immediately increase liquidity as a result of current-period sales. We believe our competitors and other vendors in the wholesale jewelry industry have also expanded their use of extended payment terms and, in aggregate, we believe that by expanding our use of extended payment terms, we have provided a competitive response in our market and that our net sales have been favorably impacted.  We are unable to estimate the impact of this program on our net sales, but if we ceased providing extended payment terms in select instances, we believe we would not be competitive for some wholesale customers in the marketplace and that our net sales and profits would likely decrease. Generally, we have not experienced any significant accounts receivable write-offs related to revenue arrangements with extended payment terms; however, we have increased our reserves for uncollectible accounts primarily due to one customer with extended terms, but we do not believe the terms are a factor with this customer’s non-payment.  Inventories decreased primarily as a result of sales, including the sale of slower moving standard grade loose jewels, offset in part by the purchase of new raw material SiC crystals during the quarter pursuant to our Amended and Restated Exclusive Supply Agreement with Cree, or the Cree Exclusive Supply Agreement; purchases of jewelry castings, findings, and other jewelry components; and production of moissanite gemstones.  Accrued rent increased primarily as a result of the lease incentives received from our landlord associated with the new corporate headquarters.  Prepaid expenses and other assets increased primarily as a result of deposits made during the quarter in advance of goods or services received.  Accounts payable increased primarily as a result of the timing of costs incurred but not yet paid as of June 30, 2014 associated with inventory-related purchases and professional services incurred but not yet due under our vendors’ payment terms.

 

We manufactured approximately $5.75 million in loose jewels and $3.5 million in finished jewelry, which includes the cost of the loose jewels and the purchase of precious metals and labor in connection with jewelry production, during the six months ended June 30, 2014. We expect our purchases of precious metals and labor to increase as we increase our finished jewelry business. In addition, from the beginning of 2006 through the second quarter of 2014, the price of gold has increased significantly (approximately 148%), resulting in higher retail price points for gold jewelry. Because the market price of gold and other precious metals is beyond our control, the recent upward price trends could continue and have a negative impact on our operating cash flow as we manufacture finished jewelry.

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On August 9, 2013, the Board authorized the extension of our share repurchase program for an additional 12 months. The program, which was originally authorized on November 13, 2009, authorizes us to repurchase up to 1,000,000 shares of our common stock until August 12, 2014 in open market or in privately negotiated transactions. As of June 30, 2014, 809,213 shares of our common stock remain available for repurchase under the program.  We have not repurchased any shares under this program during the six months ended June 30, 2014, or through August 4, 2014.  We have determined not to extend the plan past the current expiration due to covenants within the credit facility described below.

 

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We routinely review our internal control over financial reporting and from time to time make changes intended to enhance the effectiveness of our internal control over financial reporting. We will continue to evaluate the effectiveness of our disclosure controls and procedures and internal control over financial reporting on an ongoing basis and will take action as appropriate. During the three months ended June 30, 2014, we made no changes to our internal control over financial reporting, as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act, that we believe materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

PART II – OTHER INFORMATION