Charles & Colvard Ltd (CTHR) 2008 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Charles & Colvard Limited second-quarter 2008 earnings conference. Just as a reminder, today's call is being recorded. (OPERATOR INSTRUCTIONS).

With that, I would now like to turn the presentation over to your host for today's conference, Ms. Jean Fontana of Integrated Corporate Relations. Please go ahead, ma'am.

Thank you. Good afternoon, everyone. Thank you for participating in the Charles & Colvard second-quarter 2008 conference call. Joining us from management are Fritz Russ, acting Chairman of the Board; Dennis Reed, President and Chief Marketing Officer; Jim Braun, Chief Financial Officer, and Laura Kendall, member of the Board.

Before we begin, I would like to remind everyone that except for the historical information presented, the matters disclosed in the 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.

With that said, I would now like to turn the call over to Fritz Russ.

Thank you, Jean, and many thanks to all of you for joining us today to discuss Charles & Colvard's second-quarter financial results and the Company's future.

As you are all aware, we are operating in a very difficult macroenvironment. The widespread pullback in consumer spending has affected the jewelry industry much more severely than most consumer products. In these challenging times, our first priorities are to drive to positive cash flow and to stabilize the Company's financial position. We will do this through cost-cutting initiatives and by leveraging our inventory to grow topline revenue.

Earlier this week we announced the resignation of Bob Thomas from the Company's management and Board of Directors. Dennis Reed, President and Chief Marketing Officer, has assumed responsibilities for the Company's operations. The Board is very confident in his ability to lead the Company as we navigate through this difficult period.

Our Board of Directors is dedicated, active and involved. We're committed to do what it takes to guide and support Dennis and the management team to meet our shareholders' expectations of us. Indeed, we chose our three newest members based on shareholder input. Richard Bird and Ollin Sykes are themselves significant shareholders in the Company, and George Cattermole, our third addition, was nominated by one of our largest shareholders. These individuals and our returning Board members bring great experience in operations, marketing and finance and will be instrumental in helping to strengthen the financial base of the organization and to develop a strategic direction for the Company.

With Dennis' capabilities, motivated management and employees and an active Board of Directors, we will stabilize our financial position in the short-term and build a great foundation for long-term growth that capitalizes on the opportunity offered by the most brilliant jewel in the world.

We are all approaching the task at hand with a sense of urgency and accountability. I look forward to reporting on our progress.

I will now turn the call over to Dennis.

Thank you, Fritz, and thanks to the Board for trusting me with the responsibility to move the Company forward. I welcome the challenge and the opportunity.

I will begin with a brief overview of our second quarter and then describe our short-term objectives and how we intend to achieve them.

Second-quarter financial results were disappointing but probably not surprising. As you know, sales trends at retail remain challenging, particularly in the jewelry category, and we're not immune to their impact. Our sales are also affected by the transition of some of our retail customers to new Moissanite jewelry suppliers. I can report that during the second quarter of 2008 on a combined basis, the retailers from whom we believe we receive reliable sales data report an approximate 25% decline in their revenue on an approximate 9% decline in units of Moissanite jewelry. We believe this decline is in line with the decline seen by retailers selling similarly priced categories, and it also indicates a consumer trend towards lower-priced jewelry and reflects the promotional efforts of our retailers to sell through their on-hand inventory.

And now let's look ahead to the rest of the year and beyond. In doing so, please understand that this is a work-in-progress. The Board asked me to take on my new responsibilities less than 100 hours ago. Since then, the Board and I, along with other members of management, have spent two days setting clear priorities and deadlines, and since then I have worked with my colleagues to establish tasks and accountability for getting them accomplished. I will be as specific as I can in what follows, but our situation is fluid right now, and we will adjust our tactics as we get new ideas from our channel partners, our employees, our consumers and our shareholders.

First, managing for earnings is essential, but the Board and I agree that managing to become cash flow positive is even more important in this challenging environment. This will be a major priority for the rest of the year.

Beginning with cost controls, we recognize that we have lower revenues than in the last few years, and we will need to downsize our expenditures accordingly. No income statement and component will be immune from scrutiny either domestically or internationally. This week we are in the process of identifying find expenditures that we believe we can eliminate without jeopardizing our revenues. The management team and I in consultation with our Board will complete and begin implementing that plan over the next 10 days.

Converting our largest financial asset, our inventory, to cash motivates a second set of tactics. To accomplish this, we're reviewing our pricing model and developing incentives to purchase with careful attention not to jeopardize existing agreements or the pricing model currently in place. This means identifying opportunities to collaborate with current channel members or to target market situations that current channel members do not currently serve. We have already identified and are exploring with current customers opportunities that we believe have significant potential. And we're doing due diligence on three channel alternatives -- warehouse sales director to consumers, locally-based outlets stores and e-commerce -- and we will launch these initiatives if we determine that it is in the best interests of the Company and that they meet our ROI objectives.

Our relationships with our retailers are extremely important. We and our manufacturing customers depend on their sales to drive their purchases and our revenue. Our question for each retailer is, what will it take to move your inventory and ours, and we will brainstorm with them to provide great answers to that question. We want to be supportive during these challenging times and to assure mutually beneficial long-term relationships with retailers who recognize the opportunity in Moissanite.

With limits on advertising and promotional spending, we must make the message we use to attract customers to stores or online sites more effective. To accomplish this, we will expand our message beyond our current target, the self purchasing woman. Our brilliant and affordable jewel offers benefits to multiple consumer segments and a variety of gift giving occasions.

Finally, we're entering into discussions with all of our vendors to reevaluate our purchasing needs for the remainder of the year. We feel confident that we can renegotiate our short-term requirements as everyone involved with Moissanite understands the difficult environment that we are operating in and will want to do what is in the best interests for the Moissanite business long-term.

In developing and implementing all of these tactics, we are relying on what we consider a solid foundation -- what we have learned from experience, what we have learned from the recommendations of Kanter International and what we can learn from the expertise represented by our Board and channel partners.

All of us recognize the challenges we are facing in our markets and channels and in the current economic environment. Our priority is to develop and implement a comprehensive action plan that will return the Company to profitability over the near-term, and we will do so with a strong sense of urgency.

As soon as we secure the rest of the year, we will also work diligently with strong Board involvement to develop a strategic plan for sustainable long-term sales and earnings growth.

I would now like to turn the call over to Jim Braun who will go through the second-quarter financials. Jim?

Thanks, Dennis. Good afternoon and thank you for joining us for today's conference call.

For the three months ended June 30, 2008, net sales decreased 52% to $3.6 million as compared to $7.6 million in the prior year second quarter. Domestic sales in the second quarter decreased 65% to $2.2 million compared to the second quarter of 2007. International sales for the second quarter increased 13% to $1.4 million, primarily due to increased sales to India, partially offset by lower sales to Taiwan and Thailand.

Gross profit decreased 62% to $2.1 million compared to $5.5 million in the prior year period. Gross profit margins decreased to 57.4% in the second quarter of 2008 from 72.5% in the comparable quarter of 2007. The decline in gross profit margin was due to higher production costs of the inventory being relieved and the write-off of certain consigned jewels returned by a former customer, offset by the benefits of a 9% increase in our average selling price per carat. Total operating expenses decreased 20% to $3.7 million in the second quarter of 2008 compared to $4.6 million in the second quarter of 2007.

As the Company focuses on cost containment, advertising expenses declined $1.3 million, and other expenses, including salaries and travel, declined $380,000. Offsetting these reductions were severance costs of $186,000, increases in receivable bad debt reserves of $475,000 and an increase in professional fees of $103,000. These factors led to an operating loss of $1.6 million compared to operating income of $889,000 for the same period in 2007.

Net loss for the three months ended June 30, 2008 was $1.1 million or $0.06 per diluted share compared to net income of $529,000 or $0.03 per diluted share in the comparable period of 2007.

The average selling price per carat for the second quarter increased 9% when compared to the second quarter of 2007. As we have discussed in past calls, we expect that average selling price per carat will fluctuate based on stone size requirements of our customers.

I would like to point out that our effective tax rate of the income tax benefit is 31% for the three months ended June 30, 2008, which is lower than the statutory rate due to the effect of our losses at our non-US operations has caused our effective tax rate to be lower when compared to the effective tax rate in 2007.

In the second quarter, the Company's cash position decreased to 4. -- decreased, excuse me, to $4.5 million at June 30, 2008 from $5.3 million at March 31, 2008. This $800,000 second-quarter decrease was primarily due to the $627,000 decrease in accounts payable.

Total shipments of 21,100 carats for the current period were 55% less than the 46,800 carats shipped in the same period of 2007. Shipments of carats in the US decreased 68%, while international shipments of carats increased 25%.

At June 30, 2008, total inventory, including consignments, approximated the balance at March 31, 2008. Accounts receivable net decreased to $7.1 million at June 30, 2008 compared to $7.7 million at March 31, 2008, primarily due to the $475,000 increase in the allowance for bad debts previously discussed.

We will now respond to your questions and comments.

(OPERATOR INSTRUCTIONS). Tony Chiarenza, Key Equity Investors.

The first question, is the objective in the short-term to break even or call it cash flow positive in the current environment without an increase in sales?

Yes. Very succinctly yes. We want to turn cash flow positive. That is the goal.

And can we do this at this level of sales, or do we need a little bit more?

We're not in a position where we're going to be projecting what the sales are, but obviously we are diligently looking to cut costs at all levels. We hope to attain coming short-term cash flow positive in the future.

And, as we indicated in our comments, we're going to be opportunistic about how we can add incremental revenue into this declining revenue activity.

The Kanter report was mentioned many times I guess in previous calls, and I guess you just briefly mentioned it now. What was the final process with that? Was anything of that report implemented, or have you started from scratch essentially at this point?

I think some of what was presented to us in the Kanter report will be part of the action items that we're working on out of the two-day Board session that we had earlier in the week. We value their inputs, and there are some elements that we are going to integrate into our plans.

So that is just a piece of it at this point?

Right. It is a piece of it. Absolutely.

Now, as we look at the gross margins, obviously they have gotten slimmed down as you we have had several issues here. Do you foresee those gross margins widening again as the returns and write-offs stop in the second half?

Well, we're not going to be projecting what the gross margins are, but there were some items that hit the second quarter that were unique. So, therefore, if once they go away such as the taking back of broken stones that were on consignment, that had an effect on the margin of 4 to 5 percentages. Obviously that having stopped will help the margin pickup from that level.

Okay. Now the fundamental issue here it seems to me is, and I think you have emphasized it in the past, that this slowdown is not necessarily not a category issue but an industry issue. Because I think it is in a critical distinction. If it is -- obviously if it is just a sector issue and it is going to recover, we don't have a problem. But if it is a category issue, obviously we have a major problem.

Right, right.

What is your opinion on that?

Our opinion is it is -- we're a part of a jewelry industry slowdown. And it is a jewelry category slowdown that is impacting us as much or more so than the Moissanite category specifically.

Now I asked this in the past I guess, but I would like to get your opinion in terms of, as consumers obviously are constrained in their spending, would it not be logical that they might step down to Moissanite as being a cheaper alternative? Wouldn't that be a positive in this kind of environment?

It can be, Tony. We just have to market it that way to the consumer. To the degree that we could have retail partners participate in that kind of marketing message, you may begin to see that in the marketplace going into the fall. However, I do agree with your sentiment that there is a value there for the consumer, but we need to make them aware of that value.

And the consumer has to be in the store.

Right.

I think that is a key with the current economic environment.

And people, there is just no one coming into the stores is the issue?

Right. Sure.

It is sort of what we have seen in sort of the Wal-Mart factor or even what we saw in RadioShack today where people are going to these cheaper retailers and actually buying things and going to lower categories. And I would imagine there has to be an opportunity there.

I think in telling the value story to the consumer I do think there is. We really want to support our current retail customers in getting that message out there. We need to work with them to create that messaging.

So that is a focus. That is -- you are identifying an area that we're definitely paying attention to as we're working on our plan for fall.

Can you guys to the extent that you can comment, can you give us any indication why Bob Thomas resigned, or is anything you can tell us? Was that a strategic issue? Was that just time for his retirement?

Fritz, would you want to comment on that?

Yes, let me step in and answer that, Tony, to the best I can. First, Bob is the person you should ask about why he resigned. He resigned. The resignation was amicable as we indicated. He will be working with us as a consultant to the Company over time.

Backing away from that, every Board has on its agenda every year management succession. That is just something that boards always are taking a look at, and when Bob began talking about the separation of the CEO position and the Chairman position, which you have heard him speak about before, that raised that as an agenda item for the Board even higher. And so we were ready when he made the decision to resign.

And is there an active search at this point to fill both positions?

No, the CEO position we do not expect to fill. The Company as someone has said to me really is not large enough to have both a CEO and a President. The Chair position I will continue to hold it in an interim basis until we make a decision that it makes sense to move forward to either remove that or to move to somebody else.

But the really important thing there is for everyone to understand that the Board is working together as a team to help management address these issues that we are facing. And at some level, it really does not make a difference which person is serving as that interim Chairman.

Right. I guess the last critical issue, the last question, is how long -- I mean the Company is on the balance sheet financially strong, but obviously the assets are tied in that inventory. How long of a -- two or three years of this process, it seemed to me the Company should be able to sustain it to the extent that you manage your cash flow carefully and you are able to monetize some of that inventory. Even if this lasts two or three years, I would -- my opinion would be that you would be fine. I mean -- do you agree?

That is our intention. We have the same sentiment.

As we have disclosed in both the release and in the comments, monetizing the inventory is one of our highest priorities, and a lot of focus is going on to do what is the best way to do that.

Are you seeing any improvement in the retail market are the retailers telling you, or is it just it looks the same at this point?

Yes, we hear the phrase headwind right now. There is no tailwind in retail. There is a headwind. So I think especially through the summer, I don't see a change in that.

Thank you very much, and good luck, gentlemen.

(OPERATOR INSTRUCTIONS). Ryan Thibodeaux, Maple Leaf Partners.

Congratulations on a move forward finally. Jim, a couple of financial questions for you. Can you quantify the amount of the inventory write-down that is included in the cost of goods sold number?

It affected us about 4.5 percentage points. I don't have the exact number in front of me, but that was about 4.5 percentage points. So you could calculate it off of that.

Okay. And is there any -- did that affect the inventory balance at all, or would it have remained flat otherwise?

Well, it would have remained flat otherwise because if we had normally where this write-off occurred we would have a corresponding billing. If we did not have the billing, we still would have had the-- so it would have remained flat otherwise.

Okay. Well, seeing as how that is the first flat sequential inventory number we have seen since '05 I think, could you talk about maybe whether or not that is sustainable? I know that you are pursuing some monetization efforts and looking into that. But I mean assuming that does not happen, are we in a position now where we can kind of manage it at this around $44 million level (multiple speakers) building going into the end of the year?

It is our intention to monetize inventory, as well as to have discussions with our suppliers to reduce all purchases. So, therefore, it is certainly our intention to bring the inventory balance down. That obviously is subject to what the sales will be in this quarter, but (multiple speakers)

What is the purchases run-rate? Where are we now on a quarterly basis? Around $1 million or so?

We bought in the second quarter approximately $850,000 --

That is all from Cree?

No, about 710 was from Cree. The balance was from Norstel.

And that is consistent with what it was last quarter roughly?

Yes, roughly. We intend to have discussions with all of our suppliers to reduce those levels accordingly as we go forward.

Okay. And was there any severance cost at all associated with the departure of Bob Thomas in the second-quarter G&A number?

There was not. The severance that was in the G&A number in the second quarter, not just G&A but also sales and marketing, was $186,000 related to the layoffs that we did on April 15.

How many people roughly was that?

10 people.

Those were people in what, sales and marketing and backoffice?

Really every function got some. Every function.

So do we have like a run-rate going forward that we can kind of go with aside from discretionary spending?

Well, we're actually -- as Dennis said, we're trying to reduce that run-rate of the second quarter down to even a further number, and that is our focus over the next, as Dennis mentioned, 10 days. We're working on it right now. So certainly we're trying to reduce all of our costs going forward to get our fixed net lower.

And we're really focused on managing cash. Very important to us right now.

Okay. So, Fritz, is there not going to be -- so I just said, there's not going to be a CEO search? Dennis is just going to take the lead for now?

Dennis is running the Company.

Okay. Can you expand at all on some of the inventory monetization potentials? What kind of avenues are you exploring?

Well, there's two different components to that. There is a domestic component and an international component. Within the domestic component, we want to be creative with our retail customers to see if there is any way that we can help move through their existing inventory with creative ideas, and if there is ways that we can incent them with new products or new items to help that along. That is going to be the approach to folks, our major retailers domestically, that will be an approach.

In the international business, there are several opportunities out there with key markets that we feel that we can take advantage of if we're creative in how we approach those markets from a pricing standpoint and a distribution standpoint.

Is it safe to say that you are going to be more firm on price domestically, but potentially could clear out some inventory at a lower price internationally?

In markets that are underserved or where we see opportunity, we will definitely look at that. That is a fair statement.

And would these be with new partners or with existing partners internationally?

It is going to be a blend of both, right.

And can you comment at all on the litigation?

No.

Other than the press release that came out on July 16, we don't have any further comments.

Okay. And then lastly, on the last conference call, which was I think a couple of days after the Kanter presentation, you guys really could not comment on anything specifically then. Can you -- I know the question was already asked, but can you comment on anything now as to maybe some of the recommendations and which ones you found helpful and which ones you did not find helpful?

Right. I think the fundamental view that Kanter brought forth that we are acting upon right now is stabilizing the Company for long-term growth, and I think that is our focus. That is the new board members that have come in have that as a perspective, as well as our past serving board members. They have all had an opportunity now to review the report. We met for two days as a board and as a management team, and we have looked at some of those comments from Kanter, and we concur with some of their findings, and we're going to use that as a starting point to build the plan going forward.

So they are not actively involved at this point?

Currently they are not. That is correct.

David Wright, Henry Investment Trust.

A couple of questions. Has all of the K&G receivable been written off?

We have fully reserved the K&G receivable into the uncertainty of litigation.

Can you talk me through that because I cannot get the numbers to get up to $2.8 million?

Well, that is a good point. The $2.8 million represents the total amount that we feel we're due from K&G. A good portion of that was goods that we either did not get back that were on consignment or goods that we got back that were damaged. We billed K&G for those goods, which in addition to what they owed us at 12/31, but did not record the revenue related to that due to the uncertainty of litigation. So there's a substantial amount of receivables in that $2.8 million that we never actually recorded the sales on because we are in the process of litigation with them.

Yes, but you were not in the process of litigation with them until June.

That is correct. But there was uncertainty through the dialogue we had with K&G on whether we would be able to collect. So we did not record that as -- (multiple speakers)

So when you -- I mean you came into the year with $1.2 million in your A/R reserve and had added substantially to it in '07 citing both K&G and also receivables from Reeves Park. And it is not clear -- I cannot fish out from the Q1 10-Q how much you added further to the reserve. And then in Q2, if you took a write-down out of costs of goods sold, that is around 160, and the text referred to something about a $475,000 reserve. So that is why I'm asking. But you're saying today that all of the receivables from K&G have been written off?

Well, let me try to put it succinctly to you. At the end of last year. we had about, as you said, $1.2 million receivables from K&G. At that time we put us about $700,000 reserve on the receivable, and we also had some goods that were inventory on consignment that they were giving -- they were sending back to us.

After all the consigned goods had come back and we had sent bills to them, which we did not recognize any revenue in the first half of the year on the billings for the damaged goods or for the jewels that did not come back that were on consignment, we still have roughly a $475,000 receivable on the books and we fully reserved. So we have fully reserved the $1.2 million, and then we have approximately another $1.8 million or so, which we did not recognize any revenue but we sent bills to them for the various different pieces primarily for either consigned goods that came back broken or consigned goods that did not come back.

Okay. And then this is some of what is reflected in the invoices issued subsequent to 12/31/07 that show on this schedule you filed with your complaint?

That is correct.

Okay. That is -- that does now then clear that up. Sticking with reserves, one other question, when I look at all of the inventory held as long-term asset and I put that together with the current inventory, I get about seven years of sales at current run-rate based on cost of goods.

Well, that is subject to whatever sales are in the future.

Sure. But I'm just saying off of current run-rate. Is there any accounting convention -- I mean can you carry this long-term inventory at cost indefinitely?

As long -- you know, as long as you feel that you will -- that it is sellable for a price above your costs, the accounting convention is the lower of cost to market. And with the cost being at $57 a carat and us selling it on average something in excess of -- for this quarter, something in excess of $170 a carat, we do feel that there is clearly a market for it above cost.

Well, okay. So --

And then your long-term market, that is why a good portion of it is in long-term assets but still a market above cost.

Okay. So then are you contemplating adding to your inventory reserve at all related to the long-term?

We feel that is not needed at this time.

Okay and then last question. When will you be making a filing disclosing whatever severance arrangements you have with Mr. Thomas?

Once we have a signed agreement with Mr. Thomas, there is a requirement for us to file an 8-K to disclose that filing agreement.

Okay. So the inference is perhaps you don't have the agreement nailed down yet?

We're both diligently and positively working toward that.

Right. That is correct.

That concludes the Q&A portion of the call today. I would now like to turn the call back over to Dennis.

Thank you, everyone, this evening for your attention and support of our jewel and our Company, and we look forward to our continued work to build this business with you folks, for you folks, and we're here for questions in the future.

Thank you.

That concludes today's conference. We thank you all for joining us.