Charles & Colvard Ltd (CTHR) 2006 Q2 法說會逐字稿

Good afternoon ladies and gentlemen. Thank you for standing by. Welcome to today's Charles & Colvard second quarter 2006 earnings conference call. Today's call is being recorded. At this time, all participants are in a listen-only mode. Following the presentation, we will conduct a question-and-answer session. Instructions will be provided at that time for you to queue up for questions. I would like to remind everyone that this conference is being recorded, and would now like to turn the call over to Bill Zima of Integrated Corporate Relations. Please go ahead.

Good afternoon everyone. Thank you for participating in the Charles & Colvard second quarter 2006 conference call. Joining us from management are Bob Thomas, President Chief Executive Officer, Jim Braun, Chief Financial Officer, and Dennis Reeve, Executive Vice President and Chief Marketing Officer.

Before we begin, I would like to remind everyone that except for the historical information presented, the matters disclosed in this conference call include forward-looking statements. These statements represent the Company's current judgment on the future and are subject to risk factors and uncertainties that could cause actual results to differ materially. To the extent that there are any statements that could be construed as forward-looking, they should be considered in the context of all of our previous releases and federal filings. I would now like to turn the call over to Bob Thomas.

Thank you Bill and good afternoon everyone. Thank you for joining us today. I would like to start with the operational highlights for the quarter and then address the opportunities we see in our business going forward.

Second quarter sales decreased 9% to 8.5 million from 9.3 million in the prior year. The revenue shortfall when compared to the same period in '05 was primarily due to a difficult comparison because of large orders placed by K&G Creations and was required for the rollout or the sell-in of fine moissanite jewelry to Finlay Enterprises in both the first and second quarters of 2005. A small percentage, approximately 5% of the K&G shortfall can also be attributed to the loss of revenue from the Shop at Home television network, which discontinued operations during the most recent quarter.

Gross profit margins increased 970 basis points to 75% compared to 65.3% in the prior year period. This increase in gross margin resulted in a 48% increase in net income to $1.1 million, or $0.06 per diluted share compared to $740,000 or $0.04 per diluted share in the year ago period. We have now recorded 22 consecutive quarters of profitability.

While revenue was down in the second quarter, we believe that we're building strong momentum for renewed growth. Excluding our order volume from K&G for the second quarter, it is important for you to know that revenues from all other direct customers increased by 25% during the quarter. As we continue our efforts to build awareness and demand for the moissanite jewel, both domestically and abroad, we believe that we will regain sales momentum and renewed growth in coming periods.

In the first half of fiscal 2006, we added the moissanite category to approximately 265 new customer doors that, once fully distributed, represent approximately 580 new moissanite locations. This does not include the doors added by Finlay that replaced previously demoted doors due to the Federated-May merger.

Looking at our domestic versus international sales results, U.S. domestic sales in the second quarter decreased 15% to $7.2 million which was attributable to the decreased sales to K&G. International sales for the second quarter increased 59% to $1.3 million, and we saw strong results from all key geographic regions led by the successful launch of new business in Canada.

Total shipments of 51,100 carats for the current period were 5% less than the 53,900 carats shipped in the same period of 2005. Total shipments of carats in the U.S. decreased 12% while international shipments of carats increased 64%. Overall, the average selling price per carat for the second quarter was 3% below the second quarter of 2005.

This decrease was due to a product mix in which a greater percentage of smaller size jewels were sold. Larger stones have a higher selling price per carat than smaller stones. We're confident that we have the right mix in the right price points of both large and small jewels that will thereby allow us to maintain gross margin levels of between 65 and 75% during any given quarter.

As we look to the third quarter, we see some excellent opportunities to broaden our customer base through various distribution channels. K&G reports they expect to introduce an incase selection of moissanite jewelry at additional Finlay counters in conjunction with the introduction of the exclusive collection of moissanite jewelry inspired by Sarah Ferguson, the Duchess of York, and produced by K&G. We believe that we are positioned for a strong Christmas holiday season with K&G and Finlay as the Sarah Ferguson range is more fully distributed and marketed.

We also expect an initial shipment of moissanite jewelry into approximately 170 doors at a major national retail chain which has over 700 total retail locations. This rollout of an additional range of fine moissanite jewelry will be supplied by a relatively new direct customer of Charles & Colvard, Samuel Aaron International, and represents a significant opportunity to broaden awareness for our jewel while also providing the additional benefit of expanding the number of direct Charles & Colvard customers with important jewelry manufacturing experience and capacity.

K&G reports they will be testing moissanite jewelry at 22 jewelry counter locations of a major national chain, a different national chain that has over 800 locations, and that AAFES, the Army and Air Force Exchange System, a K&G customer, has decided to offer moissanite jewelry at each of its level 1, 2, and 3 locations worldwide. This will bring the total AAFES locations selling fine moissanite jewelry to approximately 120, up from the current distribution at approximately 60 locations.

Our efforts at Ellisburg continue to be successful as we now enjoy incase distribution at approximately 235 [Ellisburg diamond] locations. Our test distribution at Peoples Jewellers, a Zales Corporation division, also continues to perform at or above expectations. And we hope that we will gain incase distribution at this important retailer during the second half of this year.

While we have been successful in building new distribution channels, we have not neglected the retailers who have ongoing incase moissanite programs. One of the examples of our success with those retailers is that JC Penney is now working to broaden the range of moissanite jewelry available at their fine jewelry counters.

We continue to believe we have tremendous opportunity to raise awareness of and enhance our market opportunity for moissanite jewelry. We're working diligently with new and existing customers to grow our business. We will continue to strive to broaden our distribution in the U.S. and abroad through traditional retail channels as well as other channels such as home, television shopping, and Internet retail.

Another example of our growing distribution is that during the first week of July, we successfully debuted fine moissanite jewelry on HSN, the Home Shopping Network. HSN is one of the two largest television markers in the world. We look forward to expanding our relationship with this powerful media outlet and believe home television sales channels like HSN provide us with a fantastic forum to increase our brand awareness while adding incremental revenue.

As we evaluate our marketing efforts for the remainder of '06, we continue to work ambitiously to increase the consumer awareness of our brand. You'll notice our sales and marketing expense for the third quarter was approximately 42% -- excuse me, for the second quarter, was approximately 42% of revenue, and approximately 37% year-to-date. While that is outside our targeted range for this expense category, it gives you some idea of our optimism and our enthusiasm for the development of our business. We're firm believers that money spent on increased consumer awareness will lead to increased sales for our jewel.

We're working aggressively to enhance our market position so that the moissanite category, moissanite created by Charles & Colvard, will become a recognized and respected category in the $135 billion annual global jewelry business. We believe the potential of moissanite is just beginning to be recognized, and that our unique position and the high-value content of our moissanite jewel will enable us to grow our business and to drive significant value to our shareholders in the months and the years ahead.

Jim Braun will now describe the financial results in more detail.

Thanks Bob. As Bob mentioned, sales for the second quarter 2006 were $8.5 million or 9% lower than the $9.3 million achieved during the second quarter of 2005. Gross margin as a percentage of sales for the second quarter was 75%, an increase of 9.7 percentage points when compared to the same quarter in 2005. This increase was primarily caused by lower production costs, offset by a slight decrease in the average selling price per carat.

Operating expenses in the second quarter decreased 2.6% to $4.7 million compared to the prior year period. Marketing and sales expense decreased 6.3% or $240,000, primarily due to a $567,000 decrease in stock option compensation expense on options issued to consultants, offset by a $337,000 increase in advertising expense.

General and administrative expenses increased $202,000 primarily due to an increase in compensation expense. As a percentage of sales, operating expenses for the quarter were 55%, an increase of 3 percentage points when compared to the same quarter last year.

Net income increased 48% to $1.1 million or $0.06 per diluted share, compared to net income of $740,000 or $0.04 per share for the second quarter of 2005. For the six months ended June 30, 2006, sales decreased 19% to $16.5 million on shipments of 98,200 carats compared to sales of $20.5 million on shipments of 118,500 carats in the prior year period.

Net income for the first half of 2006 decreased 4.8% to $2.6 million or $0.14 per diluted share, compared to $2.75 million or $0.15 per diluted share in the prior period. At the end of our second quarter, our cash position decreased to $15.6 million from $20.9 million at March 31st, 2006.

This $5.3 million decrease was primarily due to the $2.9 million used to buy 280,000 shares of company stock, $2.6 million increase in inventory, and $1.5 million cash dividend paid on June 15th, 2006. These were offset by the $1.9 million of pre-tax income generated during the quarter.

Inventory increased from $26.6 million at March 31st, 2006 to $29.2 million at June 30th, 2006, primarily due to the level of raw material purchases. Based on the level of demand we're seeing for the back half of fiscal 2006, we're comfortable with our inventory levels at the end of the second quarter.

On April 18, 2006, the Board of Directors declared a $0.08 per share cash dividends that was distributed on June 15 to shareholders of record on May 31st. Share and per share data for all periods presented reflect the effects of the 5% stock dividend distributed on July 15, 2005 and the one share for four shares owned stock split effected in the form of a 25% stock dividend distributed on January 30th, 2006.

Finally, as you may recall in March 2006, the Board authorized a repurchase program for up to 1 million shares of the Company stock. This program expires in March 2007. During the three months ended June 30th, 2006, 280,000 shares were repurchased under the program at an average price of $10.19 per share.

We thank everybody for listening in, and thank you for your support. We're now going to open up the call for questions.

(OPERATOR INSTRUCTIONS). Eric Wold, Merriman Curhan Ford.

Can you give a little more color -- when you talk about the 25% increase in sales coming from the non-Finlay customers, do you have any indication of what level that was sell in versus sellthrough?

Much more minimal sell in at -- during the quarter. The only significant sell in would have been at Helzberg and a relatively small number there. The bulk of the increase can be attributed to -- or a lot of increase can be attributed to the activities in Canada and to the same-store sales being up at existing customers.

I know this is a question that -- struggles every quarter on this. Is there any way to give some -- without compromising some of the major customers, any kind of general level of same-store sales across the base or kind of maybe -- even a broad range?

Well, the numbers that we have reflect a percentage that's not unlike that 25%; in some cases a little higher, so everyone that is supplying us numbers is very pleased with the sales activity at their counters.

Okay, and then when you talk about the two new customers in the quarter, the 700 unit locations and the 900 unit locations that you're launching into in Q3, have they indicated that this is any kind of short term test that you could see full rollouts by year-end?

It would be difficult to do full rollouts in both by year end, just based on the amount of trainings required at the retail level. But we would expect to see some increased activity, as I mentioned, from Finlay. Those people have had the benefit of trunk show trading all along and as we add doors there, that could happen. And we do expect it to -- that those numbers will go up from the 170 and the 22, but I don't expect we'll be in all 1500 of those doors by year-end. And it's important for you to know that no revenue has been recognized for either of those accounts at June 30th.

But there will be in Q3?

That's correct.

Okay, and then last on inventory, I know your comfortable with the inventory levels where they are. Can you give indication based on either what you know what you think that -- you expect inventory to be higher or lower at year-end than it was (multiple speakers)

Our current projections call for it to be flat at year-end from where it is today. That is subject to $1 million on either side, Eric, but based on what we believe is going to happen today, we should go out of the year approximately the same way we [went] out of June. The [whip] maybe a little smaller as a total -- a percentage of the total. The whip is really what's increased most dramatically, not the finished goods during the quarter.

Perfect. Thanks guys.

Chris Terry, First Dallas Securities.

Bob, can you maybe elaborate a little more here on these new rollouts? And do you expect to see any type of similar fill-in numbers as what took place last year with JC Penney and Finlay?

Well, we do think that there will be in the 170 door, approximate 170 door rollout, there will be a significant sell in, and we will try to identify that for you once we have that number during the next call so that people can start to track that a little easier. But as of today, we have an indication, but we don't know what that hard number is. But it will be a significant number.

We have not received that order yet.

That's correct.

That kind of leads into, do you guys think you would maybe reinstate doing some type of guidance either mid-quarter update or some type of direction out there?

We would like to get through the back half of this year, quite frankly. There is so much going on. There are so many opportunities and activity that it's very hard for us to predict the timing and also the volume of what each one of those opportunities may end up representing. So us initiating a call to guess is counterproductive, and we would like to get through this period and just report the facts as we know them, and try not to stumble through misplaced efforts to give you a little more guidance.

So I would not expect that we would initiate any other calls, at least for the back half of this year. And we'll look at it once we get the distribution stabilized at a little higher level and we have a little better visibility to what that means.

Can you talk a little bit about what you see going into the back half of the year for your sales and marketing? There was a little uptick there.

Yes, well, as I said, it fell outside of our target spend rate. When that happens, I've said before on these calls that you can safely assume that we missed the revenue number that we were shooting for. But we do expect to expand our sales, advertising and promotion budget in the second half as compared to the second half of '05. We fully expect that is going to increase awareness and also build sales revenue.

And those monies are basically spent in three major ways. One is the fashion books -- the major fashion books. The second way is both national and local newspaper advertising as well as direct-mail efforts, and we would expect that we will be spending slightly more or maybe even significantly more in the second half of '06 versus '05. So that, again, would lead you believe if we're targeting a 35% number for that category, we would expect some growth.

Okay, so you still are maintaining that mid 30% level?

That's our target. It has been, and we think that's appropriate. The gross margin improvement allows us some flexibility there and we're cognizant of that. We knew it was coming, and we used it wisely, so we're not -- we don't feel bad about any monies we've spent in that area, and we're highly confident that the monies we will be spending will generate the desired results.

And if you look at the back half last year, I think it was a combined 40% of sales. And then this year if you were to maintain the mid 30% as a percentage of sales for the year, it would seem that the back half of this year would need to be --

I would look at the back half independent of where we are today and rely on the fact that we will be spending more hard dollars in the back half of '06 than we spent in the back half of '05.

Okay got you. Don't take me wrong there -- I'm encouraged with the optimism.

No, I understand. That's right. It's not a problem. It's just that I'm not going to use the money that has already been spent to average down on the back half. That's not -- I'm not going to shoot for a target 35 year-to-date. We're happy with what's been spent. Our target rate remains 35% for the back half, but if it comes in at 38 or 40%, so be it. We're confident that the monies we spend will generate increased revenue, perhaps not coinciding with those expenses, but in future periods.

Got you. And a couple more here, quick ones, so -- gross margin, 75% -- that was of the high-end of the range given last quarter. Where do you expect that to go from here? And maybe could you talk a little bit about average wholesale prices and what you're seeing in prices at retail and kind of the dynamics there all going into the margin?

Yes, the price of retail has been fairly stable with a slight bias upward based on two things -- number one, the price of gold, and number two, the moderate price increase that we put in place in May. So the retail prices have gone up slightly. We do not see any major discounting by any of our important customers. We have programs in place to protect against that.

But with that said, as you go into a new distribution scenario, typically the basics -- the stud earrings, three stone rings, solitaires -- make up the bulk of that range of jewelry, that assortment. As the retailer matures and adds fashion jewelry, or fashion accessory type jewelry, then you see a spread to smaller jewels, smaller stones, in multiple stone sets. And that's when our average sales price goes down slightly is when a higher percentage of our orders are made up of stones less than a half-carat in size.

So that average selling price will fluctuate. I think in the third quarter last year, actually we had a little uptick in average selling price over the second quarter as retailers and manufacturers built larger jewels ready for the fourth quarter selling season. So we don't -- we're not predicting that again, but it would not surprise us if that did not happen or did happen in the third quarter again.

So we think that we're going to be above 160 to 170, 173 maybe, in average selling price going forward. That's sort of where we think that range is. Just to answer your question the gross margin, we think 75% is at the high-end of the range that we disclosed, and we're comfortable saying that 75% should be the upper end of the range that you should consider in the near future.

And then door additions for the quarter? I missed that number.

For the first half, I believe we called it 230 -- 265. Those represent an opportunity of over 580 doors should the retailers involved in those 265 give us a full rollout to all locations they control. That number does not include the AP's numbers. It does not include the two large opportunities that we described. It does not include the Peoples division of Zales Corp. in Canada. So the total number possible for the year is still a much larger number.

Thanks Bob. I appreciate it.

[Raj Sistri], Thomas Weisel.

On the 170 additions [and stores since you have] how much portion of that will actually come to the present quarter -- I mean the September quarter? And will it span over the December and the March quarter? Can you [give us something clearer] on that?

The 170 should come in the current quarter. The sell in, the rollouts to those 170 doors, that revenue should be and will be reported in the current quarter if everything goes according to plan. And we'll try to identify that number for you at the third quarter conference call, so it will be very visible as we go through future periods and you build your models.

The -- we would expect obviously to have some sales from those -- from that initial holdout and replenishment orders possibly -- not possibly, most probably those replenishment orders for that particular account and those particular stores will probably not be visible until the fourth quarter. But because we don't expect this rollout is going to happen early in this quarter, it's going to happen towards the end of the quarter. So all our revenue will be here in the third quarter.

Also in terms of your opportunity for the 700 stores, do you think that you'd be able to [tap] additional number of stores like going forward in the December or -- you know?

In the December quarter, as I said earlier, it would be very difficult execute that in the December quarter just because the amount of training of staff that has to go on at retail and other constraints. Capital constraints on the part of manufacturers would just be one of the things we would have to consider. But it is possible that we would add additional doors out of that 700 in the fourth quarter, but it's not likely we would reach the full rollout.

Okay. Thanks for that. In terms of -- so is this all going to K&G or is it some of your other manufacturers as well?

Sorry, would you repeat that?

Yes, this is 170 doors -- is it going through your K&G Creations manufacturer or is it through some other manufacturer?

This is -- Samuel Aaron International is the Company that had been -- Dennis, how long have they been around, 80 years?

1935 on the letterhead.

1935 -- a very well-established Company located in New York that will be the supplier to this particular account. I think it's important for everyone to understand that domestic manufacturers typically will source a lot of that manufacturing offshore at this point, so even though it's a domestic supplier to Kohl's, the jewelry may in fact be assembled and made offshore at some location.

Okay, so I just want a bit on the K&G. Do you think the K&G will return to normal level in the next two quarters or will take some time?

We're very optimistic that the Finlay initiative with Sarah Ferguson will be positive. But we don't have a lot of visibility to the number of doors that Finlay will be adding today. We have asked that question and have been told that that is a work in progress and they will be giving us those numbers over the next few weeks.

But we are optimistic about K&G's ability to rebound once this inventory situation that they've experienced is resolved completely, and we think it's very close to being resolved. We do expect that they will rebound and return to more normal ordering and patterns.

Yes, also, I just want to get the sense of do you think it's possible to return to normal seasonality which you had in your business in the rest of 2006, and you know in the first quarter 2007?

We think that the seasonality of the business is more at retail, not so much at the manufacturing or at our level. We would expect to see some -- as retailers have gained confidence in the category, and we saw this for the first time last year in -- very clearly, that we see that the fourth quarter retail sales being ordered and built here in the third quarter. The first quarter, the Valentine's Day sales if you will, that inventory typically is built in the fourth quarter.

So we think that although we do track retailers to some degree, we think we're starting to evolve to be a quarter ahead of the retailer insofar as the demand for the moissanite jewel versus the demand at the counter.

[Peter Reiss], [Paulson Investments].

Just a couple quick questions. Is the reason for your -- one of the reasons for your gross margins, is that because your yields from Cree are better?

Jim, why don't you --?

Yes, the production period that we relieved in this quarter is the beginning of '05, and really since of the middle of '04, we have been seeing higher yields. And now that we're working through those, we work through the '04 production and now we are into '05, we have seen a pretty consistent yield of the material we've gotten from Cree last year and into this year. So although there is a slight variation from quarter to quarter, we're dependent on what types of jewels we're making that month, we've been pretty consistent.

If we sold the whole inventory today as of -- on the average selling price we had this quarter, we would have 75% margins. So this quarter, this past quarter has hit our average, and so we feel we're pretty consistent within relatively small bands of what is produced. I want everybody to be cautious though. If the mix changes that could change, not from what cost side is, but more from what the average selling -- what happens to the average selling price.

Good.

But the broader question is Cree continues to perform very well.

Right.

Okay. Also, Bob, you said that Shop at NBC has stopped --

No, Shop at Home has discontinued operations.

Shop at Home, I'm sorry.

Yes, Shop at Home in Nashville, were owned by --

Scripps.

Scripps bought them several years ago, thought they could turnaround, were not able to do that, and have ceased operations I believe as of June 22nd. And -- but handled the inventory in an appropriate manner we think, and have indicated to K&G that they will be selling their balances in an appropriate way.

Now, Home Shopping Network -- do you see this being a bigger customer than say Shop NBC?

Well it's a much bigger marketplace. They reach approximately 90 million homes where Shop NBC and the lately lamented Shop at Home reach approximately 45 to 50 million homes each, so it's a much broader reach with an average penetration that is also much greater. In other words, sales per household. So we are very optimistic about our association there.

As I said in the comments, we've had a successful launch. It's a very professional organization that has a very carefully planned schedule and we would expect to see more moissanite shows, but not an abundance of moissanite shows over the second half.

I see. Well, longer-term, do you see this as a major customer of yours -- maybe (inaudible) to the others?

Well, it's a fabulous opportunity because we get to build awareness -- 90 million households, many of which have never heard of moissanite, and we get to do it at the same time that we're building incremental revenue. So it's a wonderful opportunity.

It's very difficult for us to predict what the revenue stream will look like from that particular customer, but as many of you might know we have a long relationship, at this point over two years building with HSN. We were on their smaller network, America's Store, and we have been on their Internet-based platform for about 18 months now, so it's -- we do have a relationship that is built based on the success of those earlier platforms. The first live show at HSN, the first three hours we did there were successful, and we are optimistic -- jointly optimistic with the people at HSN that we have an opportunity.

But I will also tell you that Shop NBC continues to be successful with moissanite and we are very pleased that association. Even though they reach a smaller audience, they have been very successful with our category and we certainly don't want to minimize that importance and their efforts with our category.

They were the first, as many of you might remember, to offer the category. And that was a launchpad for us, if you will, that helped us break down some of the barriers to gain distribution in some of the bricks and mortars. So Shop NBC remains a very positive influence and somebody we think quite a bit of.

Okay, and as the Fergie rollout, when might the public began to see this? Do have any comment?

Well, it will be late in this quarter or early in the fourth quarter before you see a lot of PR on that at the public level. I will tell you that the Duchess has been working behind the scenes on behalf of K&G and the moissanite category in New York in other places over the last several months, and as late as two weeks ago Friday, 15 days ago now, 16 days ago, and doing some of the preliminary PR work that's necessary to launch, so we are optimistic about that.

It's hard for us to know exactly what that's going to mean, but we're very optimistic and positive about that opportunity.

All right, and my last question is it's nice to see some traction in your foreign operations. I know you spent some time on that. I believe at one time in your corporate history, foreign sales were greater than your domestic sales.

Early on, that's correct.

Do you see the foreign sales now beginning to become a major factor in your total sales?

Dennis, would you like to address that?

Hi, Peter. We would hope to see the continued expansion. It's -- the biggest challenge that we have globally is really awareness. So it's a market by market build. And as we start to get traction, using your language, in a specific market, we can start to ramp the revenues. And that's what's happening in Canada and thankfully in some other markets such as Indonesia and in the UK. And yes, I think we could characterize it as good step off points in some of those markets. The challenge is to build more of those markets globally and as quickly as we can.

Very good. Are you getting any sales out of China at this point?

Yes. Yes.

Okay. I will leave the questions to others.

Bill Armstrong, C.L. King & Associates.

A couple of questions. Earlier you mentioned that the sales and marketing kind of 42% was outside your range due to missing your sales plan. Where were the weaknesses in your sales plan?

Well basically the K&G shortfall was unanticipated. That's the big number. That is the big number. We -- when we put our sales plan together, we had no visibility to the Federated-May merger and the loss of business that Finlay would experience, and the disruption both the breadth and the depth of that disruption would trickle down to us.

It wasn't because of the comparison with the Finlay rollout last year because you knew about that. It was because of the impact of those stores Finlay is losing?

Right. They lost 25% of their locations. And that caused them to take a -- not to go into a shell necessarily, but almost to go into a shell to try to reconfigure not only their moissanite inventory but all of their inventory, and reshuffle their assets to the point where they could retrench ranch and start to rebuild their business.

And we think they've taken the appropriate steps. We just didn't have any visibility to that. When we built our sales plan, we anticipated a growth. I think when the sales plan was established, we were in approximately 235 to 240 Finlay locations. And based on the success we were having at those locations, we quite honestly anticipated additional stores at that point in time.

But the effect of what has happened has been to slowdown -- not just slowdown, but to stop and put in reverse any activity we would see -- any positive activity we would see there, and I'm not being critical. It just -- it happened and we're big boys, we will make the adjustments and get through it just like K&G Creations and just like the good people at Finlay.

So we'll get through this. It has been more disruptive than we anticipated. As again, the breadth and the depth of it, we just -- not fully understood even as late as a quarter ago.

We decided not to pull -- the main increase in the marketing side was fashion book advertising in May into six books. And we want to build awareness and so we continued with that program, which made sales and marketing expense a higher percentage than what we thought.

Got it. Did you -- or did Finley sell moissanite in any of its Belk store departments?

Yes. I'll address that. The Belk acquisition of [Masuro] which was a much, much smaller version of Finlay -- in other words, they were operating lease department -- they were leasing jewelry counters from host department stores. Masuro has been a customer of [Reeves Park], one of our direct customers for moissanite jewelry, for about 18 months now and have had great success in the counters that they operate at the moissanite category.

So the 60 doors or 40 doors that Finlay is losing at Belk will be taken over by the management team from Masuro, and we have reason to believe that we will be gaining distribution as a result of that Belk acquisition of the Masuro management team. And we'll speak more about that as we have hard numbers and as that rollout commences, but that is another account where we have good reason for great optimism.

That's helpful. And the Sarah Ferguson rollout, I don't -- I guess I don't quite understand it. Is that exclusive to Finlay?

That's correct.

Is that just an initial exclusive period?

Well, as I said before, the Sarah Ferguson initiative is a K&G initiative. And they control -- it's their dollars involved, not ours at this point. And they have made the decision, K&G made the decision early on to make the Sarah Ferguson line exclusive arrangement with the Finlay Group. And the -- all those activities are less than transparent to Charles & Colvard because it is a K&G initiative.

And we want to support it. We want to help it, but at this point we can only share of the knowledge we have and I think we've done that almost fully. I don't know if there's anything I know about that operation or that initiative that we haven't talked about.

Okay. I was wondering how they would market that to consumers since Finlay is not a name that is known by consumers. They operate in departments in Macy's and what not.

It is a challenge for them. They recognize that. We do as well. But again, we're not privy to those exact plans at this point.

Thank you.

[Burke Pekay], [Patera Capital Management].

This is (indiscernible) from Patera. Couple of quick questions. I don't want to beat a dead horse, but this marketing and sales, can you give us a sense as to what's the lead-time for planning on your spending and -- go ahead.

We have to significant sciences spending. First, we have our institutional type -- the fashion book advertising, and the lead-time on that is a little bit longer because we have to do the appropriate insertion timelines to make sure that we hit the title's requirements. So we're usually working at the soonest 120 days, maybe a little bit longer out with those folks to really coordinate a plan and to implement it, and to commit resources.

The second major support element is direct retailer support, direct advertising support through our regional partners. And that is really on a retailer by retailer basis. Some of the lead-times with respect to those can be as quick as 60 days, but the timelines on those can once again reach into the 90, 120, 180 day cycle depending on how big the retailer is and how complicated the retailer support elements can be.

We approved this week a major expenditure for one of the larger retailers for the entire second half as an example. So that is a 150 day minimum lead-time there. So some of those larger dollar commitments are made well in advance of the recognition of revenue.

Sure. And if you look at last year as a percentage of sales, the third quarter marketing and sales pending was substantially lower than the fourth quarter. And you guys talked about a 35% average for the second half. Is it fair to assume the third quarter numbers are going to be again much lower as a percentage of total sales?

The retailer support that Dennis to speaking to, primarily newspaper and direct-mail, typically those expenses are heaviest in the fourth quarter. And the fashion book advertising, the schedule we have in place will also be heavier in the fourth quarter. So from a percentage of sales I will not speak to that, but the hard dollars will be much higher in the fourth than they are in the third.

And you also mentioned the change in terms of you're seeing the impact of the retail fourth quarter sales in your shipments more in the third quarter. So based on that comment, is it fair to think your revenues in the third quarter and the fourth quarter should be somewhat similar or would you still expect more revenues in the fourth quarter?

It would depend on the planned rollouts to some degree. Let me put a hypothetical for you to illustrate that. The 170 doors we talked about earlier today, we know that sell in was going to happen in the third quarter of this year. If that retailer decided they wanted to roll into the other 530 doors in the first quarter, then the sell in for that may occur in the fourth quarter.

So again, so hard for us to predict the timing, and also the magnitude of what some of these opportunities mean, that to give you guidance is -- that we don't fully haven't handle on is unfair. And it's unfair to the Company. It's unfair to you, and so we just refrain from doing it.

Sure I appreciate that. And in terms of -- so that 170 rollout is a full-blown rollout. And I apologize if you already made some comments on this, so it's -- so we're assuming that it's a full-blown rollout. And that most likely, whether it's the first quarter or the second quarter of next year or later, this retailer will most likely roll it out to all its stores?

Let me back up there. The 170 is an incase asset program as opposed to a trunk show test program, as opposed to a memo program. It's an asset incase program with a full assortment in the cases. So that makes it a little bit different than some of the other opportunities that we have built over time.

We would -- we still characterize it as a test. We've no assurance it will go beyond that stage. We will work diligently to make sure that we do gain additional distribution and build sales, but we should be careful to continue to characterize it as a test of this point. Dennis, do you disagree with that?

I agree with that.

So you have not done any other tests with this company before? This is your first?

That's correct.

And I don't -- have you talked about your average selling price in the second quarter? Can you repeat that if you have?

Well, we said that the mix of smaller stones was a higher percentage of the total and it brought down the average selling price about 3%. I would -- there's -- probably going to give you more information than you need or want, but when we made our price adjustments and price [slighted] -- price increase at the beginning of May, the -- some of the more -- some of the larger percentage increases were on some of the smaller stones.

So in advance of that, we had many of our customers buy heavy inventory of the smaller stones in that earlier part of quarter, building inventory at what would be lower than replacement cost. So we're not sure exactly how that's going to play out going forward, what type of comparisons. We would -- just intuitively I would think our average selling price probably will bounce back up $1 or $2 in the third quarter.

And also, the average selling price in the second quarter was similar to the first quarter. So this is really -- compared to the second quarter of '05 it's down, but compared to the first quarter of '06, it's exactly the same.

I see. And can you remind me what it was in terms of dollars?

66 I believe.

That's correct.

Okay. And even with that, you had a nice margin improvement, so that's good. And finally, JC Penney said their overall jewelry business is very strong, doing double-digit increases. And I guess they've been pleased with your performance. Can you give us any feel as to how that relationship is going?

It's going very, very well as I said in my comments. We've been told they're going to expand the assortment and I would think that the moissanite category has contributed to that increase in total revenue of the jewelry division of JC Penney. I think it's very fair to characterize that relationship as very good and everyone is very pleased with the performance in the category.

That sounds good. Thank you very much.

Brian Murphy, Merriman Curhan Ford.

One quick question on product supply. Just a quick update if you have it on where Intrinsic and Norstel stand and more importantly, if and when those guys start to come on-line, if there's any risk to gross margin. Obviously Cree has been doing this for quite awhile; a lot of efficiencies have sort of come to the surface. At what point in time do you start to look for that?

Well, let me give you an update. Cree has announced their intention to purchase Intrinsic. That transaction is scheduled to close later this month. It was the last public statement anybody has made on that and the net effect of that to Charles & Colvard will be nil. Intrinsic will be folded over and become a division of Cree, and we will rely on Cree for our supply and the Intrinsic arrangement will simply die.

The Norstel arrangement is certainly still alive and they are in the final stages of their construction project, their new facility scheduled to open in late August. Our purchase commitment to them is fairly minimal, but it's also based on an acceptable quality of rough material. So it would not have an impact on our gross margins because we would not buy or pay for rough material that would be a negative impact on our cost structure.

So again, we have an agreement to buy a certain volume of material, but that's based on them hitting the quality requirements that we have in the agreement.

Great. That is all I got. Thanks.

[Tom Zooliss], Paulson Investment Company.

Congrats on a nice quarter. Bob, the top 10 retailers in the United States, could you tell us how many we've now penetrated?

Dennis, you want to -- off the top of my head, Dennis, I am going to rely on Dennis for that.

It might be easier to tell you who we haven't. If you're trying to play process of illumination to figure out who the giants are -- (multiple speakers)

No, I'm really looking for the concept. Years ago when we looked at it, we were hoping to get one of the top 10 retailers and I'm wondering how many of the top 10 do we have now?

I would say it's at least five.

We have Finlay, Penney, HSN --

The Zales Corporation.

The Zales Corporation now, and Helzberg may or may not be in the top 10. Out of the top 40, I think we saw earlier this year we're in the majority of them.

Right.

Out of the top 40 as identified by the trade publication National Jeweler, I think somebody came into my office and said can you believe we're in the majority of these accounts, either in a test or a full-time basis.

So the implication of your question and the answer to your implication is we are establishing a new jewelry category. We're being successful. It has taken longer, cost more, and is sometimes more frustrating than any of us wanted it to be, but we are being successful. And it's not a straight line from where we have been to where we're going, and there are going to be these bumps in the road as we learn and execute.

But we are definitely getting the category established and making great progress up-and-down the map with retailers in this country, and we're starting to see some international benefits as well. So without getting a real -- Dennis has the number, but it would be a guess. We don't want to give you a guess. We will take the look at it, but it's -- we are being successful in what we set out to do.

It's not a straight line. I know it's frustrating when we don't have all the answers for these -- that the analysts are used to getting, but our model is slightly different and it's more difficult for us. But we are being successful and we have great optimism for the future.

The -- you specifically talked about increased distribution with Internet sales. You have been -- had a presence on Internet in the past. Are you looking at a more aggressive or more wide distribution there?

I think you'll see some more recognizable names with the moissanite category in coming periods. Not at liberty to discuss who those might be today, but I think that you will see more Internet retailers offering a category in coming periods.

I think we have a wonderful foundation, too, with whom we're dealing with, with JCPenney.com and HSN.com and ShopNBC.com and [RothSimons.com] just to name a few. Those are very notable on-line merchants and retailers and we're thrilled have them as part of our team.

Right. Bob, could you talk a little bit and address the scalability of your business? What -- if we're talking theoretically getting to $100 million in revenue, what kind of employee number count will you have to increase? What kind of capital will you have to have to do that?

Well, we have great leverage here as we discussed before. It starts to be obvious once we get the revenue really cooking. We don't have to have a lot of employees. Dennis has done a fabulous job of building the training staff using independent contractors, and using independent contractors to help man some of these trunk show events as well as the training for these retail sales associates. It's a critical part of our template.

So we don't have to add a lot of employees. And we don't have to have any new cash. Our internal models say that we can grow this business quite nicely with the resources we have, and take it to a very, very large basis without additional capital. So the leverage is here. And we just have to get the revenue base up at a faster clip, which I'm sure will not disappoint anybody listening.

Sarah Ferguson being the first celebrity with the manufacturer, are you hearing of any additional negotiations or talks? Or are you considering possibly getting a celebrity to represent Charles & Colvard directly?

Well, there's ongoing suggestions and talks about that. I would point out to you that in jewelry retailing, there are really no major celebrity endorsers who have been effective historically. And so the really, really smart retailers aren't thrilled -- are not really excited about those possibilities.

We think Sarah Ferguson, with her history and with her experience with other products, really does give K&G -- they may have picked the right one. They may have picked the best celebrity they could have possibly chosen, but we won't know that for probably a year. But some retailers just say it's just -- as to our cost structure, it's not something we are interested in, and others are willing to try it on someone else's nickel.

So it's -- it's a discussion that we have here on a frequent basis, or infrequent maybe is a better way to put it. We do talk about it from time to time but haven't been able to identify a scenario that makes sense.

Could you also give me some feedback on your presence at the Hong Kong show compared to other years? What are you seeing as far as any kind of recognition or are you getting more respect than you have in the past?

Yes, we're getting a lot more respect because they're putting up more roadblocks. So whenever we see more roadblocks, we know we're making progress. Hong Kong's March show was successful from our point of view. There is some positive development out of that. The more important Hong Kong show is in September, and we'll see what develops there, but I will say that the reason we went to Hong Kong is playing out.

A lot of this jewelry that is going to contain moissanite, that is going to hit these national retailers in the coming months and years is going to be manufactured in southern China. And the relationships we have been able to build there, the relationships that we have both with the government as well as with the industry in Hong Kong and southern China, very solid and the investments we've made there will be rewarded over time.

So it's -- it is not so much just about what we sell there, but it's about the relationships and what that means to the opportunity to be able to supply these national retailers here that is also important. So we're -- again, impatient, but we're also practical about what's possible and what's not in the short-term. So we're going to continue to be supportive of the activities there, knowing that at some point we will be rewarded.

Thanks for all your efforts. I appreciate all the effort you put in this marketing. It's working. Thanks.

Bill Armstrong, C.L. King & Associates.

I had just a quick follow-up. Earlier when you mentioned that JC Penney plans to expand its assortment, did you mean its jewelry assortment overall or its moissanite --

We don't have visibility to their plans for the whole department. But we have been led to believe that they will be in the better -- in certain markets, in certain categories of their stores, expand the assortment of moissanite jewelry. So in other words, if they have 36 items today that may go to 42 or 44. We view that as a positive.

Got it. Thanks for the clarification.

Raj Sistri, Thomas Weisel.

I just have a short follow up question. Did you say that your SG&A on a dollar basis will be higher for the rest of 2006 as compared to 2005?

Yes.

Okay. And also in terms of the leverage, do you think you will be able to gain leverage on the marketing (indiscernible) expenses (indiscernible) 2007?

In 2007, it's possible. It -- we think that $100 million revenue number is key. If we can get to -- as we build to that incrementally, we'll start to see some leverage, but the leverage really will kick in once we pass the $85, $90, $100 million revenue number, you'll really start to see that leverage be very apparent.

Until then, based on the opportunities, we're not going to throw money in the ocean, but based on the opportunities, we're going to support those opportunities appropriately. And whether that means that our percentage of revenue is 37.5%, or 35% or 34%, we're not going to be -- try to micromanage that number. That's a target. It's not written in stone.

It's a target, and we want to manage the opportunities and support the opportunities that we think have the best opportunity to rapidly build our revenue. So that is the approach we're taking. It's a little bit entrepreneurial. It's a little less managerial, but that's the way Bob Thomas is and that is the way I am doing it.

So I can't tell you exactly where it's going to come out. I will tell you that we're not going to throw money away. We are going to spend money in an appropriate way to support meaningful, important opportunities. And if that means we spend 35% of 65 or 70 million, so be it. Once we approach the much higher revenue numbers, that leverage will be much more apparent.

Okay. I really appreciate that. Also, one last question on the inventory, how much portion of the inventory in this quarter is due to anticipation of higher sales due to additional doors this year targeted?

100%. I don't mean to be flip, but we've never apologized for our inventory level. We did not anticipate it growing quite at this rate in this current quarter or for the first half. It all goes back to the issues we talked about earlier, but we think that this inventory is a great asset, and will turn in the foreseeable future.

So the buildup came as a result of the issues we talked about, but also in preparation for good news. We fully expect to have more good news in the coming quarters, and that will relate to our higher revenue numbers.

Thank you very much.

[Tony Simcus], Private investor.

Hello Bob and crew. I have been hearing all of this chatter from all of these super experts you have got calling in, and I'm just telling you one very important thing. I own the jewelry, my wife owns the jewelry. She loves it. You need the exposure and you're working a very good thing to get it. Once people see the jewelry they will buy it.

That has been our experience.

And the other thing is I like to see -- I'm very glad you guys are getting into the military [PXs]. That is a very significant thing especially over the holidays. And the other thing is your sales volume. I noticed your sales are 8 million versus --

9.3.

Yes, 9.3. And revenue is 6.1 versus 7.2. And all of those numbers are fine but a couple of things I do know. You have got to make sure that your -- the salespeople are trained, and you have got to get some of these stores -- they don't -- those overhead spotlights right above your showcase; they have got to reflect on that showcase.

Yes sir. Well thank you very much for those comments. You are actually right, we do work on a consistent basis to train the sales associates at every opportunity where we have. And we do make recommendations about the displays and the lighting, but we are not in a position to provide the capital to change those lights out, so we're going to have to rely on the retailer.

I understand that, but you guys need a pep talk and consider yourself pep talked.

Well, thank you very much. We certainly appreciate it. Operator, we are approaching the top of the hour. How many do we have in the queue?

Chris Terry, First Dallas Securities.

Out of context but they did catch my eye, you mentioned maybe the potential for 65 to 70 million in sales this year?

No, I did not say that.

That was out of context?

Yes, that was out of context. Yes that is right.

What about the JC Penney on broadening the selection, I think you mentioned 36 items today may be going to 42, 44 items. That would be about a 20% increase. Is that out of context?

Yes, what I was -- I was trying to provide some anecdotal example of what we have been told is occurring. In other words, the range is being broadened. We do not have visibility to exactly what that looks like today.

They have different classes of stores, so that broadening might only be in one or two of the classes of the stores that they have.

Exactly.

So you cannot extrapolate that over the whole 704 or so.

No, that is an anecdotal example of the progress we're making with existing accounts. So to try to quantify that and turn it into revenue model is dangerous and I would not encourage you not to do that.

Well, this is an open forum. Don't think of me different for trying.

No, no, no, I respect the attention you have paid. I think it is great. Operator, we will take one more if it is in the queue. If not we will thank everyone.

[Chris Doucette], Sterne Agee.

Just two questions for you guys. How many doors were you in at the beginning of 2006 and how many doors are you in now?

I don't know that we have -- anecdotally we said that we -- approximately 2000 doors at the beginning of the year, and we said today (multiple speakers) excluding the independents. And there we know we have sold into thousands of independent doors over the years. And we said today that we can identify 235 out of the 580 of new at the end of June.

And that excludes the Finlay mix. We lost doors and added doors. Those numbers are net and exclude the. So Dennis, anything else?

I think that from your earlier comments I think we're fairly on track to hit our entitlement goal of 1000 new doors in '06, and so add significantly with new distribution.

Okay.

And what else was the -- what's the second part of your question?

And the second question was, were there are any one time large orders shipped in Q3 and Q4 of '05 that would make for difficult comparables in Q3 and Q4 of '06?

None of us can specifically think of a sell in in the second half of last year. There was -- (multiple speakers)

A little pipe filled for Finlay.

A little pipe filled for Finlay, but not much. So yes, I think that those difficult comparisons on the sell ins are probably -- the big sell ins are behind us. The two significant ones again were the Finlay building and the JC Penney going from 460 doors to 703 or 704. So those all -- the majority of that all occurred in the first half of '05.

So with the sell in of the 170 stores you guys have that are coming up in the third quarter, that 11.3 number that you did in 2005 should be kind of an easy comparable then?

Well we won't characterize it that way today, but we will let you make your own judgment. We are very confident about our future.

All right guys, thank you very much and good luck with the quarter.

Thank you so much and thanks one and all for participating with us this afternoon. We appreciate your interest in Charles & Colvard. And as we have tried to detail with you this afternoon we have great, great optimism about our future and hopefully you will be around the share that with us. Thank you and good night.

This does conclude today's conference. You may disconnect at this time. Have a good day.