Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days: Yes     ☒     No     ☐

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes     ☒     No     ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer”filer,” “smaller reporting company,” and “smaller reporting“emerging growth company” in Rule 12b-2 of the Exchange Act.

As of October 31, 2016,May 1, 2017, there were 21,444,88521,629,685 shares of the registrant’s common stock, no par value per share, outstanding.

 

See Notes to Condensed Consolidated Financial Statements.

 

See Notes to Condensed Consolidated Financial Statements.

 

Charles & Colvard, Ltd. (the “Company”), a North Carolina corporation founded in 1995, manufactures, markets, and distributes Charles & Colvard Created Moissanite^® (hereinafter referred 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 (SiC), is a rare mineral first discovered in a meteormeteorite crater.  Because naturally occurring SiC crystals are too small for commercial use, larger crystals must be grown in a laboratory.  Leveraging its advantage of being the original and leading worldwide source of created moissanite, jewels, the Company’s strategy is to establish itself 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. The Company believes this is possible due to moissanite’s exceptional brilliance, fire, durability, and rarity like no other jewel available on the market. The Company sells loose moissanite jewels and finished jewelry at wholesale to distributors, manufacturers, retailers, TV shopping networks, and designers, and at retail to end consumers through its wholly owned operating subsidiaries, charlesandcolvard.com, LLC (formerly Moissanite.com, LLC) and Charles & Colvard Direct, LLC (until March 2016), and through third-party marketplaces.  As

In February 2016, the Company made the strategic decision to explore a potential divestiture of its direct-to-consumer home party business previously operated through its Charles & Colvard Direct, LLC (dba Lulu Avenue^®) subsidiary.  After careful analysis of the Company’s 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 the best interest of the Company and its shareholders. On March 4, 2016, the Company and Charles & Colvard Direct, LLC entered into an asset purchase agreement with Yanbal USA, Inc. (“Yanbal”), under which Yanbal purchased certain assets related to the Company’s direct-to-consumer home party business for $500,000 and assumed certain liabilities related to such assets.  A more detailed description of this transaction is included in Note 12, “Discontinued Operations.”

Basis of Presentation and Principles of Consolidation - The accompanying unaudited condensed consolidated financial statements included in this Quarterly Report on Form 10-Q have been prepared in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for interim financial information. However, certain information or footnote disclosures normally included in complete financial statements prepared in accordance with U.S. GAAP have been condensed, or omitted, pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”). In the opinion of the Company’s management, the unaudited statements in this Quarterly Report on Form 10-Q include all normal and recurring adjustments necessary for the fair statement of the results for the interim periods presented. The results for the three and nine months ended September 30, 2016March 31, 2017 are not necessarily indicative of the results to be expected for the fiscal year ending December 31, 2016.2017.

The condensed consolidated financial statements as of and for the three and nine months ended September 30,March 31, 2017 and 2016 and 2015 included in this Quarterly Report on Form 10-Q are unaudited. The balance sheet as of December 31, 20152016 is derived from the audited financial statements as of that date. The accompanying statements should be read in conjunction with the audited financial statements and related notes, together with Management’s Discussion and Analysis of Financial Condition and Results of Operations, contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 20152016 filed with the SEC on March 8, 201610, 2017 (the “2015“2016 Annual Report”).

The accompanying condensed consolidated financial statements as of and for the three and nine months ended September 30,March 31, 2017 and 2016 and 2015 include the accounts of the Company and its wholly owned subsidiaries charlesandcolvard.com, LLC (formerly Moissanite.com, LLC), formed in 2011; Charles & Colvard Direct, LLC, formed in 2011; and Charles & Colvard (HK) Ltd., the Company’s Hong Kong subsidiary that became a dormant entity in the second quarter of 2009 and the operations of which ceased in 2008. All intercompany accounts have been eliminated.

 

Significant Accounting Policies - In the opinion of the Company’s management, the significant accounting policies used for the three and nine months ended September 30, 2016March 31, 2017 are consistent with those used for the year ended December 31, 2015.2016. Accordingly, please refer to Note 2 to the consolidated financial statementsConsolidated Financial Statements in the 20152016 Annual Report for the Company’s significant accounting policies.

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

Reclassifications - Certain amounts in the prior year’s condensed consolidated financial statements have been reclassified to conform to the current year presentation, primarily amounts described in Note 3, “Segment Information and Geographic Data” and Note 12, “Discontinued Operations” related to changes in the Company’s reportable segments.

In February 2016, the FASB issued new guidance that establishes a right-of-use (ROU) model that requires a lessee to record a ROU asset and a lease liability on the balance sheet for all leases with terms longer than 12 months. Leases will be classified as either financing or operating, with classification affecting the pattern of expense recognition in the income statement. The new standard is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. A modified retrospective transition approach is required for lessees for capital and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients available. The Company is currently evaluating the impact of its pendingexpects that upon adoption of thethis new standard, on its consolidated financial statements.

The Company reports segment information based on the “management” approach. The management approach designates the internal reporting used by management for making operating decisions and assessing performance as the source of the Company’s operating and reportable segments.

The Company evaluates the financial performance of its segments based on net sales; product line gross profit, or the excess of product line sales over product line cost of goods sold; and operating income (loss). Product line cost of goods sold is defined as product cost of goods sold, in each of the Company’s wholesale distribution and direct-to-consumer distribution operating segment excluding non-capitalized expenses from the Company’s 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.

The Company allocates certain general and administrative expenses from its parent entityTraditional segment to its direct-to-consumer distributionOnline Channels segment primarily based on net sales and number of employees to arrive at segment operating loss. Unallocated expenses, which also include interest and taxes, remain in the parent entity’s wholesale distributionits Traditional segment.

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:

 

 

Inventories are stated at the lower of cost or market on an average cost basis. Inventory costs include direct material and labor, inbound freight, purchasing and receiving costs, inspection costs, and warehousing costs. Any inventory on hand at the measurement date in excess of the Company’s current requirements based on historical and anticipated levels of sales is classified as long-term on the Company’s condensed consolidated balance sheets. The Company’s classification of its inventory as either short- or long-term inventory requires it to estimate the portion of on-hand inventory that can be realized over the next 12 months and does not include precious metal, labor, and other inventory purchases expected to be both purchased and realized in cost of goods sold over the next 12 months.

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 September 30, 2016March 31, 2017 and December 31, 2015,2016, work-in-process inventories issued to active production jobs approximated $5.75$5.78 million and $3.02$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 the Company had the exclusive right in the U.S. through August 2015 and had 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 yearyears ended December 31, 2016 and 2015, management identified an opportunity to sell approximately $6.77 million and $2.28 million, respectively, of slow-movinglegacy loose jewel inventory of less desirable quality.  As a result of this salethese sales and feedback from customers on the value of some of these goods, the Company determined a lower of cost or market reserve of $528,000$529,000 and $352,000$517,000 as of September 30, 2016March 31, 2017 and December 31, 2015,2016, 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 wholesaleTraditional 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 division 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. Typically, in the jewelry industry, slow-moving or discontinued lines are sold as closeouts or liquidated in alternative sales channels.  Management reviews the finished jewelry inventory on an ongoing basis for any lower of cost or market and obsolescence issues.  Management identified certain fashion finished jewelry inventory that could not be sold due to damage or branding issues and established an obsolescence reserve of $232,000$49,000 as of September 30, 2016March 31, 2017 and $164,000$169,000 as of December 31, 2015,2016, for the carrying costs in excess of any estimated scrap values.  As of September 30, 2016March 31, 2017 and December 31, 2015,2016, management identified certain finished jewelry featuring moissanite that was obsolete due to damage and other factors that indicate the finished jewelry is unsaleable, and established an obsolescence reserve of $60,000$22,000 and $225,000,$258,000, respectively, for the carrying costs in excess of any estimated scrap values.

Periodically, the Company ships finished goods inventory to wholesale 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. Finished goods on consignment at September 30, 2016March 31, 2017 and December 31, 20152016 are net of shrinkage reserves of $49,000 and $37,000,$46,000, respectively, to allow for certain loose jewels and finished jewelry on consignment with wholesale 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.

Total net loose jewel inventories at September 30, 2016March 31, 2017 and December 31, 2015,2016, including inventory on consignment net of reserves, were $22.16$22.94 million and $28.19$22.64 million, respectively. The loose jewel inventories at September 30, 2016March 31, 2017 and December 31, 20152016 include shrinkage reserves of $101,000$83,000 and $50,000,$67,000, respectively, which includes $9,000$11,000 and $10,000$7,000 of shrinkage reserves on inventory on consignment at September 30, 2016March 31, 2017 and December 31, 2015,2016, respectively. Loose jewel inventories at September 30, 2016March 31, 2017 and December 31, 20152016 also include recut reserves of $409,000$438,000 and $449,000,$425,000, respectively.

Total net jewelry inventories at September 30, 2016March 31, 2017 and December 31, 2015,2016, including inventory on consignment net of reserves and finished jewelry featuring moissanite manufactured by the Company, and fashion finished jewelry purchased and owned by the Company which was made for sale through Lulu Avenue^®, were $4.98$5.95 million and $4.10$5.48 million, respectively.  The finished jewelry inventories at September 30, 2016March 31, 2017 and December 31, 20152016 also include shrinkage reserves of $79,000$114,000 and $95,000,$102,000, respectively, including shrinkage reserves of $40,000$38,000 and $27,000$39,000 on inventory on consignment, respectively; and a repairs reserve of $12,000$66,000 and $31,000,$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 of approximately $3,000 for each of the three-month periods ended September 30, 2016 and 2015, and $10,000 for each of the nine-month periods ended September 30, 2016 and 2015, for estimated tax, penalties, and interest associated with uncertain tax positions.positions of approximately $14,000 and $3,000 for the three months ended March 31, 2017 and 2016, respectively.

On December 12, 2014, the Company entered into a new exclusive supply agreement (the “Supply Agreement”) with Cree,, Inc. (“Cree”), its SiC raw materials supplier.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 $29.6$29.60 million and approximately $31.5$31.50 million. As of September 30, 2016,March 31, 2017, the Company’s remaining purchase commitment through June 2018 under the Supply Agreement ranges from approximately $16.74$12.33 million to approximately $18.64$14.23 million.

During the ninethree months ended September 30,March 31, 2017 and 2016, and 2015, the Company purchased approximately $6.01$2.21 million and $4.95$1.91 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 asset-based revolving credit facility (the “Credit Facility”) from Wells Fargo Bank, National Association (“Wells Fargo”). The Credit Facility maywill 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 sublimit. The Credit Facility will mature on June 25, 2017. Accordingly, the Company is currently reviewing various credit facility alternatives.

The Credit Facility includes a $5,000,000 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 maximum. The Borrowers must maintain a minimum of $1,000,000 in excess availability at all times. There are no other financial covenants.

Each advance accrues interest at a rate equal to Wells Fargo’s 3-month LIBOR rate plus 2.50%, 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 theCree’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 credit and security agreement, dated as of June 25, 2014, as amended (collectively, the(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) any impairment of the Export-Import Bank guaranty, unless the guaranteed advances are repaid within two business days, (2) an event of default under any other indebtedness of the Borrowers in excess of $200,000, and (3) 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 September 30, 2016,March 31, 2017, the Company had not borrowed against the Credit Facility.

The following table summarizes the components of the Company’s stock-based compensation included in net loss:

No stock-based compensation was capitalized as a cost of inventory during the three- and nine-month periodsthree months ended September 30, 2016 and 2015.  March 31, 2017 or 2016.

Included in total stock-based compensation areis approximately $0 and $89,000$49,000 for the three-month periodsthree months ended September 30,March 31, 2017 and 2016, and 2015, respectively, related to discontinued operations. Included in total stock-based compensation are approximately $44,000 and $185,000 for the nine-month periods ended September 30, 2016 and 2015, respectively, related to discontinued operations.

Stock Options - The following is a summary of the stock option activity for the nine-month periodthree months ended September 30, 2016:March 31, 2017:

The weighted average grant-dategrant date fair value of stock options granted during the nine-month periodthree months ended September 30, 2016March 31, 2017 was $0.64.$0.59. The total fair value of stock options that vested during the nine-month periodthree months ended September 30, 2016March 31, 2017 was approximately $702,000.$127,000. 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 nine-month periodthree months ended September 30, 2016:March 31, 2017:

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.