A reconciliation of the Company’s product line cost of goods sold to cost of goods sold as reported in the condensed consolidated financial statements is as follows:
The Company recognizes sales by geographic area based on the country in which the customer is based. A portion of the Company’s Traditional segment sales made to international wholesale distributors represents products sold internationally that may be re-imported to U.S. retailers. Sales to international end consumers made by the Company’s Online Channels segment are included in U.S. sales because products are shipped and invoiced to a U.S.-based intermediary party that assumes all international shipping and credit risks. All intangible assets and property and equipment as of March 31,September 30, 2017 and December 31, 2016 are held and located in the United States. The following presents certain data by geographic area:
The Company’s work-in-process inventories include raw SiC crystals on which processing costs, such as labor and sawing, have been incurred; and components, such as metal castings and finished good moissanite jewels, that have been issued to jobs in the manufacture of finished jewelry. The Company’s moissanite jewel manufacturing process involves the production of intermediary shapes, called “preforms,” that vary depending upon the size and shape of the finished jewel. To maximize manufacturing efficiencies, preforms may be made in advance of current finished inventory needs but remain in work-in-process inventories. As of March 31,September 30, 2017 and December 31, 2016, work-in-process inventories issued to active production jobs approximated $5.78$5.20 million and $7.18 million, respectively.
The Company’s jewels do not degrade in quality over time and inventory generally consists of the shapes and sizes most commonly used in the jewelry industry. In addition, the majority of jewel inventory is not mounted in finished jewelry settings and is therefore not subject to fashion trends nor is obsolescence a significant factor. Presently, the Company has very small market penetration in the worldwide jewelry market, and theThe Company had the exclusive right in the U.S. through August 2015 and the exclusive right in many other countries into the third quarter of 2016 to produce and sell created SiC for use in jewelry applications. During the years ended December 31, 2016 and 2015, management identified an opportunity to sell approximately $6.77 million and $2.28 million, respectively, of legacy loose jewel inventory of less desirable quality. As a result of these sales and feedback from customers on the value of some of these goods, the Company determined a lower of cost or market reserve of $529,000 and $517,000 as of March 31, 2017 and December 31, 2016, respectively, was required on some of the remaining inventory of these lower quality goods.
The Company manufactures finished jewelry featuring moissanite. Relative to loose moissanite jewels, finished jewelry is more fashion oriented and subject to styling trends that could render certain designs obsolete. The majority of the Company’s finished jewelry featuring moissanite is held in inventory for resale and consists of such basic designs as stud earrings, solitaire and three-stone rings, pendants, and bracelets that tend not to be subject to significant obsolescence risk due to their classic styling. In addition, the Company manufactures small individual quantities of designer-inspired moissanite fashion jewelry as part of its sample line that are used in the selling process to its Traditional segment customers.
Prior to March 2016, the Company purchased fashion finished jewelry comprising base metals and non-precious gemstones for sale through Lulu Avenue®, the Company’s former direct-to-consumer home party divisionbusiness of the Company’s wholly owned operating subsidiary, Charles & Colvard Direct, LLC. This finished jewelry was fashion oriented and subject to styling trends that could change with each catalog season, of which there are generally two each year.
11As of September 30, 2017 and December 31, 2016 management established a rework reserve for recut and repairs of $534,000 and $454,000, respectively. Loose jewel inventories at September 30, 2017 and December 31, 2016 included recut reserves of $430,000 and $425,000, respectively. The finished jewelry inventories at September 30, 2017 and December 31, 2016 include a repairs reserve of $104,000 and $29,000, respectively.
TableAs of ContentsSeptember 30, 2017 and December 31, 2016 management established a shrinkage reserve of $156,000 and $169,000, respectively. The loose jewel inventories at September 30, 2017 and December 31, 2016 include shrinkage reserves of $36,000 and $67,000, respectively. The finished jewelry inventories at September 30, 2017 and December 31, 2016 include shrinkage reserves of $120,000 and $102,000, respectively.
Periodically, the Company ships finished goods inventory to wholesalecertain Traditional segment customers on consignment terms. Under these terms, the customer assumes the risk of loss and has an absolute right of return for a specified period. FinishedIncluded in the total shrinkage reserve is the shrinkage reserve for finished goods on consignmentat March 31, of $19,000 and $46,000 as of September 30, 2017 and December 31, 2016, are net of shrinkage reserves of $49,000 and $46,000, respectively, to allow for certain loose jewels and finished jewelry on consignment with wholesalecertain Traditional segment customers that may not be returned or may be returned in a condition that does not meet the Company’s current grading or quality standards.
The Company’s total inventories, net of reserves, consisted of the following as of March 31, 2017 and December 31, 2016:
| | | March 31, 2017 | | | December 31, 2016 | |
| Loose jewels | | | | | | |
| Raw materials | | $ | 3,088,681 | | | $ | 2,586,045 | |
| Work-in-process | | | 10,054,559 | | | | 10,589,424 | |
| Finished goods | | | 9,695,751 | | | | 9,455,393 | |
| Finished goods on consignment | | | 98,533 | | | | 5,473 | |
| Total loose jewels | | $ | 22,937,524 | | | $ | 22,636,335 | |
| Finished jewelry | | | | | | | | |
| Raw materials | | $ | 594,960 | | | $ | 520,572 | |
| Work-in-process | | | 637,698 | | | | 458,702 | |
| Finished goods | | | 4,308,333 | | | | 4,081,275 | |
| Finished goods on consignment | | | 405,537 | | | | 416,305 | |
| Total finished jewelry | | $ | 5,946,528 | | | $ | 5,476,854 | |
| Total supplies inventory | | $ | 40,510 | | | $ | 17,228 | |
| Total inventory | | $ | 28,924,562 | | | $ | 28,130,417 | |
Total net loose jewel inventories at March 31, 2017 and December 31, 2016, including inventory on consignment net of reserves, were $22.94 million and $22.64 million, respectively. The loose jewel inventories on consignment at March 31,September 30, 2017 and December 31, 2016 include shrinkage reserves of $83,000 and $67,000, respectively, which includes $11,000$1,000 and $7,000, of shrinkage reserves on inventoryrespectively. The finished jewelry inventories on consignment at March 31,September 30, 2017 and December 31, 2016 respectively. Loose jewel inventories at March 31, 2017 and December 31, 2016 also include recut reserves of $438,000 and $425,000, respectively.
Total net jewelry inventories at March 31, 2017 and December 31, 2016, including inventory on consignment net of reserves and finished jewelry featuring moissanite manufactured by the Company, were $5.95 million and $5.48 million, respectively. The finished jewelry inventories at March 31, 2017 and December 31, 2016 also include shrinkage reserves of $114,000$18,000 and $102,000, respectively, including shrinkage reserves of $38,000 and $39,000, on inventory on consignment, respectively; and a repairs reserve of $66,000 and $29,000, respectively.
The need for adjustments to inventory reserves is evaluated on a period-by-period basis.
The Company recognized an income tax net expense for estimated tax, penalties, and interest associated with uncertain tax positions of approximately $14,000$5,000 and $3,000, respectively, for the three months ended March 31,September 30, 2017 and 2016, respectively.and $23,000 and $10,000, respectively, for the nine months ended September 30, 2017 and 2016.
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. Beginning in 2014, the Company’s management determined that negative evidence outweighed the positive and established a full valuation allowance against its deferred tax assets. The Company maintained a full valuation allowance as of March 31,September 30, 2017 and December 31, 2016.
| 7. | COMMITMENTS AND CONTINGENCIES |
Purchase Commitments
On December 12, 2014, the Company entered into a new exclusive supply agreement (the “Supply Agreement”) with Cree, Inc. (“Cree”), which superseded and replaced the exclusive supply agreement that was set to expire in 2015. Under the Supply Agreement, subject to certain terms and conditions, the Company agreed to exclusively purchase from Cree, and Cree agreed to exclusively supply, 100% of the Company’s required SiC materials in quarterly installments that must equal or exceed a set minimum order quantity. The initial term of the Supply Agreement will expire on June 24, 2018, unless extended by the parties. The Company also has one option to unilaterally extend the term of the agreement for an additional two-year period, subject to certain conditions. The Company’s total purchase commitment under the Supply Agreement until June 2018 is dependent upon the size of the SiC material and ranges between approximately $29.60 million and approximately $31.50 million. As of March 31,September 30, 2017, the Company’s remaining purchase commitment through June 2018 under the Supply Agreement ranges from approximately $12.33$7.64 million to approximately $14.23$9.54 million.
During the threenine months ended March 31,September 30, 2017 and 2016, the Company purchased approximately $2.21$6.90 million and $1.91$6.01 million, respectively, of SiC crystals from Cree.
On June 25, 2014, the Company and its wholly owned subsidiaries, Charles & Colvard Direct, LLC and Moissanite.com, LLC (now charlesandcolvard.com, LLC) (collectively, the “Borrowers”), obtained a $10,000,000$10.00 million asset-based revolving credit facility (the “Credit Facility”) from Wells Fargo Bank, National Association (“Wells Fargo”). The Credit Facility willmay be used for general corporate and working capital purposes, including transaction fees and expenses incurred in connection therewith and the issuance of letters of credit up to a $1,000,000$1.00 million sublimit. The Credit Facility willwas scheduled to mature on June 25, 2017. Accordingly,
Effective June 22, 2017, the Company is currently reviewing various credit facility alternatives.Credit Facility was amended to extend the maturity date to June 25, 2018. The Credit Facility was also amended to reduce the interest rate payable on advances under the Credit Facility to a rate equal to Wells Fargo’s daily three-month LIBOR rate plus 2.00%, calculated on an actual/360 basis and payable monthly in arrears. In addition, the Credit Facility was amended further to include the addition of an EBITDA covenant, whereby the Borrowers must maintain a specified minimum monthly EBITDA through December 2017 if the cash position for the Borrowers’ demand deposit account maintained at Wells Fargo falls below $3.00 million or the Borrowers draw upon the Credit Facility.
The Credit Facility includes a $5,000,000$5.00 million sublimit for advances that are supported by a 90% guaranty provided by the U.S. Export-Import Bank. Advances under the Credit Facility are limited to a borrowing base, which is computed by applying specified advance rates to the value of the Borrowers’ eligible accounts and inventory, less reserves. Advances against inventory are further subject to an initial $3,000,000$3.00 million maximum. The Borrowers must maintain a minimum of $1,000,000$1.00 million in excess availability at all times. There are no other financial covenants.
Each advance accrues interest at a rate equal to either (i) Wells Fargo’s 3-monththree-month LIBOR rate plus 2.50%2.00% or (ii) Wells Fargo’s Prime Rate plus 1.00%, each calculated on an actual/360 basis and payable monthly in arrears. Principal outstanding during an event of default accrues interest at a rate of 3% in excess of the above rate. Any advance may be prepaid in whole or in part at any time. In addition, the maximum line amount may be reduced by the Company in whole or part at any time, subject to a fee equal to 2% of any reduction in the first year after closing, 1% of any reduction in the second year after closing, and 0% thereafter. There are no mandatory prepayments or line reductions.
The Credit Facility is secured by a lien on substantially all assets of the Borrowers, each of which is jointly and severally liable for all obligations thereunder. Wells Fargo’s security interest in certain SiC materials is subordinate to Cree’s security interest in such materials pursuant to the Supply Agreement and an Intercreditor Agreement with Wells Fargo.
The Credit Facility is evidenced by a creditCredit and security agreement,Security Agreement, dated as of June 25, 2014, as amended (the “Credit Agreement”), and customary ancillary documents. The Credit Agreement contains customary covenants, representations and cash dominion provisions, including a financial reporting covenant and limitations on dividends, distributions, debt, contingent obligations, liens, loans, investments, mergers, acquisitions, divestitures, subsidiaries, affiliate transactions, and changes in control.
Events of default under the Credit Facility include, without limitation, (1)(i) any impairment of the Export-Import Bank guaranty, unless the guaranteed advances are repaid within two business days, (2)(ii) an event of default under any other indebtedness of the Borrowers in excess of $200,000, and (3)(iii) a material adverse change in the ability of the Borrowers to perform their obligations under the Credit Agreement or in the Borrowers’ assets, liabilities, businesses or prospects, or other circumstances that Wells Fargo believes may impair the prospect of repayment. If an event of default occurs, Wells Fargo is entitled to take enforcement action, including acceleration of amounts due under the Credit Agreement and foreclosure upon collateral.
The Credit Agreement contains other customary terms, including indemnity, expense reimbursement, yield protection, and confidentiality provisions. Wells Fargo is permitted to assign the Credit Facility.
As of March 31,September 30, 2017, the Company had not borrowed against the Credit Facility.
| 9. | STOCK-BASED COMPENSATION |
The following table summarizes the components of the Company’s stock-based compensation included in net loss:
| | | Three Months Ended March 31, | | | Three Months Ended September 30, | | | Nine Months Ended September 30, | |
| | | 2017 | | | 2016 | | | 2017 | | | 2016 | | | 2017 | | | 2016 | |
| Employee stock options | | $ | 71,323 | | | $ | 139,183 | | | $ | 93,631 | | | $ | 94,715 | | | $ | 249,969 | | | $ | 339,441 | |
| Consultant stock options | | | - | | | | 50,248 | | | | - | | | | 39,143 | | | | - | | | | 136,253 | |
| Restricted stock awards | | | (39,030 | ) | | | 144,591 | | | | 25,472 | | | | 100,796 | | | | 75,220 | | | | 397,859 | |
| Totals | | $ | 32,293 | | | $ | 334,022 | | | $ | 119,103 | | | $ | 234,654 | | | $ | 325,189 | | | $ | 873,553 | |
No stock-based compensation was capitalized as a cost of inventory during the three and nine months ended March 31,September 30, 2017 orand 2016.
Included in total stock-based compensation is approximately $0 for each of the three-month periods ended September 30, 2017 and $49,0002016, related to discontinued operations. Included in total stock-based compensation are approximately $0 and $44,000 for the threenine months ended March 31,September 30, 2017 and 2016, respectively, related to discontinued operations.
Stock Options - The following is a summary of the stock option activity for the threenine months ended March 31,September 30, 2017:
| | | Shares | | | Weighted Average Exercise Price | | | Shares | | | Weighted Average Exercise Price | |
| Outstanding, December 31, 2016 | | | 2,134,898 | | | $ | 1.99 | | | | 2,134,898 | | | $ | 1.99 | |
| Granted | | | 125,454 | | | $ | 1.04 | | | | 681,369 | | | $ | 0.92 | |
| Forfeited | | | (23,625 | ) | | $ | 1.86 | | | | (68,000 | ) | | $ | 1.38 | |
| Expired | | | (417,002 | ) | | $ | 3.08 | | | | (603,252 | ) | | $ | 3.08 | |
| Outstanding, March 31, 2017 | | | 1,819,725 | | | $ | 1.68 | | |
| Outstanding, September 30, 2017 | | | | 2,145,015 | | | $ | 1.36 | |
The weighted average grant date fair value of stock options granted during the threenine months ended March 31,September 30, 2017 was $0.59.$0.51. The total fair value of stock options that vested during the threenine months ended March 31,September 30, 2017 was approximately $127,000.$312,000. The fair value of each stock option is estimated on the date of grant using the Black-Scholes-Merton option pricing model with the following weighted average assumptions for stock options granted during the threenine months ended March 31,September 30, 2017:
| Dividend yield | | | 0.0 | % |
| Expected volatility | | | 63.363.0 | % |
| Risk-free interest rate | | | 1.961.86 | % |
| Expected lives (years) | | | 5.515.49 | |
Although the Company issued dividends in prior years, a dividend yield of zero was used due to the uncertainty of future dividend payments. Volatility is a measure of the amount by which a financial variable such as share price has fluctuated (historical volatility) or is expected to fluctuate (expected volatility) during a period. The Company estimates expected volatility giving primary consideration to the historical volatility of its common stock.stock. The risk-free interest rate is based on the published yield available on U.S. Treasury issues with an equivalent term remaining equal to the expected life of the stock option. The expected lives of the stock options issued since 2014 represent the estimated period of time until exercise or forfeiture and are based on the simplified method of using the mid-point between the vesting term and the original contractual term. Stock options issued prior to 2014 were expensed using expected lives that represented the time until exercise or forfeiture using historical information.information. Expected forfeitures are based on the historical forfeiture rates by employee class.
The following table summarizes information about stock options outstanding at March 31,September 30, 2017:
| Options Outstanding | Options Outstanding | | | Options Exercisable | | | Options Vested or Expected to Vest | | Options Outstanding | | | Options Exercisable | | | Options Vested or Expected to Vest | |
Balance as of 3/31/2017 | | | Weighted Average Remaining Contractual Life (Years) | | | Weighted Average Exercise Price | | | Balance as of 3/31/2017 | | | Weighted Average Remaining Contractual Life (Years) | | | Weighted Average Exercise Price | | | Balance as of 3/31/2017 | | | Weighted Average Remaining Contractual Life (Years) | | | Weighted Average Exercise Price | | |
Balance as of 9/30/2017 | | Balance as of 9/30/2017 | | | Weighted Average Remaining Contractual Life (Years) | | | Weighted Average Exercise Price | | | Balance as of 9/30/2017 | | | Weighted Average Remaining Contractual Life (Years) | | | Weighted Average Exercise Price | | | Balance as of 9/30/2017 | | | Weighted Average Remaining Contractual Life (Years) | | | Weighted Average Exercise Price | |
| | 1,819,725 | | | | 7.48 | | | $ | 1.68 | | | | 1,170,784 | | | | 6.58 | | | $ | 1.95 | | | | 1,736,717 | | | | 7.40 | | | $ | 1.70 | | 2,145,015 | | | | 8.14 | | | $ | 1.36 | | | | 1,256,146 | | | | 7.32 | | | $ | 1.62 | | | | 2,039,272 | | | | 8.08 | | | $ | 1.38 | |
As of March 31,September 30, 2017, the unrecognized stock-based compensation expense related to unvested stock options was approximately $281,000,$350,000, which is expected to be recognized over a weighted average period of approximately 2223 months.
The aggregate intrinsic value of stock options outstanding, exercisable, and vested or expected to vest at March 31,September 30, 2017 was approximately $11,000.$9,000. This amount is before applicable income taxes and represents the closing market price of the Company’s common stock at March 31,September 30, 2017 less the grant price, multiplied by the number of stock options that had a grant price that is less than the closing market price. This amount represents the amount that would have been received by the optionees had these stock options been exercised on that date. During the three months ended March 31, 2017, noNo stock options were exercised.exercised during the three and nine months ended September 30, 2017. During each of the three- and nine-month periods ended September 30, 2016, the aggregate intrinsic value of stock options exercised was approximately $250.
Restricted Stock - The following is a summary of the restricted stock activity for the threenine months ended March 31,September 30, 2017:
| | | Shares | | | Weighted Average Grant Date Fair Value | | | Shares | | | Weighted Average Grant Date Fair Value | |
| Unvested, December 31, 2016 | | | 359,400 | | | $ | 0.91 | | | | 359,400 | | | $ | 0.91 | |
| Granted | | | 420,000 | | | $ | 1.11 | | | | 420,000 | | | $ | 1.11 | |
| Vested | | | (202,953 | ) | | $ | 0.91 | | | | (210,453 | ) | | $ | 0.92 | |
| Canceled | | | (160,200 | ) | | $ | 0.91 | | | | (195,200 | ) | | $ | 0.95 | |
| Unvested, March 31, 2017 | | | 416,247 | | | $ | 1.11 | | |
| Unvested, September 30, 2017 | | | | 373,747 | | | $ | 1.11 | |
As of March 31,September 30, 2017, the estimated unrecognized stock-based compensation expense related to unvested restricted shares subject to achievement of performance goals was approximately $427,000,$227,000, all of which is expected to be recognized over a weighted average period of approximately 11five months.
Dividends - The Company has not paid any cash dividends in the current year through March 31,September 30, 2017.
| 10. | NET LOSS PER COMMON SHARE |
Basic net loss from continuing and discontinued operations per common share is computed by dividing net loss by the weighted average number of common shares outstanding during the periods. Diluted net loss from continuing and discontinued operations per common share is computed using the weighted average number of common and dilutive common equivalent shares outstanding during the periods. Common equivalent shares consist of stock options that are computed using the treasury stock method. Antidilutive stock awards consist of stock options and unvested restricted shares that would have been antidilutive in the application of the treasury stock method in accordance with the “Earnings Per Share” topic of the FASB Accounting Standards Codification.
The following table reconciles the differences between the basic and diluted net loss per share presentations:
| | | Three Months Ended March 31, | | | Three Months Ended September 30, | | | Nine Months Ended September 30, | |
| | | 2017 | | | 2016 | | | 2017 | | | 2016 | | | 2017 | | | 2016 | |
| Numerator: | | | | | | | | | | | | | | | | | | |
| Net loss from continuing operations | | $ | (559,646 | ) | | $ | (748,515 | ) | | $ | (174,539 | ) | | $ | (1,147,430 | ) | | $ | (1,136,966 | ) | | $ | (2,879,201 | ) |
| Net loss from discontinued operations | | | - | | | | (558,907 | ) | | | - | | | | (10,014 | ) | | | - | | | | (573,629 | ) |
| Net loss | | $ | (559,646 | ) | | $ | (1,307,422 | ) | | $ | (174,539 | ) | | $ | (1,157,444 | ) | | $ | (1,136,966 | ) | | $ | (3,452,830 | ) |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Denominator: | | | | | | | | | | | | | | | | | | | | | | | | |
| Weighted average common shares outstanding: | | | | | | | | | | | | | | | | | | | | | | | | |
| Basic and Diluted | | | 21,118,335 | | | | 20,730,419 | | |
| Basic | | | | 21,218,468 | | | | 20,997,686 | | | | 21,184,211 | | | | 20,898,484 | |
| Stock options and restricted stock | | | | - | | | | - | | | | - | | | | - | |
| Diluted | | | | 21,218,468 | | | | 20,997,686 | | | | 21,184,211 | | | | 20,898,484 | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Net loss per common share: | | | | | | | | | | | | | | | | | | | | | | | | |
| Basic – continuing operations | | $ | (0.03 | ) | | $ | (0.04 | ) | | $ | (0.01 | ) | | $ | (0.06 | ) | | $ | (0.05 | ) | | $ | (0.14 | ) |
| Basic – discontinued operations | | | - | | | | (0.02 | ) | | | - | | | | (0.00 | ) | | | - | | | | (0.03 | ) |
| Basic – total | | $ | (0.03 | ) | | $ | (0.06 | ) | | $ | (0.01 | ) | | $ | (0.06 | ) | | $ | (0.05 | ) | | $ | (0.17 | ) |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Diluted – continuing operations | | $ | (0.03 | ) | | $ | (0.04 | ) | | $ | (0.01 | ) | | $ | (0.06 | ) | | $ | (0.05 | ) | | $ | (0.14 | ) |
| Diluted – discontinued operations | | | - | | | | (0.02 | ) | | | - | | | | (0.00 | ) | | | - | | | | (0.03 | ) |
| Diluted – total | | $ | (0.03 | ) | | $ | (0.06 | ) | | $ | (0.01 | ) | | $ | (0.06 | ) | | $ | (0.05 | ) | | $ | (0.17 | ) |
For each of the three monthsthree- and nine-month periods ended March 31,September 30, 2017, and 2016, stock options to purchase approximately 1.82 and 2.372.15 million shares respectively, were excluded from the computation of diluted net loss per common share because the exercise price of the stock options was greater than the average market price of the common shares or the effect of inclusion of such amounts would be anti-dilutive to net loss per common share. For each of the three monthsthree- and nine-month periods ended March 31,September 30, 2016, stock options to purchase approximately 2.23 million shares were excluded. For each of the three- and nine-month periods ended September 30, 2017, and 2016, approximately 416,000 and 564,000, respectively, of374,000 restricted shares that have been issued but not yet vested have been excluded from the computation of diluted net loss per common share. For each of the three- and nine-month periods ended September 30, 2016, approximately 438,000 unvested restricted shares were excluded.
| 11. | MAJOR CUSTOMERS AND CONCENTRATION OF CREDIT RISK |
Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of cash and cash equivalents and trade accounts receivable. At times, cash balances may exceed the Federal Deposit Insurance Corporation (“FDIC”) insurable limits of $250,000 per depositor at each financial institution. The Company has never experienced any losses related to these balances. Non-interest-bearing amounts on deposit in excess of FDIC insurable limits at March 31,September 30, 2017 approximated $6.31$4.85 million.
Trade receivables potentially subject the Company to credit risk. The Company’s standard wholesaleTraditional segment customer payment terms on trade receivables are generally between 30 and 90120 days, though it may offer extended terms with specific customers and on significant orders from time to time. The Company believes its competitors and other vendors in the wholesale jewelry industry have also expanded their use of extended payment terms and, in aggregate, the Company believes that by expanding its use of extended payment terms, it has provided a competitive response in its market and that its net sales have been favorably impacted. The Company is unable to estimate the impact of this program on its net sales, but if it ceased providing extended payment terms in select instances, the Company believes it would not be competitive for some wholesaleTraditional segment customers in the marketplace and that its net sales and profits would likely decrease. The Company extends credit to its customers based upon a number of factors, including an evaluation of the customer’s financial condition and credit history that is verified through trade association reference services, the customer’s payment history with the Company, the customer’s reputation in the trade, and/or an evaluation of the Company’s opportunity to introduce its moissanite jewels or finished jewelry featuring moissanite to new or expanded markets. Collateral is not generally required from customers. The need for an allowance for doubtful accounts is determined based upon factors surrounding the credit risk of specific customers, historical trends, and other information. During the year ended December 31, 2016, the Company wrote off $815,000 in accounts receivable related to one international customer that was past due on its payment arrangement as it determined that the benefits of continued collections efforts did not outweigh the cost of legal proceedings. The Company does not believe its commercial terms were a factor with this customer’s non-payment. The Company’s allowance for doubtful accounts previously included an allowance for this accounts receivable, and therefore, this write-off did not have an impact on net loss for the year ended December 31, 2016. The Company has not experienced any other significant accounts receivable write-offs related to revenue arrangements with extended payment terms.
At times, a portion of the Company’s accounts receivable will be due from customers that have individual balances of 10% or more of the Company’s total gross accounts receivable. The following is a summary of customers that represent 10%greater than or moreequal to 10% of total gross accounts receivable:
| | | March 31,September 30,
2017 | | | December 31, 2016 | |
| Customer A | | | 2321 | % | | | ** | % |
| Customer B | | | 17 | % | | | * | % |
| Customer C | | | ** | % | | | 13 | % |
*Customer Customers A and B did not have a balanceindividual balances that represented 10% or more of the total gross accounts receivable as of March 31, 2017.
**Customer A did not have a balance that represented 10% or more of the total gross accounts receivable as of December 31, 2016.
** Customer C did not have an individual balance that represented 10% or more of total gross accounts receivable as of September 30, 2017.
A significant portion of sales is derived from certain customer relationships. The following is a summary of customers that represent 10% or more of total grossnet sales:
| | Three Months Ended March 31, | | | Three Months Ended September 30, | | | Nine Months Ended September 30, | |
| | 2017 | | 2016 | | | 2017 | | | 2016 | | | 2017 | | | 2016 | |
| Customer A | | | 25 | % | | | ** | % | | | 23 | % | | | 27 | % | | | 25 | % | | | 17 | % |
| Customer C | | | 10 | % | | | ** | % | |
| Customer B | | | | 11 | % | | | * | % | | | * | % | | | * | % |
| Customer D | | | * | % | | | 59 | % | | | 10 | % | | | ** | % | | | 10 | % | | | ** | % |
| Customer E | | | | *** | % | | | *** | % | | | *** | % | | | 29 | % |
*Customer DB did not have a balancenet sales that represented 10% or more of total grossnet sales for the three months ended March 31, 2017.September 30, 2017 or the three and nine months ended September 30, 2016.
**Customers A and C Customer D did not have individual balancesnet sales that represented 10% or more of total grossnet sales for the three and nine months ended March 31,September 30, 2016.
*** Customer E did not have net sales that represented 10% or more of total net sales for the three and nine months ended September 30, 2017 or the three months ended September 30, 2016.
| 12. | DISCONTINUED OPERATIONS |
On March 4, 2016, the Company and Charles & Colvard Direct, LLC (“Direct”) a wholly-owned subsidiary of the Company, entered into an asset purchase agreement (the “Purchase Agreement”) with Yanbal, pursuant to which Yanbal agreed to purchase certain assets of Direct (the “Transferred Assets”). The transactions contemplated by the Purchase Agreement also closed on March 4, 2016 (the “Closing Date”). The Company determined that the sale of these assets represented a strategic shift that will have a major effect on the Company’s operations and financial results. The Company made the decision to divest of these assets after careful analysis of the Company’s core competencies, go-to-market strategies, and intent to advance toward profitability.
Pursuant to the terms of the Purchase Agreement, the Transferred Assets included, among other things, (i) an inventory credit to be used towards $250,000 in existing non-moissanite and moissanite inventory as of the Closing Date, consisting of Direct’s current jewelry offered under the “Lulu Avenue” trademarks, (ii) all existing marketing collateral such as packaging and catalogs for Direct’s current jewelry offered under the “Lulu Avenue” trademarks as of the Closing Date, (iii) certain assigned contracts, (iv) style advisor and customer lists, and (v) all intellectual property rights owned by the Company and Direct and used solely in connection with the operation of Direct’s direct-to-consumer home party business for the sale of fashion jewelry and related products and services in the United States, excluding the “Lulu Avenue” and “Love Knot” trademarks and other “Lulu Avenue” specific intellectual property such as the domain name www.luluavenue.com and all content located on such website (the “Lulu Intellectual Property”). The inventory credit and an exclusive, nontransferable license to use the Lulu Intellectual Property that was also granted to Yanbal on the Closing Date expired on July 31, 2016. AfterFollowing the Closing Date, the Company and Direct may not engage in the direct-to-consumer home party business and may not solicit style advisors or customers of the direct-to-consumer home party business. The Company had also agreed to provide to Yanbal certain transition services, which services ended August 31, 2016.
The purchase price for the Transferred Assets was $500,000 with selling expenses of approximately $131,000, resulting in a net purchase price of approximately $369,000. The Company recorded a liability associated with $35,000 of expense related to certain style advisor incentives and reduced prepaid expenses by $60,000 related to contracts acquired by Yanbal.
There were no assets or liabilities related to discontinued operations at March 31,September 30, 2017 or December 31, 2016.
The following table presents the major classes of line items constituting pretax loss from discontinued operations:
| | | Three Months Ended March 31, | | | Three Months Ended September 30, | | | Nine Months Ended September 30, | |
| | | 2017 | | | 2016 | | | 2017 | | | 2016 | | | 2017 | | | 2016 | |
| Net sales | | $ | - | | | $ | 717,073 | | | $ | - | | | $ | 29,850 | | | $ | - | | | $ | 804,585 | |
| Costs and expenses: | | | | | | | | | | | | | | | | | | | | | | | | |
| Cost of goods sold | | | - | | | | 259,089 | | | | - | | | | 7,188 | | | | - | | | | 276,100 | |
| Sales and marketing | | | - | | | | 863,808 | | | | - | | | | 29,611 | | | | - | | | | 940,592 | |
| General and administrative | | | - | | | | 168,535 | | | | - | | | | - | | | | - | | | | 173,909 | |
| Interest expense | | | - | | | | 11 | | | | - | | | | - | | | | - | | | | 11 | |
| Total costs and expenses | | | - | | | | 1,291,443 | | | | - | | | | 36,799 | | | | - | | | | 1,390,612 | |
| Loss from discontinued operations | | | - | | | | (574,370 | ) | | | - | | | | (6,949 | ) | | | - | | | | (586,027 | ) |
| Other income: | | | | | | | | | | | | | | | | | | | | | | | | |
| Gain on sale of long-term assets | | | - | | | | 15,463 | | |
| Total other income, net | | | - | | | | 15,463 | | |
| (Loss) gain on sale of long-term assets | | | | - | | | | (3,065 | ) | | | - | | | | 12,398 | |
| Total other (loss) income, net | | | | - | | | | (3,065 | ) | | | - | | | | 12,398 | |
| Pretax loss from discontinued operations | | $ | - | | | $ | (558,907 | ) | | $ | - | | | $ | (10,014 | ) | | $ | - | | | $ | (573,629 | ) |
| Item 2. | Management’s Discussion and Analysis of Financial Condition and Results of Operations |
This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act. Statements expressing expectations regarding our future and projections relating to products, sales, revenues, and earnings are typical of such statements and are made under the Private Securities Litigation Reform Act of 1995. These forward-looking statements include, but are not limited to, statements about our plans, objectives, representations, and contentions and are not historical facts and typically are identified by use of terms such as “may,” “will,” “should,” “could,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “continue,” and similar words, although some forward-looking statements are expressed differently.
All forward-looking statements are subject to the risks and uncertainties inherent in predicting the future. You should be aware that although the forward-looking statements included herein represent management’s current judgment and expectations, our actual results may differ materially from those projected, stated, or implied in these forward-looking statements as a result of many factors including, but not limited to, the following:
| · | Our future financial performance depends upon increased consumer awareness and acceptance, growth of sales of our products, and operational execution of our strategic initiatives. |
| · | We are currently substantially dependent on a limited number of distributors, jewelry manufacturers, and retailerssales outlets that account for the salea large percentage of our products.net sales. |
| · | The execution of our business plans could significantly impact our liquidity. |
| · | Our business and our results of operations could be materially adversely affected as a result of our inability to fulfill orders on a timely basis. |
| · | The financial difficulties or insolvency of one or more of our major customers or their lack of willingness and ability to market our products could adversely affect results. |
| · | We expect to remain dependent upon our exclusive supply agreement, or the Supply Agreement, with Cree, Inc., or Cree, which we entered into on December 12, 2014, for the sole supply of our silicon carbide, or SiC, crystals for the foreseeable future. |
| · | We face intense competition in the worldwide jewelry industry. |
| · | The resignation of our Chief Financial Officer and the departure of our Chief Revenue Officer create uncertainties and could impact our business. |
| · | Our failure to maintain compliance with NASDAQ’sNasdaq’s continued listing requirements could result in the delisting of our common stock. |
| · | Our current wholesale customers may potentially perceive us as a competitor in the finished jewelry business. |
| · | We may experience quality control challenges from time to time that can result in lost revenue and harm to our brandsbrand and reputation. |
| · | Our business and our results of operations could be materially adversely affected as a result of general economic and market conditions. |
| · | We are subject to certain risks due to our international distribution channels and vendors. |
| · | Our operations could be disrupted by natural disasters. |
| · | Sales of moissanite jewelry could be dependent upon the pricing of precious metals, which is beyond our control. |
| · | Seasonality of our business may adversely affect our net sales and operating income. |
| · | We may not be able to adequately protect our intellectual property, which could harm the value of our products and brands and adversely affect our business. |
| · | A failure of our information technology infrastructure or a failure to protect confidential information of our customers and our network against security breaches could adversely impact our business and operations. |
| · | If the e-commerce opportunity changes dramatically or if e-commerce technology or providers change their models, our results of operations may be adversely affected. |
| · | Negative or inaccurate information on social media could adversely affect our brand and reputation. |
| · | If we fail to evaluate, implement, and integrate strategic acquisition or disposition opportunities successfully, our business may suffer. |
| · | Governmental regulation and oversight might adversely impact our operations. |
| · | Some anti-takeover provisions of our charter documents may delay or prevent a takeover of our company. |
Forward-looking statements speak only as of the date they are made. We undertake no obligation to update or revise such statements to reflect new circumstances or unanticipated events as they occur except as required by the federal securities laws, and you are urged to review and consider disclosures that we make in the reports that we file with the Securities and Exchange Commission, or SEC, that discuss other factors relevant to our business.
The following discussion is designed to provide a better understanding of our unaudited condensed consolidated financial statements, including a brief discussion of our business and products, key factors that impacted our performance, and a summary of our operating results. This information should be read in conjunction with the unaudited condensed consolidated financial statements and notes thereto included in Part I, Item 1 of this Quarterly Report on Form 10-Q and the condensed consolidated financial statements and notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in our Annual Report on Form 10-K for the year ended December 31, 2016. Historical results and percentage relationships among any amounts in the condensed consolidated financial statements are not necessarily indicative of trends in operating results for future periods.
Overview
We manufacture, market and distribute Charles & Colvard Created Moissanite® (which we refer to as moissanite or moissanite jewels) and finished jewelry featuring moissanite for sale in the worldwide jewelry market. Moissanite, also known by its chemical name silicon carbide, or SiC, is a rare mineral first discovered in a meteorite crater. Because naturally occurring SiC crystals are too small for commercial use, larger crystals must be grown in a laboratory. Leveraging our advantage of being the original and leading worldwide source of created moissanite jewels, our strategy is to establish Charles & Colvard with reputable, high-quality, and sophisticated brands across multiple channels, and to position moissanite as an ethically-sourced, affordable, and luxurious alternative to other gemstones such as diamond. We believe this is possible due to moissanite’s exceptional brilliance, fire, durability, and rarity like no other jewel available on the market. We sell loose moissanite jewels and finished jewelry at wholesale prices to distributors, manufacturers, retailers, TV shopping networks, and designers, including some of the largest distributors and jewelry manufacturers in the world, which mount them into fine jewelry to be sold at retail outlets and via the Internet. We sell at retail prices to end consumers through our wholly owned operating subsidiaries, charlesandcolvard.com, LLC (formerly Moissanite.com, LLC) and Charles & Colvard Direct, LLC (until March 2016), third-party online marketplaces, drop-ship, and through third-party marketplaces.other pure-play, exclusively e-commerce outlets. As of September 30, 2016, we changed the name of our wholly owned subsidiary Moissanite.com, LLC to charlesandcolvard.com, LLC. We believe our continued and expanding use of multiple sales channels to the jewelry trade and the end consumer with branded finished jewelry featuring moissanite positions Charles & Colvard goods at the many touchpoints where consumers are when they are making their buying decisions – thereby creating greater exposure for our brand and increasing consumer demand.
In February 2016, we made the strategic decision to explore a potential divestiture of our direct-to-consumer home party business previously operated through our Charles & Colvard Direct, LLC (dba Lulu Avenue®) subsidiary. After careful analysis of our core competencies, go-to-market strategies, and intent to advance toward profitability, the management team and Board of Directors determined a divestiture of this distribution channel to be in our best interest and our shareholders’ best interest.interests. On March 4, 2016, we and Charles & Colvard Direct, LLC entered into an asset purchase agreement with Yanbal USA, Inc., or Yanbal, under which Yanbal purchased certain assets related to our direct-to-consumer home party business for $500,000 and assumed certain liabilities related to such assets. The operating results of Charles & Colvard Direct, LLC are being presented as a discontinued operation. A more detailed description of this transaction is included in Note 12, “Discontinued Operations”,Operations,” in the Notes to Condensed Consolidated Financial Statements.
Previously, we managed our business through two operating and reportable segments: wholesale distribution transacted through the parent entity, and the direct-to-consumer distribution channel transacted through our wholly owned operating subsidiary, charlesandcolvard.com, LLC (formerly Moissanite.com, LLC). During the three months ended March 31, 2017, we began managing our business through two newly defined operating and reportable segments based on our distribution channels to sell our product lines, loose jewels and finished jewelry: our “Traditional” segment, which consists of wholesale, retail, and television customers; and our “Online Channels” segment, which consists of e-commerce customersoutlets including charlesandcolvard.com, marketplaces, drop-ship, and other pure-play, exclusively e-commerce customers.outlets.
We sell our loose moissanite jewels at wholesale to some of the largest distributors and jewelry manufacturers in the world, which mount them into fine jewelry to be sold at retail outlets and via the Internet. We also sell loose moissanite jewels and finished jewelry featuring moissanite at wholesale to retailers, TV shopping networks, and designers to be sold to end consumers and directly to consumers through our e-commerce sales channel charlesandcolvard.com, third-party marketplaces, and other third-party e-commerce channels. We believe our continued and expanding use of multiple sales channels to the jewelry trade and the end consumer with branded finished jewelry featuring moissanite positions Charles & Colvard goods at the many touchpoints where consumers are when they are making their buying decisions – thereby creating greater exposure for our brand and increasing consumer demand.
Our go-forward strategy is one of optimization and growth. Our future success will be measured on our ability to expand existing channels while discovering new channel partners and new markets through calculated sales and marketing efforts. Our key strategies for 2017 are as follows:
| · | Innovate the Forever OneTM product line. We plan to invest research and development funds and efforts into the continued expansion of the Forever OneTM offering including new jewel shapes and sizes. |
| · | Expand our finished jewelry line. We plan to collaborate with key designers and jewelry suppliers to expand our product line and introduce new collections of fashion, fine, and bridal jewelry. |
| · | Invest in key retail and wholesale partnerships. We plan to leverage significant groundwork laid with existing partners whose brands and customers align with ours to amplify our reach into these established markets. |
| · | Explore new traditional and non-traditionalonline sales channels. We plan to discover unexplored channels as green field opportunities that may open new and innovative ways to reach the consumer where they are shopping. |
| · | Convey e-commerce learning to new channels. We plan to leverage our experience and significant underpinnings in e-commerce to expand our footprint into new channels and regions. |
| · | Evolve our customer service function. We plan to continually improve our customer service function with the intention of delivering world-class service to our wholesale partners and direct consumers. |
| · | Amplify our global marketing efforts. We plan to carefully measure the return on our marketing investments, and focus our efforts on profitable endeavors that drive interest in the Charles & Colvard brand, pull consumers to our many sales and educational outlets, and drive conversions. |
| · | Advance toward profitability. We plan to make calculated investments in our growth while continually striving to reach profitability. |
As we execute our strategy to build and reinvest in our businesses, significant expenses and investment of cash will be required ahead of the revenue streams we expect in the future, and this will likelymay result in some unprofitable reporting periods in 2017.the near future. Despite this, we have maintained as one of our primary goals to generate positive cash flow from continuing operations to protect our cash position. We will continue to monitor our cash burn rate and collection efforts as we grow the business.
InDuring the threenine months ended March 31,September 30, 2017, we begancontinued to see positive momentum as the outcomes of our re-branding effort took hold.began to materialize. Our Online Channels segment, including charlesandcolvard.com, marketplaces, drop-ship and other pure-play, exclusively e-commerce customers,outlets, generated a 5%an 11% increase in net sales over the same period in 2016. We believe this growth, was fueled by our ongoing digital marketing efforts, driving strong Valentine’s Day sales and overalldrove increased traffic to ourthe many e-commerce outlets.outlets where we advertise and sell goods. We remain on track with our strategic programs, including the expansion of our Online Channels segment, continued growth within our Traditional segment, and our move up-market with our Forever OneOne™ gemstone leading the charge. Continued demand from both channel partners and consumers for Forever OneOne™ products drove substantial improvement in our gross margins –margin percentage to 43% for the threenine months ended March 31,September 30, 2017, compared with 20% in30% for the same period in 2016, with Forever OneOne™ representing 86%87% of our overall loose gemstone and finished jewelry sales. In the three months ended March 31,first half of 2017, we announced the availability of Forever OneOne™ in foursix new, sought-after shapes – emerald, hearts & arrows, pear, radiant, princess, and radiant.baguette. In September 2017, we announced the availability of Forever One™ in Exotic Gems (a selection of grand loose gemstones that range from six carats to 15.5 carats) and three new shapes – heart, marquise, and trillion. With these additional shapes, we have increased the appointmentForever One™ moissanite collection to a total of our new Senior Merchandising Director, we14 gemstone shapes. We are now focusedcontinuing to focus on our expanded jewelry line, leveraging our new gemstone shapes into additional fashion, bridal, and fine jewelry selections.
Our total consolidated net sales for the threenine months ended March 31,September 30, 2017 of $5.65$18.50 million were 50%20% less than total consolidated net sales during the threenine months ended March 31,September 30, 2016. The decrease in consolidated net sales for the three months ended March 31, 2017 was primarily due primarily to the sale, in a single transaction, during the three months ended March 31,first quarter of 2016, of approximately $6.77 million of legacy loose gemstone inventory, or the Legacy Inventory Sale, at low margins, as a result ofresulting from our efforts to reduce inventories.inventory levels. Traditional segment net sales for the threenine months ended March 31,September 30, 2017 of $3.49$12.02 million were 63%31% lower than Traditional segment net sales during the threenine months ended March 31,September 30, 2016, primarily due to the Legacy Inventory Sale.Sale in the prior year. Online Channels segment net sales for the threenine months ended March 31,September 30, 2017 of $2.16$6.48 million were 5% higher11% greater than Online Channels segment net sales during the threenine months ended March 31,September 30, 2016, primarily due to thean ongoing increase in marketplaces, drop-ship, and other pure-play, exclusively ecommerce customers.e-commerce outlets.
Loose jewel sales comprised 70%69% of our total consolidated net sales for the threenine months ended March 31,September 30, 2017 and decreased 59%30% to $3.93$12.77 million, compared with $9.64$18.20 million in the same period of 2016.2016, primarily due to the Legacy Inventory Sale in the prior year. Finished jewelry sales for the threenine months ended March 31,September 30, 2017 comprised 30%31% of our total consolidated net sales and decreased 2%increased 16% to $1.72$5.73 million, compared with $1.75$4.94 million in the same period of 2016.2016 due to increased demand in the Traditional segment.
Operating expenses from continuing operations were $2.97$9.07 million for the threenine months ended March 31,September 30, 2017, compared with $2.97$9.72 million in the same period of 2016. Sales and marketing expenses increased $387,000,$226,438 or 25%4%, to $1.92$5.45 million, primarily as a result of an increase in compensation expenses related to severance in connection with severance benefits related to the departure of our former Chief Revenue Officer. GeneralGeneral and administrative expenses decreased $388,000,$767,600, or 27%18%, to $1.05$4.38 million, primarily as a result of a decrease in compensationcompensation-related expenses and professional services fees, partially offset by an increase in bad debt expense associated with our allowance for doubtful accounts reserve policy.
We recorded a net loss of $560,000,$1.14 million, or $0.03$0.05 per diluted share, for the threenine months ended March 31,September 30, 2017, compared to a net loss of $1.31$3.45 million, or $0.06$0.17 per diluted share, in the same period ofin 2016. The decreased net loss was primarily due to the discontinuance of our direct-to-consumer home party business and an increaseda more favorable gross profit margin. We recorded a net loss from continuing operations of $560,000$1.14 million for the threenine months ended March 31,September 30, 2017, compared to a net loss from continuing operations of $749,000$2.88 million in the same period of 2016. The decreased net loss from continuing operations was primarily due to an increase in Forever One™ sales with a more favorable gross profit margin.
The execution of our strategy to grow our company, with the ultimate goal of increasing consumer awareness and clearly communicating the value proposition of moissanite directly to consumers, is challenging and not without risk. As such, there can be no assurance that future results for each reporting period will exceed past results in sales, operating cash flow, and/or net income due to the challenging business environment in which we operate and our investment in various initiatives to support our growth strategies. However, as we execute our growth strategy and messaging initiatives, we remain committed to our current priorities of generating positive cash flow and strengthening our financial position while both monetizing our existing inventory and manufacturing our created moissanite loose jewels and finished jewelry featuring moissanite to meet sales demand. We believe the results of these efforts will propel our revenue growth and profitability and further enhance shareholder value in coming years, but we fully recognize the business and economic challenges that we face.
Critical Accounting Policies and Estimates
Our discussion and analysis of our financial condition and results of operations are based upon our condensed consolidated financial statements, which we prepared in accordance with accounting principles generally accepted in the United States, or U.S. GAAP. The preparation of these condensed consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, and expenses and related disclosures of contingent assets and liabilities. “Critical accounting policies and estimates” are defined as those most important to the financial statement presentation and that require the most difficult, subjective, or complex judgments. We base our estimates on historical experience and on various other factors that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Under different assumptions and/or conditions, actual results of operations may materially differ. We have disclosed our critical accounting policies and estimates in our Annual Report on Form 10-K for the year ended December 31, 2016, and that disclosure should be read in conjunction with this Quarterly Report on Form 10-Q.
Results of Operations
The following table sets forth certain consolidated statements of operations data for the three and nine months ended March 31,September 30, 2017 and 2016:
| | | Three Months Ended March 31, | | | Three Months Ended September 30, | | | Nine Months Ended September 30, | |
| | | 2017 | | | 2016 | | | 2017 | | | 2016 | | | 2017 | | | 2016 | |
| Net sales | | $ | 5,645,382 | | | $ | 11,393,271 | | | $ | 6,208,808 | | | $ | 5,212,973 | | | $ | 18,495,982 | | | $ | 23,133,248 | |
| Costs and expenses: | | | | | | | | | | | | | | | | | | | | | | | | |
| Cost of goods sold | | | 3,220,615 | | | | 9,163,888 | | | | 3,483,603 | | | | 3,221,007 | | | | 10,544,303 | | | | 16,278,989 | |
| Sales and marketing | | | 1,915,335 | | | | 1,528,585 | | | | 1,757,007 | | | | 1,891,162 | | | | 5,449,195 | | | | 5,222,757 | |
| General and administrative | | | 1,054,171 | | | | 1,442,695 | | | | 1,137,736 | | | | 1,244,400 | | | | 3,612,618 | | | | 4,380,218 | |
| Research and development | | | 819 | | | | 1,868 | | | | 489 | | | | - | | | | 3,633 | | | | 2,848 | |
| Loss on abandonment of property and equipment | | | | - | | | | 473 | | | | - | | | | 116,021 | |
| Total costs and expenses | | | 6,190,940 | | | | 12,137,036 | | | | 6,378,835 | | | | 6,357,042 | | | | 19,609,749 | | | | 26,000,833 | |
| Loss from operations | | | (545,558 | ) | | | (743,765 | ) | | | (170,027 | ) | | | (1,144,069 | ) | | | (1,113,767 | ) | | | (2,867,585 | ) |
| Other expense: | | | | | | | | | | | | | | | | | | | | | | | | |
| Interest expense | | | - | | | | (1,507 | ) | | | (5 | ) | | | (36 | ) | | | (97 | ) | | | (1,548 | ) |
| Total other expense | | | - | | | | (1,507 | ) | |
| | | | | | | | | | |
| Total other expense, net | | | | (5 | ) | | | (36 | ) | | | (97 | ) | | | (1,548 | ) |
| Loss before income taxes from continuing operations | | | (545,558 | ) | | | (745,272 | ) | | | (170,032 | ) | | | (1,144,105 | ) | | | (1,113,864 | ) | | | (2,869,133 | ) |
| Income tax net expense from continuing operations | | | (14,088 | ) | | | (3,243 | ) | | | (4,507 | ) | | | (3,325 | ) | | | (23,102 | ) | | | (10,068 | ) |
| Net loss from continuing operations | | | (559,646 | ) | | | (748,515 | ) | | | (174,539 | ) | | | (1,147,430 | ) | | | (1,136,966 | ) | | | (2,879,201 | ) |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Discontinued Operations: | | | | | | | | | |
| Discontinued operations: | | | | | | | | | | | | | | | | | |
| Loss from discontinued operations | | | - | | | | (574,370 | ) | | | - | | | | (6,949 | ) | | | - | | | | (586,027 | ) |
| Gain on sale of assets from discontinued operations | | | - | | | | 15,463 | | |
| (Loss) gain on sale of assets from discontinued operations | | | | - | | | | (3,065 | ) | | | - | | | | 12,398 | |
| | | | | | | | | | | | | | | | | | |
| Net loss from discontinued operations | | | - | | | | (558,907 | ) | | | - | | | | (10,014 | ) | | | - | | | | (573,629 | ) |
| Net loss | | $ | (559,646 | ) | | $ | (1,307,422 | ) | | $ | (174,539 | ) | | $ | (1,157,444 | ) | | $ | (1,136,966 | ) | | $ | (3,452,830 | ) |
Consolidated Net Sales
Consolidated net sales for the three and nine months ended March 31,September 30, 2017 and 2016 comprise the following:
| | | | Three Months Ended March 31, | | | | Change | | | Three Months Ended September 30, | | | Change | | | Nine Months Ended September 30, | | | Change | |
| | | | 2017 | | | | 2016 | | | | Dollars | | | | Percent | | | 2017 | | | 2016 | | | Dollars | | | Percent | | | 2017 | | | 2016 | | | Dollars | | | Percent | |
| Loose jewels | | $ | 3,929,720 | | | $ | 9,640,598 | | | $ | (5,710,878 | ) | | | -59 | % | | $ | 4,098,472 | | | $ | 3,597,479 | | | $ | 500,993 | | | 14 | % | | $ | | 12,770,835 | | | $ | 18,195,370 | | | $ | (5,424,535 | ) | | -30 | % |
| Finished jewelry | | | 1,715,662 | | | | 1,752,673 | | | | (37,011 | ) | | | -2 | % | | | 2,110,336 | | | | 1,615,494 | | | | 494,842 | | | 31 | % | | | | 5,725,147 | | | | 4,937,878 | | | | 787,269 | | | 16 | % |
| Total consolidated net sales | | $ | 5,645,382 | | | $ | 11,393,271 | | | $ | (5,747,889 | ) | | | -50 | % | | $ | 6,208,808 | | | $ | 5,212,973 | | | $ | 995,835 | | | 19 | % | | $ | | 18,495,982 | | | $ | 23,133,248 | | | $ | (4,637,266 | ) | | -20 | % |
Consolidated net sales were $5.65$6.21 million for the three months ended March 31,September 30, 2017 compared to $11.39$5.21 million for the three months ended March 31,September 30, 2016, an increase of $996,000, or 19%. Consolidated net sales were $18.50 million for the nine months ended September 30, 2017 compared to $23.13 million for the nine months ended September 30, 2016, a decrease of $5.75$4.64 million, or 50%20%. The decreaseincrease in consolidated net sales for the three months ended March 31,September 30, 2017 was primarily due to an increase in finished jewelry net sales in the Traditional segment, and to a lesser extent, in the Online Channels segment, and increased net sales in loose jewels in both the Online Channels segment and Traditional segment. The decrease in consolidated net sales for the nine months ended September 30, 2017 was primarily due to the Legacy Inventory Sale during the three months ended March 31, 2016.first quarter of the prior year.
Sales of loose jewels represented 70%66% and 69% of total consolidated net sales for the three and nine months ended March 31,September 30, 2017, respectively, compared to 85%69% and 79%, respectively, of total consolidated net sales for the corresponding periodperiods of the prior year. For the three months ended March 31,September 30, 2017, loose jewel sales were $3.93$4.10 million compared to $9.64$3.60 million for the corresponding period of the prior year, an increase of $501,000, or 14%. The increase for the three months ended September 30, 2017 was primarily due to the increased demand in our Forever One™ gemstones. For the nine months ended September 30, 2017, loose jewel sales were $12.77 million compared to $18.20 million for the corresponding period of the prior year, a decrease of $5.71$5.42 million, or 59%30%. The decrease for the threenine months ended March 31,September 30, 2017 was primarily due to the Legacy Inventory Sale during the three months ended March 31, 2016.first quarter of the prior year.
Sales of finished jewelry represented 30%34% and 31% of total consolidated net sales for the three and nine months ended March 31,September 30, 2017, respectively, compared to 15%31% and 21%, respectively, of total consolidated net sales for the corresponding periodperiods of the prior year. For the three months ended March 31,September 30, 2017, finished jewelry sales were $1.72$2.11 million compared to $1.75$1.62 million for the corresponding period of the prior year, a decreasean increase of $37,000,$495,000, or 2%31%. For the nine months ended September 30, 2017, finished jewelry sales were $5.73 million compared to $4.94 million for the corresponding period of the prior year, an increase of $787,000, or 16%. The increase in finished jewelry sales for the three- and nine-month periods ended September 30, 2017 was due primarily to strong finished jewelry retail sales in both of our Online Channels segment and Traditional segment.
U.S. net sales accounted for approximately 93% of total consolidated net sales for each of the three monthsthree- and nine-month periods ended March 31,September 30, 2017, compared to 93%88% and 89%, respectively, of total consolidated net sales for the corresponding periodperiods of the prior year. U.S. net sales decreasedincreased to $5.24$5.75 million, or 51%25%, during the three months ended March 31,September 30, 2017 from the corresponding period of the prior year primarily as a result of increased demand in the U.S. distributor market and increased sales from U.S. customers in both our Traditional segment and Online Channels segment. U.S. net sales decreased to $17.21 million, or 17%, during the nine months ended September 30, 2017 from the corresponding period of the prior year primarily as a result of the Legacy Inventory Sale during the three months ended March 31, 2016.first quarter of the prior year.
Our two largest U.S. customers during the three months ended March 31, 2017 accounted for 25% and 10%, respectively of total consolidated sales, but neither accounted for a significant portion of our total consolidated sales during the same period of 2016. Our largest U.S. customer during the three months ended March 31,September 30, 2017 and 2016 accounted for 59%23% and 27% of total consolidated sales during each respective period. This same customer accounted for 25% and 17%, respectively, of total consolidated sales during the nine months ended September 30, 2017 and 2016 and was our largest U.S. customer during each period. Our second largest U.S. customer during the three months ended September 30, 2017 accounted for 11% of total consolidated sales, but did not account for a significant portion of our consolidated sales during the same period in 2016 or the nine-month periods ended September 30, 2017 or 2016. Our third largest U.S. customer during the three months ended September 30, 2017 accounted for 10% of our total consolidated sales during that period and the nine months ended September 30, 2017, but did not account for a significant portion of 2017. We expect that we will remain dependent on our ability, and thatconsolidated sales during the three or nine months ended September 30, 2016. Finally, our largest U.S. customer during the nine months ended September 30, 2016 accounted for 29% of total consolidated sales as a result of the one-time Legacy Inventory Sale transaction. This U.S. customer did not account for a significant portion of our largest customers, to maintain and enhance retail programs.consolidated sales during any of the other periods presented herein. A change in or loss of any of these customerlarge customers or retailer relationships could have a material adverse effect on our results of operations.
International net sales accounted for approximately 7% of total consolidated net sales for each of the three monthsthree- and nine-month periods ended March 31,September 30, 2017, compared to 7%12% and 11%, respectively, of total consolidated net sales for the corresponding periodperiods of the prior year. International net sales decreased 46%26% and 47% during the three and nine months ended March 31,September 30, 2017, respectively, from the corresponding periodperiods of the prior year as we serve distributors in the Hong Kong and India markets and demand for loose jewels in these markets was down compared to the corresponding periodperiods of the prior year. We have been evaluating each of thethese and other potential distributors in these international markets to determine the best long-term partner. Additionally, we anticipate the need to develop a direct-to-consumer presence, which would require marketing and e-commerce investment to drive expected growth in these regions. As a result, our sales in these markets may continue to fluctuate significantly each reporting period.
We did not have an international customer account for 10% or more than 10% of total consolidated sales during the three and nine months ended March 31,September 30, 2017 or 2016. A portion of our international consolidated sales represents jewels sold internationally that may be re-imported to U.S. retailers. Our top three international distributors by sales volume during the three months ended March 31,September 30, 2017 were located in Hong Kong, Canada,United Kingdom, and Hong Kong.Kong, respectively. For the nine months ended September 30, 2017 the top two international distributors by sales volume were located in Hong Kong and the third was located in Canada.
Costs and Expenses
Cost of Goods Sold
Cost of goods sold for the three and nine months ended March 31,September 30, 2017 and 2016 are as follows:
| | | Three Months Ended March 31, | | | Change | | | Three Months Ended September 30, | | | Change | | | Nine Months Ended September 30, | | | Change | |
| | | 2017 | | | 2016 | | | Dollars | | | Percent | | | 2017 | | | 2016 | | | Dollars | | | Percent | | | 2017 | | | 2016 | | | Dollars | | | Percent | |
| Product line cost of goods sold | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Loose jewels | | $ | 1,990,130 | | | $ | 7,814,060 | | | $ | (5,823,930 | ) | | | -75 | % | | $ | 2,244,588 | | | $ | 1,808,979 | | | $ | 435,609 | | | | 24 | % | | $ | 6,647,861 | | | $ | 11,992,862 | | | $ | (5,345,001 | ) | | | -45 | % |
| Finished jewelry | | | 814,212 | | | | 765,107 | | | | 49,105 | | | | 6 | % | | | 989,561 | | | | 706,179 | | | | 283,382 | | | | 40 | % | | | 2,606,328 | | | | 2,666,960 | | | | (60,632 | ) | | | -2 | % |
| Total product line cost of goods sold | | | 2,804,342 | | | | 8,579,167 | | | | (5,774,825 | ) | | | -67 | % | | | 3,234,149 | | | | 2,515,158 | | | | 718,991 | | | | 29 | % | | | 9,254,189 | | | | 14,659,822 | | | | (5,405,633 | ) | | | -37 | % |
| Non-product line cost of goods sold | | | 416,273 | | | | 584,721 | | | | (168,448 | ) | | | -29 | % | | | 249,454 | | | | 705,849 | | | | (456,395 | ) | | | -65 | % | | | 1,290,114 | | | | 1,619,167 | | | | (329,053 | ) | | | -20 | % |
| Total cost of goods sold | | $ | 3,220,615 | | | $ | 9,163,888 | | | $ | (5,943,2735 | ) | | | -65 | % | | $ | 3,483,603 | | | $ | 3,221,007 | | | $ | 262,596 | | | | 8 | % | | $ | 10,544,303 | | | $ | 16,278,989 | | | $ | (5,734,686 | ) | | | -35 | % |
Total cost of goods sold was $3.48 million for the three months ended September 30, 2017 compared to $3.22 million for the three months ended March 31,September 30, 2016, a net increase of $263,000, or 8%. Total cost of goods sold was $10.54 million for the nine months ended September 30, 2017 compared to $9.16$16.28 million for the threenine months ended March 31,September 30, 2016, a decrease of $5.94$5.73 million, or 65%35%. Product line cost of goods sold is defined as product cost of goods sold in each of our Traditional segment and Online Channels segment excluding non-capitalized expenses from our manufacturing and production control departments, comprising personnel costs, depreciation, rent, utilities, and corporate overhead allocations; freight out; inventory valuation allowance adjustments; and other inventory adjustments, comprising costs of quality issues, damaged goods, and inventory write-offs.write-downs.
The increase in cost of goods sold for the three months ended September 30, 2017 was primarily due to an increase in sales volume partially offset by a favorable change in product mix with greater sales of higher margin finished jewelry product in the third quarter of 2017 compared with the same period in 2016. The net decrease in non-product line cost of goods sold comprises a $299,000 decrease in other inventory adjustments; a $149,000 decrease in non-capitalized manufacturing and production control expenses; a $6,000 decrease in freight out; and a $2,000 decrease in inventory valuation allowances.
The decrease in cost of goods sold for the threenine months ended March 31,September 30, 2017 compared to the same period in 2016 was primarily due to the Legacy Inventory Sale during the three months ended March 31,first quarter of 2016. The net decrease in non-product line cost of goods sold comprises a $321,000$155,000 decrease in the change inother inventory valuation allowances,adjustments; a $43,000$168,000 decrease in non-capitalized manufacturing and production control expenses,expenses; and a $1,000$10,000 decrease in freight out.inventory valuation allowances. These decreases were offset in part by a $197,000$4,000 increase in other inventory adjustments. Seefreight out. For further discussion of non-product line cost of goods sold, see Note 3, “Segment Information and Geographic Data”,Data,” in the Notes to Condensed Consolidated Financial Statements for further discussion of non-product line cost of goods sold.included elsewhere in this Quarterly Report on Form 10-Q.
Sales and Marketing
Sales and marketing expenses for the three and nine months ended March 31,September 30, 2017 and 2016 are as follows:
| | Three Months Ended March 31, | | Change | |
| | 2017 | | 2016 | | Dollars | | | Percent | |
| Sales and marketing | | $ | 1,915,335 | | | $ | 1,528,585 | | | $ | 386,750 | | | | 25 | % |
| | | Three Months Ended September 30, | | | Change | | | Nine Months Ended September 30, | | | Change | |
| | | 2017 | | 2016 | | | Dollars | | | Percent | | | 2017 | | 2016 | | | Dollars | | | Percent | |
| Sales and marketing | | $ | 1,757,007 | | $ | 1,891,162 | | | $ | (134,155 | ) | | | -7 | % | | $ | 5,449,195 | | $ | 5,222,757 | | | $ | 226,438 | | | 4 | % |
Sales and marketing expenses were $1.92$1.76 million for the three months ended March 31,September 30, 2017 compared to $1.53$1.89 million for the three months ended March 31,September 30, 2016, a decrease of $134,000, or 7%. Sales and marketing expenses were $5.45 million for the nine months ended September 30, 2017 compared to $5.22 million for the nine months ended September 30, 2016, an increase of $387,000,$226,000, or 25%4%.
The increasedecrease in sales and marketing expenses for the three months ended March 31,September 30, 2017 compared to the same period in 2016 was primarily due to a $375,000 increase$244,000 decrease in compensationadvertising expenses; a $53,000 increase$67,000 decrease in travel expenses; a $43,000 increase in professional services; a $39,000 increase in office-related and othercompensation-related expenses; and a $3,000 increase$39,000 decrease in depreciation expenses.travel expense. These increasesdecreases were partially offset by a $168,000 decrease$92,000 increase in advertising expensesprofessional services fees; an $84,000 increase in software-related costs principally in connection with maintenance agreements associated with our migration to a cloud-based data storage arrangement as well as other software-related agreements; a $24,000 increase in recruiting fees; a $10,000 increase in depreciation; and a $19,000 decrease$6,000 increase in recruitingall other sales and marketing expenses.
The increasedecrease in compensationadvertising expenses for the three months ended March 31,September 30, 2017 compared to the same period in 2016 was primarily due to a $246,000$372,000 decrease in outside agency fees related to re-branding and the re-platformed web presence and a $5,000 net decrease in print media expenses. These decreases were partially offset by a $78,000 increase in Internet marketing; a $44,000 increase in cooperative advertising; and an $11,000 increase in promotions.
Compensation expenses for the three months ended September 30, 2017 compared to the same period in 2016 decreased primarily as a result of a $35,000 decrease in severance expense primarilyexpenses related to the departure of our former Chief Revenue Officer;personnel changes; a $77,000$35,000 decrease in employee stock-based compensation expense; and an $8,000 decrease in bonus expense. These decreases were partially offset by an $8,000 increase in relocation expense and a $3,000 increase in salaries, commissions, and related employee benefits; a $42,000 increase in bonus expense; and a $10,000 increase in relocation expense.benefits.
The decreaseincrease in advertisingsales and marketing expenses for the threenine months ended March 31,September 30, 2017 compared to the same period in 2016 was primarily due to a $121,000$383,000 increase in compensation-related expense; a $181,000 increase in professional services fees; a $178,000 increase in software-related costs principally in connection with maintenance agreements associated with our migration to a cloud-based data storage arrangement as well as other software-related agreements; a $25,000 increase in general office-related expenses; a $16,000 increase in depreciation; and an $11,000 increase in recruiting fees. These increases were partially offset by a $572,000 decrease in internet marketing;advertising expenses; a $44,000$45,000 decrease in cooperative advertising;travel expense; and a $12,000 decrease in research and development expenses.
The decrease in advertising expenses for the nine months ended September 30, 2017 compared to the same period in 2016 comprises a $733,000 decrease in outside agency fees and a $37,000 decrease in outside agency fees; a $26,000 decrease in print media expenses; and a $6,000 decrease in trade show related expenses. These decreases were partially offset by a $54,000$78,000 increase in social media expensecooperative advertising; a $73,000 increase in promotional expenses; a $38,000 increase in Internet marketing; and a $12,000$9,000 increase in all other advertising expenses.
Compensation expenses for the nine months ended September 30, 2017 compared to the same period in 2016 increased primarily as a result of a $238,000 increase in salaries, commissions, and related employee benefits in the aggregate; a $191,000 increase in severance expense primarily related to the departure of our Chief Revenue Officer during the first quarter of 2017; a $68,000 increase in bonus expense; and a $13,000 increase in relocation expense. These increases were partially offset by a $127,000 decrease in employee stock-based compensation expense.
Sales and marketing expenses are allocated across our Traditional segment and Online Channels segment, which in 2016 included allocations to Charles & Colvard Direct, LLC, a segment we are reporting as discontinued operations. See Note 12, “Discontinued Operations”,Operations,” in the Notes to the Condensed Consolidated Financial Statements for further discussion of discontinued operations. Approximately $61,000 of sales and marketing expenses for the threenine months ended March 31,September 30, 2016, isall of which were incurred during the first six months of 2016, are attributable to sales and marketing expenses that are now being allocated to our remaining two continuing operationsoperating segments that were previously allocated to Charles & Colvard Direct, LLC. The Company had no such sales and marketing expenses during the third quarter of 2016.
General and Administrative
General and administrative expenses for the three and nine months ended March 31,September 30, 2017 and 2016 are as follows:
| | Three Months Ended March 31, | | Change | |
| | 2017 | | 2016 | | Dollars | | | Percent | |
| General and administrative | | $ | 1,054,171 | | | $ | 1,442,695 | | | $ | (388,524 | ) | | | -27 | % |
| | | Three Months Ended September 30, | | | Change | | | Nine Months Ended September 30, | | | Change | |
| | | 2017 | | | 2016 | | | Dollars | | | Percent | | | 2017 | | | 2016 | | | Dollars | | | Percent | |
| General and administrative | | $ | 1,137,736 | | | $ | 1,244,400 | | | $ | (106,664 | ) | | -9 | % | | $ | 3,612,618 | | | $ | 4,380,218 | | | $ | (767,600 | ) | | -18 | % |
General and administrative expenses were $1.05$1.14 million for the three months ended March 31,September 30, 2017 compared to $1.44$1.24 million for the three months ended March 31,September 30, 2016, a decrease of $389,000,$107,000, or 27%9%. General and administrative expenses were $3.61 million for the nine months ended September 30, 2017 compared to $4.38 million for the nine months ended September 30, 2016, a decrease of $768,000, or 18%.
The decrease in general and administrative expenses for the three months ended March 31,September 30, 2017 compared to the same period in 2016 was primarily due to a $432,000$189,000 decrease in compensation expenses; a $199,000$20,000 decrease in professional services;business taxes and licenses; an $11,000 decrease in insurance expenses; a $21,000$5,000 decrease in depreciation and amortization expense; and a $10,000$4,000 decrease in travel expense.expenses. These decreases were partially offset by a $103,000$68,000 increase in bad debt expense associated with our allowance for doubtful accounts reserve policy.policy; a $28,000 increase in professional services fees; a $9,000 increase in board retainer fees; and a $17,000 increase in miscellaneous other general and administrative expenses.
The decrease in compensationCompensation expenses decreased for the three months ended March 31,September 30, 2017 compared to the same period in 2016 primarily due to an $81,000 decrease in employee stock-based compensation expense; an $80,000 decrease in salaries and related employee benefits in the aggregate; a $24,000 decrease in bonus expense; and a $4,000 decrease in severance expense.
Professional services fees increased for the three months ended September 30, 2017 compared to the same period in 2016 primarily due to an increase of $61,000 in legal fees. This increase was partially offset by a decrease of $27,000 in consulting and other professional services primarily related to human resources and sales and use tax projects in the same period in 2016; a $4,000 decrease in investor and public relations expenses; and a $2,000 decrease in accounting services.
The decrease in general and administrative expenses for the nine months ended September 30, 2017 compared to the same period in 2016 was primarily due to a $209,000$908,000 decrease in stock-based compensation expense related primarily to the valuation of performance based restricted stock;expenses; a $201,000$95,000 decrease in salariesprofessional services fees; a $76,000 decrease in depreciation and related employee benefits;amortization expense; a $44,000 decrease in insurance expenses; a $28,000 decrease in travel expenses; a $2,000 decrease in board retainer fees; and a $22,000 decrease of $29,000 in bonuses.miscellaneous other general and administrative expenses. These decreases were partially offset by a $7,000$156,000 increase in severance expense.bad debt expense associated with our allowance for doubtful accounts reserve policy; a $46,000 increase in bank fees, which includes fees associated with the Wells Fargo Credit Facility and credit card clearing transactions; a $16,000 increase in equipment-related rental expense; and a $14,000 increase in business taxes and licenses.
Professional servicesCompensation expenses decreased for the threenine months ended March 31,September 30, 2017 compared to the same period in 2016 primarily due to a $130,000$429,000 decrease in legalsalaries and related employee benefits in the aggregate; a $407,000 decrease in employee stock-based compensation expense; and a $75,000 decrease in bonus expense. These decreases were partially offset by an increase of $3,000 in severance expenses related to personnel changes.
Professional services fees decreased for the nine months ended September 30, 2017 compared to the same period in 2016 primarily due to a decrease of $83,000 in consulting and other professional services primarily related to the divestiture of our direct-to-consumer home party businesshuman resources and sales and use tax projects in the prior year;same period in 2016; a $77,000 decrease of $51,000 in audit and taxaccounting services; and a $2,000$1,000 decrease in investor and public relations expenses. These decreases were partially offset by a $10,000an increase in other professional services.
legal fees of $40,000.
General and administrative expenses are allocated across our Traditional segment and Online Channels segment, which in 2016 included allocations to Charles & Colvard Direct, LLC, a segment we are reporting as discontinued operations. See Note 12, “Discontinued Operations”,Operations,” in the Notes to the Condensed Consolidated Financial Statements for further discussion of discontinued operations. Approximately $170,000$175,000 of general and administrative expenses for the threenine months ended March 31,September 30, 2016, isall of which were incurred during the first six months of 2016, are attributable to general and administrative expenses that are now being allocated to our remaining two continuing operationsoperating segments that were previously allocated to Charles & Colvard Direct, LLC. The Company had no such general and administrative expenses during the third quarter of 2016.
Loss on Abandonment of Property and Equipment
Loss on abandonment of property and equipment for the three and nine months ended September 30, 2017 and 2016 is as follows:
| | | Three Months Ended September 30, | | | Change | | | Nine Months Ended September 30, | | | Change | |
| | | 2017 | | | 2016 | | | Dollars | | | Percent | | | 2017 | | | 2016 | | | Dollars | | | Percent | |
| Loss on abandonment of property and equipment | | $ | - | | | $ | 473 | | | $ | (473 | ) | | | -100 | % | | $ | - | | | $ | 116,021 | | | $ | (116,021 | ) | | | -100 | % |
The Company had no losses on abandonment of property and equipment for the three and nine months ended September 30, 2017 compared to approximately $500 and $116,000 for the three and nine months ended September 30, 2016, respectively, a decrease of approximately $500 and $116,000, respectively, or 100% for each period.
During the nine-month period ended September 30, 2016, we abandoned costs of construction in progress related to website branding and design for our direct-to-consumer e-commerce business due to a change in our corporate strategy to consolidate our web properties.
Provision for Income Taxes
We recognized an income tax net expense of approximately $4,500 and $3,300 for the three-month periods ended September 30, 2017 and 2016, respectively. We recognized an income tax net expense of approximately $23,100 and $10,100 for the nine-month periods ended September 30, 2017 and 2016, respectively. Income tax provisions in these periods primarily relate to estimated tax, penalties, and interest associated with uncertain tax positions of approximately $14,000 and $3,000 for the three-month periods ended March 31, 2017 and 2016, respectively.positions.
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. Beginning in 2014, management determined that negative evidence outweighed the positive and established a full valuation allowance against our deferred tax assets. We maintained a full valuation allowance as of March 31,September 30, 2017 and December 31, 2016.
Liquidity and Capital Resources
We require cash to fund our operating expenses and working capital requirements, including outlays for capital expenditures. As of March 31,September 30, 2017, our principal sources of liquidity were cash and cash equivalents totaling $6.63$5.13 million, trade accounts receivable of $2.23$2.61 million, and net current inventory of $9.50$11.12 million, as compared to cash and cash equivalents totaling $7.43 million, trade accounts receivable of $2.80$2.79 million, and net current inventory of $9.77 million as of December 31, 2016. As described more fully below, we also have access to a $10our $10.00 million asset-based revolving credit facility.facility, or the Credit Facility, from Wells Fargo Bank, National Association, or Wells Fargo.
During the threenine months ended March 31,September 30, 2017, our working capital decreased by approximately $1.70$2.23 million to $14.37$13.83 million from $16.07 million at December 31, 2016. As described more fully below, the decrease in working capital at March 31,September 30, 2017 is primarily attributable to a decrease in our cash and cash equivalents due toresulting from cash used in our decreased cash from operations, a decrease in accounts receivable, and a decreasedan increase in accounts payable, accrued cooperative advertising, and accrued expenses and other liabilities. These factors were offset partially by an increase in both our allocation of inventory to short-term from long-term.long-term and prepaid expenses and other assets.
During the threenine months ended March 31,September 30, 2017, $599,000$2.05 million of cash was used in continuing operations. The primary drivers of the use of cash were oura net loss of $560,000 that included a decrease of $37,000$1.14 million, which includes $765,000 of non-cash expenses,expenditures; an increase in inventory of $528,000,$2.81 million; and a decreasean increase in accounts payableprepaid expenses and other assets of $76,000.$49,000. These factors were partially offset by a decrease in accounts receivable of $471,000, a decrease$105,000; an increase in prepaid expenses and other assetsaccounts payable of $65,000,$907,000 and an increase in accrued expensesliabilities of $67,000. Inventory increased$169,000. The inventory increase was, in part, due to the purchase of new raw material SiC crystals during the quarterperiod pursuant to the Supply Agreement; production of moissanite jewels; and purchases of jewelry castings and other jewelry components due to increased demand in certain channels. Accounts receivable decreased primarily due to collections efforts.channels and preparation for the upcoming holiday season. We did not offer any extended wholesaleTraditional segment customer payment terms during the threenine months ended March 31,September 30, 2017; however, we may offer these terms from time to time, which 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 expanded their use of extended payment terms and, in aggregate, we believe that through our use of extended payment terms, we have providedprovide 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 ceasedcease providing extended payment terms in select instances, we believe we would not be competitive for some wholesaleTraditional segment customers in the marketplace and that our net sales and profits would likely decrease.
WeDuring the nine months ended September 30, 2017, we manufactured approximately $3.17$11.41 million in loose jewels and $1.08$4.73 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 three months ended March 31, 2017.production. We expect our purchases of precious metals and labor to increase as we increase our finished jewelry business. In addition, the price of gold has increased significantly over the past decade, resulting in higher retail price points for gold jewelry. Because the market price of gold and other precious metals is beyond our control, the upward price trends could continue and have a negative impact on our operating cash flow as we manufacture finished jewelry.
Historically, our raw material inventories of SiC crystals had been purchased under exclusive supply agreements with a limited number of suppliers. Because the supply agreements restricted the sale of these crystals exclusively to us, the suppliers negotiated minimum purchase commitments with us that, when combined with our reduced sales during the periods when the purchase commitments were in effect, have resulted in levels of inventories that are higher than we might otherwise maintain. As of March 31,September 30, 2017, $19.43$19.78 million of our inventories were classified as long-term assets. Loose jewel sales and finished jewelry that we manufacture will utilize both the finished goodsgood loose jewels currently on-hand and, as we deplete certain shapes and sizes, our on-hand raw material SiC crystals of $3.09$4.08 million and new raw material that we are purchasing pursuant to the Supply Agreement. A more detailed description of our inventories is included in Note 5, “Inventories,” in the Notes to Condensed Consolidated Financial Statements included elsewhere in this Quarterly Report on Form 10-Q.
On December 12, 2014, we entered into the Supply Agreement with Cree, our long-timeraw material SiC raw materialscrystal supplier. Under the Supply Agreement, subject to certain terms and conditions, we agreed to exclusively purchase from Cree, and Cree agreed to exclusively supply, 100% of our required SiC materials in quarterly installments that must equal or exceed a set minimum order quantity. The initial term of the Supply Agreement will expire on June 24, 2018, unless extended by the parties. We also have one option to unilaterally extend the term of the agreement for an additional two-year period, subject to certain conditions. Our total purchase commitment under the Supply Agreement until June 2018 is dependent upon the size of the SiC material and ranges between approximately $29.60 million and approximately $31.50 million. As of March 31,September 30, 2017, our remaining purchase commitment through June 2018 under the Supply Agreement ranges from approximately $12.33$7.64 million to approximately $14.23$9.54 million.
During the threenine months ended March 31,September 30, 2017, we purchased approximately $2.21$6.90 million of SiC crystals from Cree. We expect to use existing cash and cash equivalents, and other working capital together with future cash expected to be provided by operating activities and, if necessary, our Credit Facility, to finance our purchase commitment under the Supply Agreement.
We made no income tax payments during the threenine months ended March 31,September 30, 2017. As of March 31,September 30, 2017, we had approximately $882,000 of remaining federal income tax credits, $533,000 of which expire between 2018 and 2021 and the balance without an expiration, which can be carried forward to offset future income taxes. As of March 31,September 30, 2017, we also had a federal tax net operating loss carryforward of approximately $25.03$25.01 million expiring between 2020 and 2036, which can be used to offset against future federal taxable income, a North Carolina tax net operating loss carryforward of approximately $20.26$20.23 million expiring between 2023 and 2031, and various other state tax net operating loss carryforwards expiring between 2021 and 2036, which can be used to offset against future state taxable income.
On June 25, 2014, we and our wholly owned subsidiaries, Charles & Colvard Direct, LLC and Moissanite.com, LLC (now charlesandcolvard.com, LLC), collectively referred to as the Borrowers, obtained the Credit Facility from Wells Fargo. The Credit Facility willmay be used for general corporate and working capital purposes, including transaction fees and expenses incurred in connection therewith and the issuance of letters of credit up to a $1,000,000$1.00 million sublimit. The Credit Facility willwas scheduled to mature on June 25, 2017. Accordingly, we are currently reviewing various credit facility alternatives.
Effective June 22, 2017, the Credit Facility was amended to extend the maturity date to June 25, 2018. The Credit Facility was also amended to reduce the interest rate payable on advances under the Credit Facility to a rate equal to Wells Fargo’s daily three-month LIBOR rate plus 2.00%, calculated on an actual/360 basis and payable monthly in arrears. In addition, the Credit Facility was amended further to include the addition of an EBITDA covenant, whereby the Borrowers must maintain a specified minimum monthly EBITDA through December 2017 if the cash position for the Borrowers’ demand deposit account maintained at Wells Fargo falls below $3.00 million or the Borrowers draw upon the Credit Facility.
The Credit Facility includes a $5,000,000$5.00 million sublimit for advances that are supported by a 90% guaranty provided by the U.S. Export-Import Bank. Advances under the Credit Facility are limited to a borrowing base, which is computed by applying specified advance rates to the value of the Borrowers’ eligible accounts and inventory, less reserves. Advances against inventory are further subject to an initial $3,000,000$3.00 million maximum. We must maintain a minimum of $1,000,000$1.00 million in excess availability at all times. There are no other financial covenants.
Each advance accrues interest at a rate equal to either (i) Wells Fargo’s 3-monththree-month LIBOR rate plus 2.50%2.00% or (ii) Wells Fargo’s Prime Rate plus 1.00%, each calculated on an actual/360 basis and payable monthly in arrears. Principal outstanding during an event of default accrues interest at a rate of 3% in excess of the above rate. Any advance may be prepaid in whole or in part at any time. In addition, the maximum line amount may be reduced by us in whole or part at any time, subject to a fee equal to 2% of any reduction in the first year after closing, 1% of any reduction in the second year after closing, and 0% thereafter. There are no mandatory prepayments or line reductions.
The Credit Facility is secured by a lien on substantially all assets of the Borrowers, each of which is jointly and severally liable for all obligations thereunder. Wells Fargo’s security interest in certain SiC materials is subordinate to Cree’s security interest in such materials pursuant to the Supply Agreement and an Intercreditor Agreement with Wells Fargo.
The Credit Facility is evidenced by a creditCredit and security agreementSecurity Agreement dated as of June 25, 2014, as amended, or the Credit Agreement, and customary ancillary documents. The Credit Agreement contains customary covenants, representations and cash dominion provisions, including a financial reporting covenant and limitations on dividends, distributions, debt, contingent obligations, liens, loans, investments, mergers, acquisitions, divestitures, subsidiaries, affiliate transactions, and changes in control.
Events of default under the Credit Facility include, without limitation, (1)(i) any impairment of the Export-Import Bank guaranty, unless the guaranteed advances are repaid within two business days, (2)(ii) an event of default under any other indebtedness of the Borrowers in excess of $200,000, and (3)(iii) a material adverse change in the ability of the Borrowers to perform their obligations under the Credit Agreement or in the Borrowers’ assets, liabilities, businesses or prospects, or other circumstances that Wells Fargo believes may impair the prospect of repayment. If an event of default occurs, Wells Fargo is entitled to take enforcement action, including acceleration of amounts due under the Credit Agreement and foreclosure upon collateral.
The Credit Agreement contains other customary terms, including indemnity, expense reimbursement, yield protection, and confidentiality provisions. Wells Fargo is permitted to assign the Credit Facility.
As of March 31,September 30, 2017, we had not borrowed against the Credit Facility.
We believe that our existing cash and cash equivalents and other working capital, together with future cash expected to be provided by operating activities, will be sufficient to meet our working capital and capital expenditure needs over the next 12 months. Our future capital requirements and the adequacy of available funds will depend on many factors, including our rate of sales growth; the expansion of our sales and marketing activities,activities; the timing and extent of raw materials and labor purchases in connection with loose jewel production to support our moissanite jewelsjewel business and precious metals and labor purchases in connection with jewelry production to support our finished jewelry business; the timing of capital expenditures; and risk factors described in more detail in “Risk Factors” in this report and in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2016. We obtained the Credit Facility to mitigate these risks to our cash and liquidity position. Also, we may make investments in, or acquisitions of, complementary businesses, which could also require us to seek additional equity or debt financing.
| Item 3. | Quantitative and Qualitative Disclosures About Market Risk |
Not applicable.
Evaluation of Disclosure Controls and Procedures
Our management, with the participation of our Chief Executive Officer and Interim Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, or persons performing similar functions, as appropriate, to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, as ours are designed to do, and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on such evaluation, our Chief Executive Officer and Interim Chief Financial Officer concluded that, as of the end of the period covered by this Quarterly Report on Form 10-Q, our disclosure controls and procedures were effective at the reasonable assurance level.
Changes in Internal Control Over Financial Reporting
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 March 31,September 30, 2017, 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
There are no material pending legal proceedings to which we are a party or to which any of our property is subject.
We discuss in our Annual Report on Form 10-K for the year ended December 31, 2016 and our Quarterly Report on Form 10-Q for the quarter ended June 30, 2017 various risks that may materially affect our business. There have been no material changes to such risks.risks, except as set forth below.
Our failure to maintain compliance with Nasdaq’s continued listing requirements could result in the delisting of our common stock. Our common stock is currently listed on the Nasdaq Capital Market. On May 4, 2017, we received a notification letter from Nasdaq’s Listing Qualifications Department indicating that we were not in compliance with Nasdaq Listing Rule 5450(a)(1), because the minimum bid price of our common stock closed below $1.00 per share for 30 consecutive business days on the Nasdaq Global Select Market, and that we had 180 calendar days, or until October 31, 2017, to regain compliance with the minimum $1.00 bid price per share requirement. We received notice transferring our listing to the Nasdaq Capital Market from the Nasdaq Global Select Market, effective November 3, 2017, which resulted in an additional 180-day period within which to regain compliance with the $1.00 minimum bid price requirement.
While we intend to engage in efforts to regain compliance, and thus maintain our listing, including by carrying out a reverse stock split, if necessary, there can be no assurance that we will be able to regain compliance during the applicable time periods set forth above. If we fail to continue to meet all applicable listing requirements in the future and Nasdaq determines to delist our common stock, the delisting could substantially decrease trading in our common stock and adversely affect the market liquidity of our common stock; adversely affect our ability to obtain financing on acceptable terms, if at all; and may result in the potential loss of confidence by investors, suppliers, customers, and employees and fewer business development opportunities. Additionally, the market price of our common stock may decline further and shareholders may lose some or all of their investment.
Negative or inaccurate information on social media could adversely affect our brand and reputation. We are actively using various forms of digital and social media outreach to accomplish greater awareness of our brand and the value proposition we offer. These social media platforms and other forms of Internet-based communications allow access not only by us, but by any individual, to a broad audience of consumers and other interested persons. Consumers value readily available information concerning goods that they have or plan to purchase, however, they may act on such information without further investigation or authentication. Many social media platforms immediately publish the content of their participants’ posts, often without filters or checks on accuracy of the content posted. While we actively monitor social media sites, we may be unable to quickly and effectively respond to or correct inaccurate and/or unfavorable information posted on social media platforms. Any such information may harm our reputation or brand, which could in turn materially and adversely affect our business, results of operations, and financial condition.
We are subject to certain risks due to our international distribution channels and vendors. We currently have approximately 20 international distributors for moissanite jewels and finished jewelry covering portions of Western Europe, Australia, India, China and other Southeast Asian countries, and the Middle East. In addition, we use certain companies based outside the U.S. to facet our moissanite jewels and to manufacture finished jewelry. Due to our reliance on development of foreign markets and use of foreign vendors, we are subject to the risks of conducting business outside of the U.S. These risks include the following:
| · | the adverse effects on U.S.-based companies operating in foreign markets that might result from war; terrorism; changes in diplomatic, trade, or business relationships; or other political, social, religious, or economic instability; |
| · | the continuing adverse economic effects of any global financial crisis; |
| · | unexpected changes in, or impositions of, legislative or regulatory requirements; |
| · | delays resulting from difficulty in obtaining export licenses; |
| · | tariffs and other trade barriers and restrictions; |
| · | the burdens of complying with a variety of foreign laws and other factors beyond our control; |
| · | the potential difficulty of enforcing agreements with foreign customers and suppliers; and |
| · | the complications related to collecting receivables through a foreign country’s legal system. |
Additionally, while all of our foreign transactions are denominated in U.S. dollars, foreign currency fluctuations could impact demand for our products or the ability of our foreign suppliers to continue to perform. Further, some of our foreign distributors operate relatively small businesses and may not have the financial stability to assure their continuing presence in their markets. There can be no assurance that the foregoing factors will not adversely affect our operations in the future or require us to modify our anticipated business practices.
The following exhibits are being filed herewith and are numbered in accordance with Item 601 of Regulation S-K:
Exhibit No. | | Description |
10.1 | |
Charles & Colvard, Ltd. 2017 Senior Management Equity Incentive | Board Compensation Program, effective JanuaryOctober 1, 2017 (incorporated herein by reference to Exhibit 10.1 to our Current Report on Form 8-K, as filed with the SEC on February 24, 2017) |
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10.2 | | Separation of Employment Agreement, dated March 9, 2017, between Charles & Colvard, Ltd. and Steve Larkin |
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| | Certification by Chief Executive Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |
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| | Certification by Chief Financial Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |
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| | Certification by Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
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| | Certification by Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
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| 101 | | The following materials from Charles & Colvard, Ltd.’s Quarterly Report on Form 10-Q for the quarter ended March 31,September 30, 2017 formatted in XBRL (eXtensible Business Reporting Language) and furnished electronically herewith: (i) Condensed Consolidated Balance Sheets; (ii) Condensed Consolidated Statements of Operations; (iii) Condensed Consolidated Statements of Cash Flows; and (iv) Notes to Condensed Consolidated Financial Statements. |
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
| | | CHARLES & COLVARD, LTD. |
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| | By: | /s/ Suzanne Miglucci |
May 4,November 2, 2017 | | Suzanne Miglucci |
| | | President and Chief Executive Officer |
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| | By: | /s/ Clint J. Pete |
May 4,November 2, 2017 | | Clint J. Pete |
| | | Interim Chief Financial Officer |
| | | (Principal Financial Officer and Chief Accounting Officer) |