UNITED STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549


_________________





FORM
10-Q


_________________


(Mark
One)


x    Quarterly
report pursuant to Section 13 or 15(d) of the Securities Exchange Act of
1934





For
the quarterly period ended September 30, 2009





OR





o    Transition
report pursuant to Section 13 of 15(d) of the Securities Exchange Act of
1934





For
the transition period from ______ to ______





Commission
File Number: 000-23329


_________________





Charles
& Colvard, Ltd.


(Exact
name of registrant as specified in its charter)


_________________





North
      Carolina
            56-1928817(State
      or other jurisdiction of
            (I.R.S.
      Employerincorporation
      or organization)
            Identification
      No.)








300
      Perimeter Park Drive, Suite A
              Morrisville,
      North Carolina
            27560(Address
      of principal executive offices)
            (Zip
      Code)





(919)
468-0399


(Registrant’s
telephone number, including area code)


_________________





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: Yesx  Noo





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. See
the definitions of “large accelerated filer,” “accelerated filer” and “smaller
reporting company” in Rule 12b-2 of the Exchange Act.





Large
accelerated
filer                                                      o                                                                Accelerated
filero





Non-accelerated
filer                                                      o (Do not check if a
smaller reporting company)Smaller reporting company x





Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act). Yeso Nox





As of
November 9, 2009, there were approximately 18,925,224 shares of the registrant’s
common stock, no par value per share, outstanding.


Table of Contents








CHARLES
& COLVARD, LTD.





FORM
10-Q


For the
Quarterly Period Ended September 30, 2009





TABLE OF CONTENTS








Page
      No.PART
      I – FINANCIAL INFORMATIONItem
      1.
            Financial
      StatementsCondensed Consolidated Balance Sheets as of September
      30, 2009 (unaudited) and December 31, 2008
            3Condensed Consolidated Statements of Operations
      (unaudited) for the three and nine months ended September 30, 2009 and
      2008
            4Condensed Consolidated Statements of Cash Flows
      (unaudited) for the nine months ended September 30, 2009 and
      2008
            5Notes to Condensed Consolidated Financial Statements
      (unaudited)
            6Item
      2.
            Management’s Discussion and Analysis of Financial Condition
      and Results of Operations
            16Item
      3.
            Quantitative and Qualitative Disclosures About Market
      Risk
            24Item
      4.
            Controls and Procedures
            24Item
      4T.
            Controls and Procedures
            24PART
      II – OTHER INFORMATIONItem
      1.
            Legal Proceedings
            25Item
      1A.
            Risk Factors
            25Item
      6.
            Exhibits
            30Signatures
            32








2
 Table of Contents


PART
I – FINANCIAL INFORMATION





Item
1.                                Financial
Statements





CHARLES
& COLVARD, LTD.


CONDENSED CONSOLIDATED BALANCE SHEETS





September 30,
              2009
              (unaudited)
            
            
            December 31,
              2008ASSETSCurrent
      assets:Cash
      and cash equivalents
            
            $
            6,795,215
            
            
            $
            5,587,144Accounts
      receivable, net
            
            
            918,473
            
            
            
            3,754,657Interest
      receivable
            
            
            60
            
            
            
            2,747Income
      tax receivable
            
            
            -
            
            
            
            2,074,420Note
      receivable
            
            
            -
            
            
            
            142,000Inventory,
      net
            
            
            2,297,863
            
            
            
            6,849,239Inventory
      on consignment, net
            
            
            672,127
            
            
            
            1,442,608Prepaid
      expenses and other assets
            
            
            292,077
            
            
            
            500,643Deferred
      income taxes
            
            
            1,484,140
            
            
            
            1,231,071Total
      current assets
            
            
            12,459,955
            
            
            
            21,584,529Property
      and equipment, net
            
            
            339,160
            
            
            
            412,234Patent
      and license rights, net
            
            
            268,081
            
            
            
            279,315Inventory,
      non-current, net
            
            
            39,241,461
            
            
            
            34,727,841Note
      receivable, non-current
            
            
            224,627
            
            
            
            82,627Deferred
      income taxes, non-current
            
            
            575,075
            
            
            
            940,903TOTAL
      ASSETS
            
            $
            53,108,359
            
            
            $
            58,027,449LIABILITIES
      AND STOCKHOLDERS’ EQUITYCurrent
      liabilities:Accounts
      payable
            
            $
            315,530
            
            
            $
            1,631,074Deferred
      revenue
            
            
            -
            
            
            
            171,181Accrued
      co-op advertising
            
            
            308,965
            
            
            
            401,849Accrued
      expenses and other liabilities
            
            
            200,171
            
            
            
            623,584Total
      current liabilities
            
            
            824,666
            
            
            
            2,827,688Long-term
      liabilities:Accrued
      income taxes
            
            
            3,214,218
            
            
            
            3,154,110Total
      liabilities
            
            
            4,038,884
            
            
            
            5,981,798Commitments
      and contingenciesStockholders’
      equity:Common
      stock, no par value
            
            
            52,910,075
            
            
            
            52,910,075Additional
      paid-in capital – share-based compensation
            
            
            6,160,289
            
            
            
            6,177,246Accumulated
      deficit
            
            
            (10,000,889
            )
            
            
            (7,041,670
            )Total
      stockholders’ equity
            
            
            49,069,475
            
            
            
            52,045,651TOTAL
      LIABILITIES AND STOCKHOLDERS’ EQUITY
            
            $
            53,108,359
            
            
            $
            58,027,449





See Notes
to Condensed Consolidated Financial Statements.


3
 Table of Contents


CHARLES & COLVARD, LTD.


CONDENSED CONSOLIDATED STATEMENTS OF
OPERATIONS


(unaudited)





Three
      Months Ended September 30,
            
            
            Nine
      Months Ended September 30,2009
            
            
            2008
            
            
            2009
            
            
            2008Net
      sales
            
            $
            2,145,003
            
            
            $
            4,162,544
            
            
            $
            5,950,398
            
            
            $
            11,206,104Costs
      and expenses:Cost
      of goods sold
            
            
            848,936
            
            
            
            1,519,997
            
            
            
            2,580,899
            
            
            
            4,227,588Sales
      and marketing
            
            
            673,917
            
            
            
            2,006,745
            
            
            
            1,504,308
            
            
            
            5,821,681General
      and administrative
            
            
            1,082,000
            
            
            
            5,480,036
            
            
            
            4,411,042
            
            
            
            8,686,837Research
      and development
            
            
            31,084
            
            
            
            12,461
            
            
            
            376,775
            
            
            
            35,640Total
      costs and expenses
            
            
            2,635,937
            
            
            
            9,019,239
            
            
            
            8,873,024
            
            
            
            18,771,746Loss
      from operations
            
            
            (490,934
            )
            
            
            (4,856,695
            )
            
            
            (2,922,626
            )
            
            
            (7,565,642
            )Interest
      income
            
            
            6,746
            
            
            
            21,495
            
            
            
            25,594
            
            
            
            96,218Loss
      before income taxes
            
            
            (484,188
            )
            
            
            (4,835,200
            )
            
            
            (2,897,032
            )
            
            
            (7,469,424
            )Income tax benefit (expense)
            
            
            (17,270
            )
            
            
            1,712,587
            
            
            
            (62,187
            )
            
            
            2,570,236Net
      loss
            
            $
            (501,458
            )
            
            $
            (3,122,613
            )
            
            $
            (2,959,219
            )
            
            $
            (4,899,188
            )Net
      loss per common share:Basic
      and fully diluted
            
            $
            (0.03
            )
            
            $
            (0.17
            )
            
            $
            (0.16
            )
            
            $
            (0.27
            )Weighted
      average number of shares used in computing net loss per common
      share:Basic
      and fully diluted
            
            
            18,925,224
            
            
            
            18,334,136
            
            
            
            18,638,453
            
            
            
            18,209,532





See Notes
to Condensed Consolidated Financial Statements.





4
 Table of Contents


CHARLES & COLVARD, LTD.


CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS


(unaudited)





Nine
      Months Ended September 30,2009
            
            
            2008CASH
      FLOWS FROM OPERATING ACTIVITIES:Net
      loss
            
            $
            (2,959,219
            )
            
            $
            (4,899,188
            )Adjustments
      to reconcile net loss to net cash provided by (used in) operating
      activities:Depreciation
      and amortization
            
            
            126,418
            
            
            
            159,756Share-based
      compensation
            
            
            93,520
            
            
            
            333,983Provision
      for uncollectible accounts
            
            
            152,600
            
            
            
            4,540,000Provision
      for sales returns
            
            
            (140,000
            )
            
            
            125,000Consignment
      inventory reserve
            
            
            (153,000
            )
            
            
            324,000Provision
      (benefit) for deferred income taxes
            
            
            112,759
            
            
            
            (1,785,494
            )Loss
      on disposal of assets
            
            
            -
            
            
            
            62,135Changes
      in assets and liabilities:Accounts
      receivable
            
            
            1,549,344
            
            
            
            1,445,091Income
      tax receivable
            
            
            2,074,420
            
            
            
            (596,637
            )Inventory
            
            
            2,235,477
            
            
            
            (663,913
            )Other
      assets, net
            
            
            211,253
            
            
            
            272,077Accounts
      payable
            
            
            (1,315,544
            )
            
            
            (2,507,210
            )Deferred
      revenue
            
            
            (171,181
            )
            
            
            100,000Accrued
      co-op advertising
            
            
            (92,884
            )
            
            
            218,208Other
      accrued liabilities, net
            
            
            (363,305
            )
            
            
            257,801Net
      cash provided by (used in) operating activities
            
            
            1,360,658
            
            
            
            (2,614,391
            )CASH
      FLOWS FROM INVESTING ACTIVITIES:Purchases
      of property and equipment
            
            
            (20,044
            )
            
            
            (28,910
            )Patent
      and license rights costs
            
            
            (22,066
            )
            
            
            (268,751
            )Proceeds
      from sale of equipment
            
            
            -
            
            
            
            898Net
      cash used in investing activities
            
            
            (42,110
            )
            
            
            (296,763
            )CASH
      FLOWS FROM FINANCING ACTIVITIES:Excess
      tax cost from share-based payment arrangements
            
            
            (110,477
            )
            
            
            -Net
      cash used in financing activities
            
            
            (110,477
            )
            
            
            -Effect
      of foreign currency translations
            
            
            -
            
            
            
            1,263NET
      INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
            
            
            1,208,071
            
            
            
            (2,909,891
            )CASH
      AND CASH EQUIVALENTS, BEGINNING OF PERIOD
            
            
            5,587,144
            
            
            
            7,048,409CASH
      AND CASH EQUIVALENTS, END OF PERIOD
            
            $
            6,795,215
            
            
            $
            4,138,518Supplemental
      schedule of non-cash operating activities:Inventory
      acquired from settlement of accounts receivable
            
            $
            1,274,240
            
            
            $
            -Supplemental
      schedule of non-cash investing activities:Reduction
      of note receivable
            
            $
            -
            
            
            $
            140,763





S     
See Notes to Condensed Consolidated Financial Statements.


5
 Table of Contents


CHARLES
& COLVARD, LTD.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


(unaudited)





1.            BASIS
OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES





Description of
Business - Charles & Colvard, Ltd. (“the Company”) was
incorporated in North Carolina on June 28, 1995, and its primary business
is the manufacture, marketing, and distribution of Charles & Colvard
Created Moissanite® jewels (hereinafter referred to as moissanite or moissanite
jewels) for sale in the worldwide jewelry market. Moissanite, also known by its
chemical name of silicon carbide (“SiC”), is a rare mineral first discovered in
a meteor crater. Because naturally occurring SiC crystals are too small for
commercial use, larger crystals must be grown in a laboratory. Leveraging the
Company’s advantage of being the sole source worldwide of lab-created moissanite
jewels, the Company’s strategy is to establish itself as a reputable,
high-quality, and sophisticated brand and to position moissanite as a unique
jewel, distinct from all others based on its exceptional brilliance, luster,
durability, and rarity. The Company primarily sells loose moissanite jewels to
jewel distributors and jewelry manufacturers, although it has begun to sell a
limited amount of moissanite jewelry.





Basis of
Presentation - The accompanying 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, 2009 are not necessarily indicative of the results to be expected
for the fiscal year ending December 31, 2009.





The
condensed consolidated financial statements as of and for the three and nine
months ended September 30, 2009 and 2008 included in this Quarterly Report on
Form 10-Q are unaudited. The balance sheet as of December 31, 2008 is obtained
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, 2008 filed with the SEC on
March 31, 2009 (the “2008 Annual Report”).





Principles of
Consolidation - The accompanying condensed consolidated financial
statements as of and for the three and nine months ended September 30, 2009 and
2008 include the accounts of the Company and its wholly owned subsidiary in Hong
Kong, Charles & Colvard (HK) Ltd., which became a dormant entity in the
second quarter of 2009. The 2008 consolidated financial statements also include
the accounts of a Chinese corporation, Guangzhou Charles & Colvard
Trading Limited, controlled by the Company as beneficial owner of the entire
interest. All intercompany accounts have been eliminated. During the year ended
December 31, 2008, the Company ceased operations of both its Hong Kong
subsidiary and the controlled company in China.





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, 2009 are consistent with those used for the year ended December
31, 2008. Accordingly, please refer to the 2008 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 consolidated financial statements relate to
valuation and classification of inventories, accounts receivable reserves,
deferred tax assets, uncertain tax positions, and co-op advertising. Actual
results could differ materially from those estimates.


Recently
Adopted/Issued Accounting Pronouncements -Accounting for Business
Combinations. In December 2007, the Financial Accounting Standards Board
(“FASB”) issued new U.S. GAAP guidance related to business


6
 Table of Contents


combinations
that establishes principles and requirements for how an acquirer recognizes and
measures in its financial statements the identifiable assets acquired, the
liabilities assumed, any noncontrolling interest in the acquiree, and the
goodwill acquired. The guidance also establishes disclosure requirements to
enable the evaluation of the nature and financial effects of the business
combination and was effective for business combinations occurring on or after
January 1, 2009. The adoption of this guidance did not have an effect on
the Company’s consolidated financial statements.





Noncontrolling Interests in
Consolidated Financial Statements. In December 2007, the FASB issued new
U.S. GAAP guidance related to noncontrolling interests in consolidated financial
statements that establishes accounting and reporting standards for ownership
interests in subsidiaries held by parties other than the parent, the amount of
consolidated net income attributable to the parent and to the noncontrolling
interest, changes in a parent’s ownership interest, and the valuation of
retained noncontrolling equity investments when a subsidiary is deconsolidated.
The guidance also establishes disclosure requirements that clearly identify and
distinguish between the interests of the parent and the interests of the
noncontrolling owners and was effective for the Company beginning
January 1, 2009. The adoption of this guidance did not have an effect on
the Company’s consolidated financial statements.





Determination of the Useful Life of
Intangible Assets. In April 2008, the FASB issued new U.S. GAAP guidance
related to the determination of the useful life of intangible assets that
requires entities to consider their own historical experience in renewing or
extending similar arrangements when developing assumptions regarding the useful
lives of intangible assets and also mandates certain related disclosure
requirements. The guidance is effective for fiscal years beginning after
December 15, 2008, with early adoption prohibited. The adoption of this
guidance did not have an effect on the Company’s consolidated financial
statements.





Interim Disclosures About Fair Value
of Financial Instruments. In April 2009, the FASB issued new U.S.
GAAP guidance that requires disclosures about fair value of financial
instruments for interim reporting periods of publicly traded companies as well
as in annual financial statements. This guidance also requires those disclosures
in summarized financial information at interim reporting periods and is
effective for interim and annual reporting periods ending after June 15,
2009. The adoption of this guidance did not have an effect on the Company’s
consolidated financial statements.





Subsequent Events. In May
2009, the FASB issued new U.S. GAAP guidance that establishes the accounting for
and disclosure of events that occur after the balance sheet date but before
financial statements are issued or are available to be issued. It requires the
disclosure of the date through which an entity has evaluated subsequent events
and the basis for that date, that is, whether that date represents the date the
financial statements were issued or were available to be issued. The Company
adopted this guidance in the second quarter of 2009, and it did not have an
effect on the Company’s consolidated financial statements.





FASB Accounting Standards
Codification. In June 2009, the FASB issued new U.S. GAAP guidance
concerning the organization of authoritative guidance under U.S. GAAP. This new
guidance created the FASB Accounting Standards Codification (the
“Codification”). The Codification has become the source of authoritative U.S.
GAAP recognized by the FASB to be applied by nongovernmental entities. Rules and
interpretive releases of the SEC under authority of federal securities laws are
also sources of authoritative U.S. GAAP for SEC registrants. The Codification
became effective for the Company in its third quarter of 2009. As the
Codification is not intended to change or alter existing U.S. GAAP, it did not
have any impact on the Company’s consolidated financial statements. On its
effective date, the Codification superseded all then-existing non-SEC accounting
and reporting standards. All other non-grandfathered, non-SEC accounting
literature not included in the Codification will become
non-authoritative.





Measuring Liabilities at Fair
Value. In August 2009, the FASB issued new U.S. GAAP guidance
clarifying the measurement of liabilities at fair value. Among other things, the
guidance clarifies how the price of a traded debt security (an asset value)
should be considered in estimating the fair value of the issuer’s liability and
is effective for the first reporting period beginning after its
issuance. The Company does not expect the adoption of this guidance to have
a material impact on its consolidated financial statements.





Multiple-Deliverable Revenue
Arrangements. In October 2009, the FASB issued new U.S. GAAP
guidance that requires an entity to allocate revenue arrangement consideration
at the inception of an arrangement to all of its


7
 Table of Contents


deliverables
based on their relative selling prices (the relative-selling-price method). The
guidance eliminates the use of the residual method of allocation, in which the
undelivered element is measured at its estimated selling price and the delivered
element is measured as the residual of the arrangement consideration, and
requires the relative-selling-price method in all circumstances in which an
entity recognizes revenue for an arrangement with multiple
deliverables. The new guidance must be adopted no later than the beginning
of the first fiscal year beginning on or after June 15, 2010, with early
adoption permitted through either prospective application for revenue
arrangements entered into, or materially modified, after the effective date or
through retrospective application to all revenue arrangements for all periods
presented. The Company does not expect the adoption of this guidance to
have an effect on its consolidated financial statements.





All other
new and recently issued, but not yet effective, accounting pronouncements have
been deemed to be not relevant to the Company and therefore are not expected to
have any impact once adopted.





2.            OPERATING
SEGMENT INFORMATION





All of
the Company’s activities are within a single reportable segment. The following
presents certain data by geographic area:





Three
      Months Ended September 30,2009
              
              
              2008Net
      salesUnited
      States
              
              $
              1,429,651
              
              
              $
              2,908,449International
              
              
              715,352
              
              
              
              1,254,095Total
              
              $
              2,145,003
              
              
              $
              4,162,544
  Nine
      Months Ended September 30,2009
              
              
              2008Net
      salesUnited
      States
              
              $
              3,847,928
              
              
              $
              7,590,275International
              
              
              2,102,470
              
              
              
              3,615,829Total
              
              $
              5,950,398
              
              
              $
              11,206,104
  September
      30, 2009
              
              
              December
      31, 2008Property
      and equipment, netUnited
      States
              
              $
              339,160
              
              
              $
              412,234International
              
              
              -
              
              
              
              -Total
              
              $
              339,160
              
              
              $
              412,234
  September
      30, 2009
              
              
              December
      31, 2008Patent
      and license rights, netUnited
      States
              
              $
              86,221
              
              
              $
              100,397International
              
              
              181,860
              
              
              
              178,918Total
              
              $
              268,081
              
              
              $
              279,315


3.            FAIR
VALUE MEASUREMENTS





Under
U.S. GAAP, fair value is defined as the price that would be received to sell an
asset or paid to transfer a liability in an orderly transaction between market
participants at the measurement date. U.S. GAAP also establishes a hierarchy for
inputs used in measuring fair value that maximizes the use of observable inputs
and minimizes the use of unobservable inputs by requiring that the most
observable inputs be used when available. Observable inputs are obtained from
independent sources and can be validated by a third party, whereas unobservable
inputs reflect assumptions regarding what a third party would use in pricing an
asset or liability. The fair value hierarchy consists of three levels based on
the reliability of inputs, as follows:


8
 Table of Contents





Level 1
– quoted prices in active markets for identical assets and
liabilities


Level 2
– inputs other than Level 1 quoted prices that are directly or indirectly
observable


Level 3
– unobservable inputs that are not corroborated by market data





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








4.           INVENTORY





Inventories
are stated at the lower of cost or market determined on a first-in, first-out
basis. Inventory costs include direct material and labor, inbound freight,
purchasing and receiving costs, inspection costs, and warehousing costs. Any
inventory on hand in excess of the Company’s current requirements based on
historical and anticipated levels of sales is classified as non-current on the
Company’s consolidated balance sheets.





The
Company currently sells one grade of jewel with limited exceptions to test
market acceptance. The grade is classified as very good (“VG”) and consists of
near-colorless jewels that meet certain standards. Only VG jewels are valued in
inventory. Jewels that have not met the Company’s quality standards, including
colored jewels, are not valued in inventory. As market conditions change,
including the influences of customer demand, there may be a market for a portion
of this unvalued inventory that management may pursue in the
future.





Obsolescence
is not a factor in the Company’s inventory valuation. The Company’s jewels do
not degrade over time and inventory generally consists of the cuts 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. The Company has very small market penetration in the
worldwide jewelry market, and the Company has the exclusive right in the United
States through mid-2015 and in many other countries through mid-2016 to produce
and sell lab-created SiC for use in jewelry applications. In view of the
foregoing factors, management has concluded that no excess or obsolete inventory
reserve requirements exist as of September 30, 2009.





All
inventories are carefully reviewed for quality standards before they are entered
into finished goods. As the quality of the Company’s raw material has improved,
so have the standards used to evaluate finished goods. The Company reviews the
inventory on an ongoing basis to ensure its inventory meets current quality
standards.





Total
loose-jewel inventories at September 30, 2009 and December 31, 2008, net of a
reserve of $400,000, was $40,045,377 and $41,229,684, respectively. This reserve
was established to allow for the carat weight loss associated with the possible
future re-cutting of a portion of the loose-jewel inventory to achieve higher
quality standards. The need for adjustments to this reserve is evaluated on a
period-by-period basis.





All
jewelry inventories are finished goods, the majority of which the Company does
not actively market. As a result, a jewelry inventory reserve was established to
reduce the majority of the jewelry inventory value to scrap value, or the amount
the Company would expect to obtain by melting the gold in the jewelry and
returning to loose-jewel finished goods inventory those jewels that meet grading
standards. Jewelry inventory at September 30, 2009 and December 31,
2008, net of reserves of $1,364,000 and $245,000, respectively, was $1,351,752
and $208,807, respectively. As part of the Company's January 2009 settlement
agreement with Reeves Park, Inc. (“Reeves Park”), the Company received jewelry
inventory to reduce its outstanding receivable from that customer. The majority
of the jewelry received pursuant to this agreement was reserved to scrap value
due to the lack of a plan to market this inventory.





The
Company’s total inventories consisted of the following as of September 30, 2009
and December 31, 2008:


9
 Table of Contents





September
      30, 2009
            
            
            December
      31, 2008Raw
      materials
            
            $
            6,750,025
            
            
            $
            6,755,863Work-in-process
            
            
            1,895,074
            
            
            
            1,969,806Finished
      goods
            
            
            32,894,225
            
            
            
            32,851,411Totals
            
            $
            41,539,324
            
            
            $
            41,577,080Current
      portion
            
            $
            2,297,863
            
            
            $
            6,849,239Non-current
      portion
            
            
            39,241,461
            
            
            
            34,727,841Totals
            
            $
            41,539,324
            
            
            $
            41,577,080





5.           INVENTORY
ON CONSIGNMENT





Periodically,
the Company ships finished goods inventory to customers on consignment, or
“memo,” terms. For shipments on memo terms, the customer assumes the risk of
loss and has an absolute right of return for a specified period. The Company
does not recognize revenue on these transactions until the earlier of
(1) the customer informing the Company that it will keep the inventory or
(2) the expiration of the memo period if the inventory is not returned.
Inventory shipped to customers on memo terms is classified as inventory on
consignment on the Company’s consolidated balance sheets. Inventory on
consignment at September 30, 2009 and December 31, 2008 of $672,127
and $1,442,608, respectively, are net of reserves of $132,000 and $285,000,
respectively, to allow for certain jewelry on consignment at a customer that has
filed for Chapter 11 bankruptcy protection and to allow for certain jewels on
consignment with customers that may not be returned or may be returned
damaged.





6.           ACCRUED
EXPENSES





During
the year ended December 31, 2008, the Company reduced staffing levels,
resulting in severance expense of approximately $659,000 that was included in
operating expenses. Staffing levels were further reduced in the nine months
ended September 30, 2009, resulting in severance expense of approximately
$345,000 that was included in operating expenses. As of September 30, 2009 and
December 31, 2008, there was $4,000 and $227,000, respectively, of
remaining severance expenses included in accrued expenses and other liabilities
on the Company’s consolidated balance sheets.





7.           INCOME
TAXES





During
the three and nine months ended September 30, 2009, the Company did not
recognize an income tax benefit for operating losses due to the uncertainty of
sufficient future taxable income to utilize its deferred tax
assets.





During
2008, the Company discontinued the operations of its Hong Kong subsidiary and,
as a result, had a significant tax deduction on its 2008 tax returns resulting
from unpaid obligations of the subsidiary to the Company. The Company has
determined that this deduction qualifies as an uncertain tax position under U.S.
GAAP and has recorded a long-term accrued income tax liability of $2.2 million.
This liability will be resolved when the Company receives an official ruling on
the deduction from the appropriate governmental agencies or when the statute of
limitations expires. The deferred tax asset on the Company’s accompanying
consolidated balance sheets represents available net operating loss carrybacks
available to the Company in the event the deduction is disallowed. If the
deduction is resolved in a favorable manner, the Company will reverse all or
some of this liability and increase the Company’s valuation allowance related to
the deferred tax asset, resulting in a net income tax expense or benefit
depending upon the facts and circumstances at that time.





8.           COMMITMENTS
AND CONTINGENCIES





Lease
Commitments





In March
2004, the Company entered into a seven-year lease, beginning in August 2004, for
approximately 16,500


10
 Table of Contents


square
feet of mixed-use space from an unaffiliated third party at a base cost of
$11,727 per month, plus additional common-area expenses based on the Company’s
proportionate share of the lessor’s operating costs. Terms of the lease provide
for escalations of the base monthly rent throughout the lease term, up to
$13,546 at August 1, 2010. The lease also provided for two rent holidays
(August 2004 through September 2004 and August 2005 through May 2006) throughout
the term during which no rent was payable and a $74,000 moving allowance that
was paid to the Company in September 2004. The Company recognizes rent expense
on a straight-line basis, giving consideration to the rent holidays and the
moving allowance paid to the Company. At the Company’s option, the lease can be
extended for three successive five-year periods.





The
Company also had other operating leases in Hong Kong and China. Due to the
cessation of these operations during 2008, all remaining lease commitments were
terminated with the exception of an office operating lease in Hong Kong that
expires in December 2009. As of September 30, 2009, the remaining lease
commitment on this lease is $14,000, excluding a security deposit of $17,000. As
the space is not being utilized, the remaining lease commitment was fully
expensed in 2008.





The
future minimum lease payments of the Company, excluding the Hong Kong lease
discussed above, are as follows: $40,000 for the remainder of 2009, $160,000 in
2010, and $95,000 in 2011, totaling $295,000. Rent expense for the three months
ended September 30, 2009 and 2008 was $43,000 and $129,000, respectively. Rent
expense for the nine months ended September 30, 2009 and 2008 was $126,000 and
$261,000, respectively. Rent expense for the three and nine months ended
September 30, 2008 included $64,000 of remaining commitment on the Company’s
Hong Kong office operating lease.





Purchase
Commitments





On
June 6, 1997, the Company entered into an amended and restated exclusive
supply agreement with Cree, Inc. (“Cree”). The exclusive supply agreement had an
initial term of ten years that was extended in January 2005 to July 2015. In
connection with the exclusive supply agreement, the Company has committed to
purchase from Cree a minimum of 50% (by dollar volume) of its raw material SiC
crystal requirements. If the Company’s orders require Cree to expand beyond
specified production levels, the Company must commit to purchase certain minimum
quantities. In September 2008, the Company entered into an agreement with Cree
to delay the Company’s commitment to purchase $710,000 of SiC crystals during
the fourth quarter of 2008. This purchase commitment will be included in the
Company’s yet-to-be established 2009 purchase commitment with Cree, and the
Company is currently in negotiations with Cree to further delay this commitment
and any additional purchases until 2010.





In
February 2005, the Company entered into an exclusive supply agreement with
Norstel AB (“Norstel”) for the supply of SiC crystals to be used in the
manufacturing of moissanite jewels. In April 2008, the Company entered into an
amendment to the exclusive supply agreement with Norstel due to an update of
Norstel’s delivery schedule and capability and also due to the Company’s desire
to limit its purchase of raw materials. Under the amendment, the Company’s
minimum purchase commitment from Norstel continues until (i) the Company
has purchased an aggregate amount of approximately $7.9 million of SiC crystals,
or (ii) September 26, 2011, whichever occurs first. This purchase
commitment is contingent upon Norstel being able to deliver SiC crystals of
acceptable quality in the amount committed. In October 2008, the Company entered
into a new letter agreement that suspended the Company’s commitment to purchase
SiC crystals from Norstel during the fourth quarter of 2008. It has not yet been
determined what the Company’s commitment to Norstel will be for 2009, although
the Company has committed to purchase a minimum of 40% of its quarterly SiC
requirements from Norstel. In addition, the Company advanced $400,000 to Norstel
in 2005 for the purchase of certain equipment. This advance, which is in the
form of a note receivable, began to be repaid in January 2007 through a 20%
reduction on each invoice for subsequent purchases of SiC crystals. Effective
March 1, 2008, pursuant to the April 2008 amendment to the exclusive supply
agreement, the Company began receiving a 30% reduction on each invoice for
purchases of SiC crystals and will continue to receive this reduction until the
advance is repaid. The balance on the advance as of September 30, 2009 was
$224,627. Due to the undetermined recommencement of purchases from Norstel, the
Company has chosen to classify the entire remaining outstanding receivable as
long-term on its consolidated balance sheet as of September 30,
2009.


11
 Table of Contents


Legal
Proceedings





There are
no material pending legal proceedings to which the Company is a party or to
which any of the Company’s property is subject. Please refer to Part I, Item 3
of the Company’s Annual Report on Form 10-K for the fiscal year ended December
31, 2008 and Part II, Item 1 of the Company’s Quarterly Reports on Form 10-Q for
the quarterly periods ended March 31, 2009 and June 30, 2009 for a description
of the Company’s previously reported material legal proceedings.





9.           SHARE-BASED
COMPENSATION





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





Three
      Months Ended September 30,
            
            
            Nine
      Months Ended September 30,2009
            
            
            2008
            
            
            2009
            
            
            2008Employee
      stock options
            
            $
            15,846
            
            
            $
            (15,781
            )
            
            $
            (144,610
            )
            
            $
            112,796Consultant
      stock options
            
            
            -
            
            
            
            (49
            )
            
            
            -
            
            
            
            (154
            )Restricted stock awards
            
            
            77,367
            
            
            
            76,666
            
            
            
            238,130
            
            
            
            221,341Income
      tax benefit
            
            
            (27,963
            )
            
            
            (26,052
            )
            
            
            (50,488
            )
            
            
            (103,211
            )Total
            
            $
            65,250
            
            
            $
            34,784
            
            
            
            43,032
            
            
            $
            230,772





No
share-based compensation was capitalized as a cost of inventory during the three
and nine months ended September 30, 2009, and $279 and $3,106 of share-based
compensation was capitalized as a cost of inventory during the three and nine
months ended September 30, 2008, respectively. There was a $180,000 decrease in
compensation costs on employee stock options during the nine months ended
September 30, 2009 due to the February 2009 termination of three executive
officers.





Stock Options -The following
is a summary of the stock option activity for the nine months ended September
30, 2009:





Shares
            
            
            Weighted
      Average Exercise PriceOutstanding,
      December 31, 2008
            
            
            739,164
            
            
            $
            5.94Granted
            
            
            173,000
            
            
            $
            0.46Exercised
            
            
            -
            
            
            $
            -Canceled
            
            
            (204,933
            )
            
            $
            8.17Outstanding,
      September 30, 2009
            
            
            707,231
            
            
            $
            3.95





The fair
value of each option grant is estimated on the grant date using the
Black-Scholes-Merton option pricing model. The valuations of options granted
during the nine months ended September 30, 2009 were based on the following
assumptions:





Dividend
      yield
            0.0%Expected
      volatility
            82.4%Risk-free
      interest rate
            2.69%Expected
      lives (years)
            6.0





Although
the Company issued dividends in prior years, a dividend yield was not used due
to the uncertainty of future dividend payments. Expected volatility is based on
the historical volatility of the Company’s stock. The risk-free interest rate is
based on the implied yields on U.S. Treasury zero-coupon issues over the
expected life of the option. The expected lives of the options represent the
estimated period of time until exercise or forfeiture and are based on
historical experience of similar awards.


12
 Table of Contents





The
following table summarizes information about stock options outstanding at
September 30, 2009:





Options
      Outstanding
            
            Options
      Exercisable
            
            Options
      Vested or Expected to VestBalance
      as of 9/30/2009
            Weighted
              Average
      Remaining
              Contractual
      Life
            Weighted
              Average
              Exercise
              Price
            
            Balance
      as of
              9/30/2009
            Weighted
              Average
      Remaining
              Contractual
      Life
            Weighted
              Average
              Exercise
              Price
            
            Balance
              as
      of 9/30/2009
            Weighted
              Average
      Remaining
              Contractual
      Life
            Weighted
              Average
              Exercise
              Price707,231
            4.71
            $3.95
            
            577,206
            3.55
            $4.74
            
            682,325
            4.52
            $4.08





As of
September 30, 2009, the unrecognized share-based compensation expense related to
unvested stock options is approximately $42,000, which is expected to be
recognized over a weighted average period of approximately 34
months.





The
aggregate intrinsic value of options outstanding, exercisable, and vested or
expected to vest at September 30, 2009 was $19,054, $4,749, and $16,313,
respectively. This amount is before applicable income taxes and represents the
closing market price of the Company’s common stock at September 30, 2009 less
the grant price, multiplied by the number of options that have a grant price
that is less than the closing market price. This amount represents the amount
that would have been received by the optionees had these options been exercised
on that date.





Restricted Stock -The
following is a summary of the restricted stock activity for the nine months
ended September 30, 2009:





Shares
            
            
            Weighted
      Average Grant Date Fair ValueUnvested,
      December 31, 2008
            
            
            227,610
            
            
            $
            1.34Granted
            
            
            591,088
            
            
            $
            0.48Vested
            
            
            (227,610
            )
            
            $
            1.34Canceled
            
            
            -
            
            
            $
            -Unvested,
      September 30, 2009
            
            
            591,088
            
            
            $
            0.48





On May
30, 2008, the Company granted its non-employee Board members an aggregate of
227,610 shares of restricted stock. The restrictions on these shares lapsed on
the date of the annual meeting in May 2009. The aggregate fair value of the
restricted stock granted was $305,000 based on the closing market price of the
Company’s common stock on May 30, 2008.





On
February 23, 2009, the Company granted five of its non-employee Board
members (excluding Richard A. Bird) an aggregate of 103,262 shares of restricted
stock in connection with the negotiation between the Company and Bird Capital
Group, Inc. (“BCG”) of a management services agreement (“the BCG Agreement”).
The restrictions on these shares are scheduled to lapse on February 23, 2010
without regard to continued service on the Board. The aggregate fair value of
the restricted stock granted was $47,500 based on the closing market price of
the Company’s common stock on February 19, 2009.





On
May 18, 2009, the Company granted its non-employee Board members (excluding
Richard A. Bird) an aggregate of 329,787 shares of restricted stock. The
restrictions on these shares will lapse on the date of the annual meeting in May
2010, subject to continued service on the Board. The aggregate fair value of the
restricted stock granted was $155,000 based on the closing market price of the
Company’s common stock on May 18, 2009.





On June
23, 2009, the Company granted its newly appointed Chief Financial Officer 60,000
shares of restricted stock. The restrictions on these shares will lapse on June
15, 2010, subject to the Chief Financial Officer’s continued employment or
service to the Company. The fair value of the restricted stock granted was
$30,000 based on the closing market price of the Company’s common stock on June
23, 2009.


13
 Table of Contents


On June
26, 2009, the Board appointed Dr. Charles D. Lein to serve as a director of the
Company, and he was granted 98,039 shares of restricted stock. The restrictions
on these shares will lapse on the date of the annual meeting in May 2010,
subject to continued service on the Board. The fair value of the restricted
stock granted was $50,000 based on the closing market price of the Company’s
common stock on June 26, 2009.





Pursuant
to the terms of the compensation arrangement with George R. Cattermole, the
Company's Chairman of the Board, to serve in the role of Interim Chief Executive
Officer until a permanent chief executive officer is appointed, the Company is
accruing 30% of Mr. Cattermole's compensation, or $1,800 per week, to be paid as
restricted stock, with all restrictions lapsing at the time of such issuance,
upon the appointment of a new chief executive officer. As of September 30, 2009,
total accrued compensation relating to the restricted stock portion of this
agreement was $19,440.





As of
September 30, 2009, the unrecognized share-based compensation expense
related to unvested restricted stock was approximately $165,000, which is
expected to be recognized over a weighted average period of approximately seven
months.





Dividends - The Company has
not paid any cash dividends in the current year through September 30,
2009.





10.           NET
LOSS PER COMMON SHARE





Basic net
loss per common share is computed by dividing net loss by the weighted average
number of common shares outstanding during the periods. Diluted net loss per
common share is computed using the weighted average number of common and
dilutive common equivalent shares outstanding during the periods. Common
equivalent shares consist of stock options that are computed using the treasury
stock method.





The
following table reconciles the differences between the basic and diluted
earnings per share presentations:





Three
      Months Ended September 30,
            
            
            Nine
      Months Ended September 30,2009
            
            
            2008
            
            
            2009
            
            
            2008Numerator:Net
      loss
            
            $
            (501,458
            )
            
            $
            (3,122,613
            )
            
            $
            (2,959,219
            )
            
            $
            (4,899,188
            )Denominator:Weighted
      average common shares outstandingBasic
            
            
            18,925,224
            
            
            
            18,334,136
            
            
            
            18,638,453
            
            
            
            18,209,532Stock
      options
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Diluted
            
            
            18,925,224
            
            
            
            18,334,136
            
            
            
            18,638,453
            
            
            
            18,209,532Net
      loss per common share:Basic
            
            $
            (0.03
            )
            
            $
            (0.17
            )
            
            $
            (0.16
            )
            
            $
            (0.27
            )Diluted
            
            $
            (0.03
            )
            
            $
            (0.17
            )
            
            $
            (0.16
            )
            
            $
            (0.27
            )





For the
three months ended September 30, 2009 and 2008, stock options to purchase
approximately 645,000 and 843,000 shares, respectively, were excluded from the
computation of diluted net loss per common share because the exercise price of
the options was greater than the average market price of the common shares or
the effect of inclusion of such amounts would be anti-dilutive to net loss per
common share. For the nine months ended September 30, 2009 and 2008, stock
options to purchase approximately 664,000 and 901,000 shares, respectively, were
excluded from the computation of diluted net loss per common share because the
exercise price of the options was greater than the average market price of the
common shares or the effect of inclusion of such amounts would be anti-dilutive
to net loss per common share.


14
 Table of Contents


11.            MAJOR
CUSTOMERS AND CONCENTRATION OF CREDIT RISK





Financial
instruments that potentially subject the Company to concentrations of credit
risk consist primarily of cash equivalents and trade receivables. The Company
maintains cash and cash equivalents with high quality financial institutions and
invests in low-risk securities, primarily money market funds. At times, cash
balances may exceed the Federal Deposit Insurance Corporation insurable
limits.





The
Company’s standard payment terms on trade receivables are generally between 30
and 60 days for jewel distributors and between 60 and 120 days for jewelry
manufacturers. The Company extends credit to its customers based upon a number
of factors, including an evaluation of the customer’s financial condition and
credit history, the customer’s payment history with the Company, the customer’s
reputation in the trade, and an evaluation of the Company’s opportunity to
introduce its moissanite jewels to new or expanded markets. Collateral is not
generally required from customers. The need for an allowance for doubtful
accounts is determined based upon factors surrounding the credit risk of
specific customers, historical trends, and other information.





As of
September 30, 2009, the Company had no trade accounts receivable from Reeves
Park. This reduction in receivables from $4.9 million or 62% of receivables at
December 31, 2008 is the result of the Company entering into a settlement
agreement with Reeves Park in January 2009 to settle its outstanding balance.
Under the terms of the settlement agreement, the Company accepted a return of
inventory, received directly certain cash payments due to Reeves Park from its
customers, and received a settlement fee payment from Reeves Park. Based on the
$2.3 million estimated net realizable value of the transactions under the
settlement agreement, the Company increased its allowance for uncollectible
accounts at December 31, 2008 for Reeves Park to $2.6 million. The
transactions under the settlement agreement are complete as of
September 30, 2009 and the underlying allowance for uncollectible accounts
is zero.





As of
September 30, 2009, two customers accounted for 36% and 12% of trade accounts
receivable, respectively. As of December 31, 2008, two customers accounted for
62% and 15% of trade accounts receivable, respectively.





A
significant portion of revenues is derived from certain customer relationships.
The following is a summary of customers that represent greater than or equal to
10% of total gross revenues:





Three
      Months Ended September 30, 2009
              
              
              Three
      Months Ended September 30, 2008Revenues
              
              
              %
      of Revenues
              
              
              Revenues
              
              
              %
      of RevenuesCustomer
      A
              
              $
              665,565
              
              
              
              31
              %
              
              $
              1,322,009
              
              
              
              32
              %Customer
      B
              
              
              38,907
              
              
              
              2
              %
              
              
              591,738
              
              
              
              14
              %
   Nine
      Months Ended September 30, 2009
              
              
              Nine
      Months Ended September 30, 2008Revenues
              
              
              %
      of Revenues
              
              
              Revenues
              
              
              %
      of RevenuesCustomer
      A
              
              $
              1,064,872
              
              
              
              18
              %
              
              $
              2,125,065
              
              
              
              19
              %Customer
      B
              
              
              95,184
              
              
              
              2
              %
              
              
              1,206,724
              
              
              
              11
              %Customer
      C
              
              
              611,775
              
              
              
              10
              %
              
              
              -
              
              
              
              -Customer
      D
              
              
              4,634
              
              
              
              -
              
              
              
              1,134,214
              
              
              
              10
              %Customer
      E
              
              
              (125,551
              )
              
              
              -2
              %
              
              
              1,173,263
              
              
              
              11
              %







12.           SUBSEQUENT
EVENTS





The
Company has performed an evaluation of subsequent events through November 13,
2009, which is the date the financial statements were issued.


15
 Table of Contents


Effective
October 15, 2009, the Board extended the appointment of George R. Cattermole,
the Company’s current Chairman of the Board, as the Company’s Interim Chief
Executive Officer until the hiring of a permanent chief executive
officer.





On
November 4, 2009, the Company executed a letter agreement dated October 16, 2009
(the “Letter Agreement”) with Stuller, Inc. (“Stuller”), which replaces in its
entirety the prior letter agreement between the Company and Stuller dated June
19, 2007. Pursuant to its terms, the Letter Agreement became effective upon the
Company’s execution of the Letter Agreement on November 4, 2009.





On
November 5, 2009, the Board appointed Randy N. McCullough as the Company’s
President and Chief Executive Officer. In connection with Mr. McCullough’s
appointment as President and Chief Executive Officer, the Company entered into
an employment agreement with Mr. McCullough effective as of November 5,
2009.





On
November 5, 2009, the Board appointed H. Marvin Beasley to serve as director of
the Company. Mr. Beasley was also appointed to serve as a member of the Audit
Committee of the Board and as chairman of a newly created Long-Term Planning
Committee of the Board, which will work with management to establish a long-term
strategy for the Company. Current Board members George R. Cattermole and Dr.
Charles D. Lein have also been appointed to serve on the Long-Term Planning
Committee.





Effective
November 12, 2009, the Board authorized a share repurchase program of up to an
aggregate 1 million shares of company stock. The program authorizes the Company
to repurchase shares of the Company’s common stock until August 12, 2010 in open
market or private transactions. The Company expects to use available cash to
finance these purchases and will determine the timing and amount of stock
repurchases based on its evaluation of market conditions and other
factors.





Item
2.                                 Management’s Discussion and Analysis of Financial Condition and Results
of Operations





This
Quarterly Report on Form 10-Q contains forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933, as amended, or the
Securities Act, and Section 21E of the Securities Exchange Act of 1934, as
amended, or the Exchange Act. Statements expressing expectations regarding our
future and projections relating to products, sales, revenues, and earnings are
typical of such statements and are made under the Private Securities Litigation
Reform Act of 1995. These forward-looking statements include, but are not
limited to, statements about our plans, objectives, representations, and
contentions and are not historical facts and typically are identified by use of
terms such as “may,” “will,” “should,” “could,” “expect,” “plan,” “anticipate,”
“believe,” “estimate,” “predict,” “continue,” and similar words, although some
forward-looking statements are expressed differently.





All
forward-looking statements are subject to the risks and uncertainties inherent
in predicting the future. You should be aware that although the forward-looking
statements included herein represent management’s current judgment and
expectations, our actual results may differ materially from those projected,
stated, or implied in these forward-looking statements as a result of many
factors including, but not limited to, the recent downturn in the worldwide
economy and its ongoing impact on our business and the business of our customers
and suppliers, any continued trends in the general economy that would adversely
affect consumer spending, a further decline in our sales, dependence on consumer
acceptance of our products, dependence on Cree, Inc., or Cree, as the current
supplier of most of the raw material, ability to develop a material second
source of supply, dependence on a limited number of customers, risks of
conducting operations in foreign countries, dependence on third parties for the
sales and marketing of our products to end consumers, continued listing of our
common stock on the NASDAQ Global Select Market, and the impact of significant
changes in our management on our ability to execute our business strategy in the
near-term, in addition to the other risks and uncertainties described in more
detail in “Risk Factors” in Part II, Item 1A of this Quarterly Report on Form
10-Q. Forward-looking statements speak only as of the date they are made. We
undertake no obligation to update or revise such statements to reflect new
circumstances or unanticipated events as they occur except as required by the
federal securities laws, and you are urged to review and consider disclosures
that we make in the reports that we file with the Securities and Exchange
Commission, or the SEC, that discuss other factors relevant to our
business.





The
following discussion is designed to provide a better understanding of our
unaudited financial statements, including a brief discussion of our business and
products, key factors that impacted our performance, and a
summary


16
 Table of Contents


of our
operating results. The following discussion should be read in conjunction with
the unaudited financial statements and the notes thereto included in Part I,
Item 1 of this Quarterly Report on Form 10-Q and the consolidated financial
statements and notes thereto and Management’s Discussion and Analysis of
Financial Condition and Results of Operations contained in our Annual Report on
Form 10-K for the year ended December 31, 2008. Historical results and
percentage relationships among any amounts in the financial statements are not
necessarily indicative of trends in operating results for any future
periods.





Overview





Our
primary business is the manufacture, marketing, and distribution of Charles
& Colvard Created Moissanite® jewels (which we refer to as moissanite or
moissanite jewels) for sale in the worldwide jewelry market. Moissanite, also
known by its chemical name of silicon carbide, or SiC, is a rare mineral first
discovered in a meteor crater. Because naturally occurring SiC crystals are too
small for commercial use, larger crystals must be grown in a laboratory.
Leveraging our advantage of being the sole source worldwide of lab-created
moissanite jewels, our strategy is to establish our company as a reputable,
high-quality, and sophisticated brand and to position moissanite as a unique
jewel, distinct from all others based on its exceptional brilliance, luster,
durability, and rarity. We primarily sell loose moissanite jewels to jewel
distributors and jewelry manufacturers, although we have begun to sell a limited
amount of moissanite jewelry and are exploring additional opportunities in
finished jewelry. Moissanite has primarily been marketed to the self-purchasing
woman as the perfect reward or indulgence for a woman celebrating her
achievements or milestones in her life. Beginning in 2008 and continuing into
2009, we have expanded our marketing message beyond the self-purchasing woman,
and we are seeking to expand moissanite’s global market reach, increase market
awareness of our moissanite jewels, develop additional marketing channels to the
jewelry trade and the consumer, and help create a more compelling consumer value
proposition that will drive increased demand for our product.





The
implementation of our strategy and corresponding messaging has been inhibited by
several unfavorable conditions. The current global economic recession has
resulted in a significant slowdown in the retail environment, with the impact on
the jewelry industry particularly severe. We believe that market conditions are
stabilizing, and we are receiving some feedback from channel partners that
demand is improving. Despite this, a number of major retailers have excessive
inventories of moissanite jewelry and have curtailed their purchases from
jewelry manufacturers to whom we sell our moissanite jewels. As a result, our
net sales for the first nine months of 2009 were 47% less than net sales during
the same period of 2008. To reduce the impact of reduced sales to our net
profit, we achieved an $8.3 million reduction in operating expenses in the first
nine months of 2009 as a result of very tight cost control, a reduction in
headcount, and decreased expenses for sales and marketing programs, as well as a
non-recurrence of bad debt, severance, and subsidiary cessation expenses that we
incurred in the first nine months of 2008. Net loss for the first nine months of
2009 was $3.0 million, or $0.16 per diluted common share, compared with a net
loss of $4.9 million, or $0.27 per diluted common share, for the same period of
2008. Net loss for the first nine months of 2008 benefited from a $2.6 million
income tax benefit. We did not recognize an income tax benefit for our operating
losses during the first nine months of 2009 due to the uncertainty of sufficient
future taxable income to utilize our deferred tax assets.




Because
of this difficult operating environment, our current priority is to generate
positive cash flow and to stabilize our financial position through cost-cutting
initiatives and selling down our inventory. We also have been working to expand
our industry expertise at the Board and senior management levels. In the second
quarter of 2009, we added Dr. Charles D. Lein to our Board of Directors, who has
more than 27 years of experience in the jewelry, wholesale, and retail
industries. In November 2009, we also added H. Marvin Beasley to our Board of
Directors, who has more than 36 years of experience in the retail jewelry
industry. In September 2009, we hired Thomas G. Pautz, who has 25 years of sales
and marketing experience in the jewelry industry, as our Vice President, Sales
and Marketing. We recently completed our search for a new Chief Executive
Officer with the appointment of Randy N. McCullough and expect Mr. McCullough to
be nominated as a director candidate for election at our next annual meeting of
shareholders. We believe Mr. McCullough’s 36 years of diverse, progressive
responsibilities in the jewelry industry will be a valuable resource as he leads
us in defining new sales, marketing, and product placement strategies. To this
end, we are evaluating the price sensitivity of moissanite and may consider
price reductions to stimulate sales to a broader market. In addition, we
recently increased our cooperative advertising percentage to further support the
advertising and marketing initiatives of our channel partners. We fully
recognize the challenges of our business in the current economy, and our legacy
issues divert resources from future strategic initiatives. It will take time
to


17
 Table of Contents


accomplish
the improvements we seek. However, we believe that we have made much progress in
building the right leadership team to define a strategic roadmap that can
significantly improve our business.





Critical
Accounting Policies and Estimates





Our
discussion and analysis of financial condition and results of operations are
based upon our financial statements, which we prepared in accordance with
accounting principles generally accepted in the United States, or U.S. GAAP. The
preparation of these financial statements requires us to make estimates and
judgments that affect the reported amounts of assets, liabilities, revenues, and
expenses and related disclosures of contingent assets and liabilities. “Critical
accounting policies and estimates” are defined as those most important to the
financial statement presentation and that require the most difficult,
subjective, or complex judgments. We base our estimates on historical experience
and on various other factors that we believe to be reasonable under the
circumstances, the results of which form the basis for making judgments about
the carrying value of assets and liabilities that are not readily apparent from
other sources. Under different assumptions and/or conditions, actual results of
operations may materially differ. We have disclosed our critical accounting
policies and estimates in our Annual Report on Form 10-K for the year ended
December 31, 2008, and that disclosure should be read in conjunction with this
Quarterly Report on Form 10-Q.





Results
of Operations





The
following discussion relates to certain results of operations for the three and
nine months ended September 30, 2009.





Net
Sales





Net sales
for the three and nine months ended September 30, 2009 and 2008 comprise the
following:





Three
      Months Ended September 30,
            
            
            Change
            
            
            Nine
      Months Ended September 30,
            
            
            Change2009
            
            
            2008
            
            
            Dollars
            
            
            Percent
            
            
            2009
            
            
            2008
            
            
            Dollars
            
            
            PercentLoose
      jewels
            
            $
            1,874,683
            
            
            $
            4,012,994
            
            
            $
            (2,138,311
            )
            
            
            -53
            %
            
            $
            4,898,302
            
            
            $
            10,781,370
            
            
            $
            (5,883,068
            )
            
            
            -55
            %Jewelry
            
            
            259,670
            
            
            
            126,828
            
            
            
            132,842
            
            
            
            105
            %
            
            
            1,030,141
            
            
            
            320,839
            
            
            
            709,302
            
            
            
            221
            %Other
            
            
            10,650
            
            
            
            22,722
            
            
            
            (12,072
            )
            
            
            -53
            %
            
            
            21,955
            
            
            
            103,895
            
            
            
            (81,940
            )
            
            
            -79
            %Total
      net sales
            
            $
            2,145,003
            
            
            $
            4,162,544
            
            
            $
            (2,017,541
            )
            
            
            -48
            %
            
            $
            5,950,398
            
            
            $
            11,206,104
            
            
            $
            (5,255,706
            )
            
            
            -47
            %





Net sales
were $2,145,000 for the three months ended September 30, 2009 compared to
$4,163,000 for the three months ended September 30, 2008, a decrease of
$2,018,000 or 48%. Net sales were $5,950,000 for the nine months ended September
30, 2009 compared to $11,206,000 for the nine months ended September 30, 2008, a
decrease of $5,256,000 or 47%. In the third quarter of 2009, carat sales of
moissanite jewels and jewelry decreased 43% to approximately 13,000 carats from
23,000 carats in the third quarter of 2008. Sales of moissanite jewelry
represented 12% of total net sales in the third quarter of 2009 compared to 3%
of total net sales in the same period of 2008. For the nine months ended
September 30, 2009, carat sales of moissanite jewels and jewelry decreased 47%
to approximately 33,000 carats from 62,000 carats in the same period of 2008.
Sales of moissanite jewelry represented 17% of total net sales for the nine
months ended September 30, 2009 compared to 3% of total net sales in the same
period of 2008. The majority of our moissanite jewelry sales in 2009 were to a
certain customer for sales at trunk show events. This customer has decided to
cancel the remaining scheduled trunk shows after September 2009, and we are
therefore expecting a significant decline in our jewelry sales in the fourth
quarter of 2009 unless we can identify alternate channels for this inventory. In
the third quarter of 2009, the average selling price per carat for our sales of
loose jewels decreased 4% from the third quarter of 2008. For the nine months
ended September 30, 2009, the average selling price per carat for our sales of
loose jewels decreased 7% from the nine months ended September 30, 2008
primarily as a result of a special pricing in the first quarter of 2009. U.S.
net sales accounted for approximately 67% and 70% of net sales during the three
months ended September 30, 2009 and 2008, respectively, and approximately 65%
and 68% of net sales during the nine months ended September 30, 2009 and 2008,
respectively.





U.S. net
sales and carat shipments, which do not include shipments of consigned
inventory, decreased by 51% and


18
 Table of Contents


44%,
respectively, for the three months ended September 30, 2009 as compared to the
three months ended September 30, 2008; and by 49% and 54%, respectively, for the
nine months ended September 30, 2009 as compared to the nine months ended
September 30, 2008. U.S. sales decreased during these periods primarily due to
the ongoing significant slowdown in the retail environment, reduced sales and
excessive inventory of moissanite jewelry at retailers, and reduced purchases
from jewelry manufacturers serving major retailers that sell moissanite jewelry.
Some of our retailers have indicated they are experiencing less than desired
inventory turns for their moissanite jewelry. There continues to be a pullback
in consumer spending that has negatively affected the jewelry industry and
exacerbated the moissanite jewelry retail inventory turn issue. We experienced
an improvement in orders placed by a major U.S. distributor during the three
months ended September 30, 2009 but saw no significant orders by other U.S.
customers, including manufacturing customers to support in-case business at the
largest retailers selling moissanite jewelry. Further, we do not anticipate
significant orders from our manufacturing customers to service these larger
retailers in the near-term. As retailers evaluate their businesses, we are at
risk that some retailers may not be able to achieve acceptable financial
performance and may choose not to continue selling moissanite
jewelry.





Also
negatively impacting revenue during the three and nine months ended September
30, 2009 was the termination of our manufacturing agreement with Reeves Park,
Inc., or Reeves Park, during the fourth quarter of 2008 due to repeated failure
by Reeves Park to make timely payments on its open payables to us. We assisted
those retailers supplied by Reeves Park to find an alternate supplier of
moissanite jewelry if they chose to stay in the moissanite jewelry business, but
a few of these retailers decided not to continue carrying moissanite jewelry and
other retailers have not yet decided whether they plan to continue their
moissanite businesses. We will likely continue to see a negative impact on our
results of operations, at least in the near-term, due to current inventory
levels and/or the retailers’ contemplation of continuing with their moissanite
businesses. One of these retailers returned to us a consignment of Reeves Park
jewelry that we assumed as part of our settlement agreement with Reeves Park.
This retailer is still currently selling moissanite jewelry but has consolidated
its inventory into fewer stores in an attempt to achieve better inventory turn.
We did not have any sales to Reeves Park during the three and nine months ended
September 30, 2009, and it accounted for 3% and 10%, respectively, of our sales
during the same periods of 2008.





Our
largest customer during the three months ended September 30, 2009 accounted for
31% of our sales compared to 32% during the same period of 2008. A second
customer accounted for 14% of our sales in the same period of 2008 but did not
account for a significant percentage of our sales during the three months ended
September 30, 2009. No additional customers accounted for more than 10% of sales
in the third quarter of 2009 or 2008. Our two largest customers during the nine
months ended September 30, 2009 accounted for 18% and 10%, respectively, of our
sales compared to 19% and 0%, respectively, during the same period of 2008. No
additional customers accounted for more than 10% of sales in the nine months
ended September 30, 2009. Three additional customers in 2008 comprised 11%, 10%,
and 10% of our sales during the nine months ended September 30, 2008. We expect
that we will remain dependent on our ability and that of our largest customers
to maintain and enhance their retail programs. A change in or loss of any of
these customer or retailer relationships could have a material adverse effect on
our results of operations. One of the retailers carrying moissanite jewelry
filed for Chapter 11 bankruptcy protection in March 2009, and we do not expect
to receive new orders for the foreseeable future from this customer. As part of
a July 2009 stipulation and consent order entered with this customer, however,
we did record $146,000 of sales during the three months ended September 30, 2009
on inventory previously held on consignment.





International
net sales and carat shipments, which do not include shipments of consigned
inventory, decreased by 43% and 38%, respectively, for the three months ended
September 30, 2009 as compared to the three months ended September 30, 2008; and
by 42% and 34%, respectively, for the nine months ended September 30, 2009 as
compared to the nine months ended September 30, 2008. International sales
decreased during the three months ended September 30, 2009 primarily due to
reduced sales to Thailand, India and Turkey; and during the nine months ended
September 30, 2009 primarily due to reduced sales in India, Thailand, Turkey,
and Taiwan. A portion of our international sales represents jewels sold
internationally that will be re-imported to North American retailers. Our top
three international distributors during the three and nine months ended
September 30, 2009 were located in the United Kingdom, Hong Kong, and
Italy.


19
 Table of Contents


Costs
and Expenses





Cost
of Goods Sold





Cost of
goods sold for the three and nine months ended September 30, 2009 and 2008 are
as follows:





Three
      Months Ended September 30,
            
            Change
            
            
            Nine
      Months Ended September 30,
            
            Change2009
            
            2008
            
            Dollars
            
            Percent
            
            
            2009
            
            2008
            
            Dollars
            
            PercentCost
      of goods sold
            $
            848,936
            
            $
            1,519,997
            
            $
            (671,061
            )
            -44
            %
            
            $
            2,580,899
            
            $
            4,227,588
            
            $
            (1,646,689
            )
            -39
            %





Cost of
goods sold was $849,000 for the three months ended September 30, 2009 compared
to $1,520,000 for the three months ended September 30, 2008, a decrease of
$671,000 or 44%. Cost of goods sold was $2,581,000 for the nine months ended
September 30, 2009 compared to $4,228,000 for the nine months ended September
30, 2008, a decrease of $1,647,000 or 39%. Cost of goods sold decreased
primarily due to the 48% and 47% decrease in sales for the three and nine months
ended September 30, 2009, respectively. Other factors that contributed to the
decreases were that cost of goods sold for the three and nine months ended
September 30, 2008 included a $184,000 and $324,000, respectively, increase in
our reserve on consigned inventory to allow non-return or damage of certain
jewels on consignment with customers; and a larger quantity of damaged jewel
returns in the three and nine months ended September 30, 2008 over the same
periods of 2009. These factors were partially offset during the nine months
ended September 30, 2009 by a $264,000 increase in jewelry reserves primarily
due to an adjustment of the value of consigned jewelry inventory with a retailer
in Chapter 11 bankruptcy protection as well as an increased allocation of
expenses, previously capitalized as a cost of inventory, to cost of goods sold
as a result of reduced manufacturing activities.





Sales
and Marketing





Sales and
marketing expenses for the three and nine months ended September 30, 2009 and
2008 are as follows:





Three
      Months Ended September 30,
            
            Change
            
            
            Nine
      Months Ended September 30,
            
            Change2009
            
            2008
            
            Dollars
            
            Percent
            
            
            2009
            
            2008
            
            Dollars
            
            PercentSales
      and marketing
            $
            673,917
            
            $
            2,006,745
            
            $
            (1,332,828
            )
            -66
            %
            
            $
            1,504,308
            
            $
            5,821,681
            
            $
            (4,317,373
            )
            -74
            %





Sales and
marketing expenses were $674,000 for the three months ended September 30, 2009
compared to $2,007,000 for the three months ended September 30, 2008, a decrease
of $1,333,000 or 66%. Sales and marketing expenses were $1,504,000 for the nine
months ended September 30, 2009 compared to $5,822,000 for the nine months ended
September 30, 2008, a decrease of $4,317,000 or 74%.





The
decrease in sales and marketing expenses is primarily due to a $621,000 and
$1,864,000 decrease in advertising expenses and a $476,000 and $1,490,000
decrease in compensation costs for the three and nine months ended September 30,
2009, respectively, as compared to the comparative periods in 2008. Our co-op
advertising program reimburses a portion of our customers' marketing costs based
on the amount of their purchases from us and is subject to the customer
providing us documentation of all advertising copy that includes our products.
Co-op advertising expenses decreased by $286,000 and $870,000 for the three and
nine months ended September 30, 2009, respectively, as compared to the
comparative periods in 2008, due to lower sales. Our direct advertising costs
decreased by $335,000 and $994,000 for the three and nine months ended September
30, 2009, respectively, as compared to the comparative periods in 2008, because
we reduced marketing activities as we assessed the effectiveness of our sales
and marketing strategies. The decrease in compensation costs is primarily
attributable to headcount reductions and reduced severance expense in our
continuing effort to reduce costs.





General
and Administrative





General
and administrative expenses for the three and nine months ended September 30,
2009 and 2008 are as follows:




Three
      Months Ended September 30,
            
            Change
            
            
            Nine
      Months Ended September 30,
            
            Change2009
            
            2008
            
            Dollars
            
            Percent
            
            
            2009
            
            2008
            
            Dollars
            
            PercentGeneral
      and administrative
            $
            1,082,000
            
            $
            5,480,036
            
            $
            (4,398,036
            )
            -80
            %
            
            $
            4,411,042
            
            $
            8,686,837
            
            $
            (4,275,795
            )
            -49
            %





20
 Table of Contents


General
and administrative expenses were $1,082,000 for the three months ended September
30, 2009 compared to $5,480,000 for the three months ended September 30, 2008, a
decrease of $4,398,000 or 80%. General and administrative expenses were
$4,411,000 for the nine months ended September 30, 2009 compared to $8,687,000
for the nine months ended September 30, 2008, a decrease of $4,276,000 or
49%.





The
decrease in general and administrative expenses is primarily due to a $4,102,000
and $4,396,000 reduction in bad debt expense and a $289,000 and $406,000
decrease in compensation costs for the three and nine months ended September 30,
2009, respectively, as compared to the comparative periods in 2008, offset in
part by $595,000 in fees paid to Bird Capital Group, Inc., or BCG, under its
February 2009 management services agreement with us during the nine months ended
September 30, 2009. During the nine months ended September 30, 2008, we
increased our allowance for bad debts by $4,000,000 for uncollectible accounts
for Reeves Park and $475,000 to fully reserve the outstanding balance from
K&G Creations. The decrease in compensation costs is primarily attributable
to headcount reductions and reduced severance expenses in our continuing effort
to reduce costs. We expect general and administrative expenses to decrease in
the fourth quarter of 2009 from the level of expenses incurred during the first
three quarters of 2009 as a result of our termination of the management services
agreement with BCG and additional cost-saving opportunities we are
pursuing.





Research
and Development





Research
and development expenses for the three and nine months ended September 30, 2009
and 2008 are as follows:





Three
      Months Ended September 30,
            
            Change
            
            
            Nine
      Months Ended September 30,
            
            Change2009
            
            2008
            
            Dollars
            
            Percent
            
            
            2009
            
            2008
            
            Dollars
            
            PercentResearch
      and development
            $
            31,084
            
            $
            12,461
            
            $
            18,623
            
            149
            %
            
            $
            376,775
            
            $
            35,640
            
            $
            341,135
            
            957
            %





Research
and development expenses were $31,000 for the three months ended September 30,
2009 compared to $12,000 for the three months ended September 30, 2008, an
increase of $19,000 or 149%. Research and development expenses were $377,000 for
the nine months ended September 30, 2009 compared to $36,000 for the nine months
ended September 30, 2008, an increase of $341,000 or 957%.





The
increase in research and development expenses during the nine months ended
September 30, 2009 is primarily attributable to our December 2008 research and
development agreement that required us to pay $50,000 per month for six months
and concluded in May 2009. We expect research and development expenses to
continue to remain at a level consistent with the third quarter of 2009 as we
focus on reducing our current inventory levels.





Interest
Income





Interest
income for the three and nine months ended September 30, 2009 and 2008 is as
follows:





Three
      Months Ended September 30,
            
            Change
            
            
            Nine
      Months Ended September 30,
            
            Change2009
            
            2008
            
            Dollars
            
            Percent
            
            
            2009
            
            2008
            
            Dollars
            
            PercentInterest
      income
            $
            6,746
            
            $
            21,495
            
            $
            (14,749
            )
            -69
            %
            
            $
            25,594
            
            $
            96,218
            
            $
            (70,624
            )
            -73
            %





Interest
income was $7,000 for the three months ended September 30, 2009 compared to
$21,000 for the three months ended September 30, 2008, a decrease of $15,000 or
69%. Interest income was $26,000 for the nine months ended September 30, 2009
compared to $96,000 for the nine months ended September 30, 2008, a decrease of
$71,000 or 73%. This decrease resulted primarily from a lower interest rate
earned on our cash balances.


21
 Table of Contents


Provision
for Income Taxes





During
2008, we recorded a valuation allowance against certain deferred tax assets. Due
to continued uncertainty over sufficient future taxable income to fully use
these deferred tax assets, we did not record an income tax benefit for the
losses incurred during the three and nine months ended September 30, 2009.
During the three and nine months ended September 30, 2009, we recorded $17,270
and $62,187, respectively, of income tax expense primarily due to interest and
penalties accrued under U.S. GAAP for uncertain tax positions. We did record an
income tax benefit for the losses incurred during the three and nine months
ended September 30, 2008. Our effective income tax rate for the three and nine
months ended September 30, 2008 was 35% and 34%, respectively. Our statutory tax
rate is 38.5% and consists of the federal income tax rate of 34% and the North
Carolina state income tax rate of 4.5%, net of the federal benefit. Our
effective income tax rate is lower than the statutory rate during the three and
nine months ended September 30, 2008 primarily due to the effect of losses at
our non-U.S. operations, as we did not record a benefit for these non-U.S.
losses due to the uncertainty of generating sufficient future taxable income in
these tax jurisdictions to offset the losses. In August 2008, we ceased
operations in these jurisdictions.





As a
result of the closure of our Hong Kong subsidiary, we had a significant tax
deduction on our 2008 tax returns resulting from unpaid obligations of the
subsidiary to us. We have determined that this deduction qualifies as an
uncertain tax position under U.S. GAAP and have recorded a long-term accrued
income tax liability of $2.2 million. This liability will be resolved when we
receive an official ruling on the deduction from the appropriate governmental
agencies or when the statute of limitations expires. The deferred tax asset on
our consolidated balance sheets represents available net operating loss
carrybacks available to us in the event the deduction is disallowed. If the
deduction is resolved in a favorable manner, we will reverse all or some of this
liability and increase our valuation allowance related to the deferred tax
asset, resulting in a net income tax expense or benefit depending upon the facts
and circumstances at that time.





Liquidity
and Capital Resources





We
require cash to fund our operating expenses and working capital requirements,
including outlays for capital expenditures. As of September 30, 2009, our
principal sources of liquidity were cash and cash equivalents totaling $6.8
million, trade accounts receivable of $918,000, and inventory of $3.0 million,
as compared to cash and cash equivalents totaling $5.6 million, trade accounts
receivable of $3.8 million, and inventory of $8.3 million as of December 31,
2008. Of the $3.8 million trade accounts receivable balance at December 31,
2008, $2.3 million related to Reeves Park with whom we completed a settlement
agreement to reduce the outstanding balance in 2009.





During
the nine months ended September 30, 2009, our working capital decreased by
approximately $7.1 million to $11.6 million from $18.8 million at December 31,
2008. As described more fully below, the decrease in working capital at
September 30, 2009 is primarily attributable to decreases in trade accounts
receivable as discussed above, continuing sales declines, and reclassifications
of inventory between short-term and long-term.





During
the nine months ended September 30, 2009, $1.4 million of cash was provided by
operations primarily as a result of a $1.5 million decrease in accounts
receivable (excluding the impact of the change in reserves and the non-cash
purchase of inventory under the Reeves Park settlement), receipt of a $2.1
million income tax receivable from the Internal Revenue Service, and a $2.1
million decrease in inventory (excluding the impact of the non-cash purchase of
inventory under the Reeves Park settlement), partially offset by a $1.3 million
decrease in accounts payable and our $3.0 million net loss. Accounts receivable
were down primarily due to cash collections and the impact of our settlement
with Reeves Park. Our accounts payable are typically at their highest level at
December 31 of each year due to our increased expenses for sales and marketing
during the fourth quarter holiday season, and our decrease in accounts payable
is due to payments made on these expenses as well as the overall reduction in
expenses and inventory purchase commitments consistent with our efforts to
reduce costs and inventory while conserving cash.





We did
not make any purchases of raw material inventory during the nine months ended
September 30, 2009. During 2008, we significantly reduced our raw material
inventory purchase commitments from prior years to improve cash flow from
operations. Further, we were able to negotiate with our two leading raw material
suppliers to defer purchases during the three months ended December 31, 2008
into 2009, while keeping in place our long-term supply agreements. We expect our
reduced and deferred purchase commitments to help us convert
inventory


22
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into cash
at a faster rate. Our raw material inventories of SiC crystals are purchased
under exclusive supply agreements with a limited number of suppliers. Because
the supply agreements restrict the sale of these crystals exclusively to us, the
suppliers negotiate minimum purchase commitments with us that, combined with our
reduced sales, have resulted in levels of inventories that are higher than we
might otherwise maintain. Our current rate of sales and our high level of
inventory resulted in $39.2 million of our inventories being classified as
long-term assets at September 30, 2009.





On June
6, 1997, we entered into an amended and restated exclusive supply agreement with
Cree for the supply of SiC crystals for use in the manufacturing of moissanite
jewels. The exclusive supply agreement had an initial term of ten years that was
extended in January 2005 to July 2015. In connection with the exclusive supply
agreement, we have committed to purchase a minimum of 50% (by dollar volume) of
our requirements for SiC crystals from Cree. If our orders require Cree to
expand beyond specified production levels, we must commit to purchase certain
minimum quantities. In September 2008, we entered into an agreement with Cree to
delay our commitment to purchase $710,000 of SiC crystals during the fourth
quarter of 2008. This purchase commitment will be included in our yet-to-be
established 2009 purchase commitment with Cree, and we are currently in
negotiations with Cree to further delay this commitment and any additional
purchases until 2010.





In
February 2005, we entered into an exclusive supply agreement with Norstel AB, or
Norstel, for the supply of SiC crystals for use in the manufacturing of
moissanite jewels. In April 2008, we entered into an amendment to the exclusive
supply agreement with Norstel due to an update of Norstel’s delivery schedule
and also due to our desire to limit our purchase of raw materials. Under the
amendment, our minimum purchase commitment from Norstel continues until (i) we
have purchased an aggregate amount of approximately $7.9 millionof SiC crystals, or (ii)
September 26, 2011, whichever occurs first. As of September 30, 2009, we have
purchased $550,000 of SiC crystals since inception of the exclusive supply
agreement. In October 2008, we entered into a new letter agreement with Norstel
which amended and supplemented the April 2008 amendment. Pursuant to the new
letter agreement, our commitment to purchase SiC inventory from Norstel during
the fourth quarter of 2008 was suspended. It is not yet determined what our
total commitment from Norstel will be for 2009, although we have committed to
purchase a minimum of 40% of our quarterly SiC requirements from Norstel. In
addition, we advanced $400,000 to Norstel in 2005 for the purchase of certain
equipment. This advance, which is in the form of a note receivable, began to be
repaid in January 2007 through a 20% reduction on each invoice for subsequent
purchases of SiC crystals. Effective March 1, 2008, pursuant to the April 2008
amendment to the exclusive supply agreement, we began receiving a 30% reduction
on each invoice for subsequent purchases of SiC crystals from Norstel and will
continue to receive this reduction until the advance is repaid. The balance on
the advance as of September 30, 2009 was $224,627. Due to the undetermined
recommencement of purchases from Norstel, we have chosen to classify the entire
remaining outstanding receivable as non-current on our consolidated balance
sheet as of September 30, 2009.





As of
September 30, 2009, we had no trade accounts receivable from Reeves Park. As of
December 31, 2008, we had trade accounts receivable from Reeves Park of $4.9
million, or 62% of receivables (not considering our allowances for uncollectible
accounts or returns). In January 2009, we entered into a settlement
agreement with Reeves Park to settle its outstanding balance by accepting a
return of inventory, the receipt of certain cash payments due to Reeves Park
from its customers, and the payment by Reeves Park of a settlement fee to us.
Based on the $2.3 million estimated net realizable value of the transactions
under the settlement agreement, we increased our allowance for uncollectible
accounts at December 31, 2008 for Reeves Park to $2.6 million. The transactions
under the settlement agreement are complete as of September 30, 2009 and
the underlying allowance for uncollectible accounts is zero.





In
February 2009, we entered into a management services agreement with BCG, under
which BCG provided management services to us, including the services of Richard
A. Bird, a then current director, as our full-time non-employee Chief Executive
Officer. Pursuant to the agreement, we paid management fees to BCG of $75,000
per month during 2009, except the monthly fee was $175,000 per month for each of
the first two months of the agreement to compensate BCG for additional work
related to the development of a new business strategy. All fees paid under the
agreement are included in general and administrative expenses on our statement
of operations. The agreement was terminated on July 2, 2009 by mutual agreement
of BCG, Mr. Bird, and us.





We did
not make any income tax payments during the nine months ended September 30, 2009
due to our loss position. We received payment in April 2009 of a $2.1 million
income tax receivable. As of December 31, 2008, we


23
 Table of Contents


had
federal income tax credits of $0.6 million that can be carried forward to offset
future income tax and these credits begin expiring in 2012. As of December 31,
2008, we also had a North Carolina net operating loss carryforward of
approximately $7.5 million that begins to expire in 2013.





Our
future capital requirements and the adequacy of available funds will depend on
many factors, including the risk factors described in more detail in “Risk
Factors” in Part II, Item 1A of this Quarterly Report on Form 10-Q. Based on our
cash and cash equivalents and other working capital, management believes that
our existing capital resources are adequate to satisfy our capital requirements
for at least the next 12 months, provided that there are no extraordinary events
and that economic conditions impacting consumer spending do not further
deteriorate and adversely affect the demand for moissanite. There can be no
assurance that the efforts taken to date and future actions will be able to
withstand the impact of any economic downturn that extends deeper or longer than
we currently anticipate. Under these conditions, our operations and other
sources of funds may not be sufficient to fund our operations, and we may be
required to seek alternative sources of funding. There is no assurance, however,
that we will be able to obtain financing on acceptable terms, or at all,
especially in light of the ongoing turmoil in the financial
markets.





Recent
Developments





Effective
October 15, 2009, the Board extended the appointment of George R. Cattermole,
our current Chairman of the Board, as our Interim Chief Executive Officer until
the hiring of a permanent chief executive officer.




On
November 4, 2009, we executed a letter agreement dated October 16, 2009, or the
Letter Agreement, with Stuller, Inc., or Stuller, which replaces in its entirety
our prior letter agreement with Stuller dated June 19, 2007. Pursuant to its
terms, the Letter Agreement became effective upon our execution of the Letter
Agreement on November 4, 2009.





On
November 5, 2009, the Board appointed Randy N. McCullough as our President and
Chief Executive Officer. In connection with Mr. McCullough’s appointment as
President and Chief Executive Officer, we entered into an employment agreement
with Mr. McCullough effective as of November 5, 2009.





On
November 5, 2009, the Board appointed H. Marvin Beasley to serve as a director.
Mr. Beasley was also appointed to serve as a member of the Audit Committee of
the Board and as chairman of a newly created Long-Term Planning Committee of the
Board, which will work with management to establish a long-term strategy for us.
Current Board members George R. Cattermole and Dr. Charles D. Lein have also
been appointed to serve on the Long-Term Planning Committee.





Effective
November 12, 2009, the Board authorized a share repurchase program of up to an
aggregate 1 million shares of company stock. The program authorizes us to
repurchase shares of our common stock until August 12, 2010 in open market or
private transactions. We expect to use available cash to finance these purchases
and will determine the timing and amount of stock repurchases based on our
evaluation of market conditions and other factors.





Item 3.Quantitative and
Qualitative Disclosures About Market Risk





Not
applicable.





Item
4.Controls and Procedures





Not
applicable.





Item
4T.Controls
and Procedures





Our
management, with the participation of our Chief Executive Officer and Chief
Financial Officer, has evaluated the effectiveness of our disclosure controls
and procedures as of the end of the period covered by this Quarterly Report on
Form 10-Q. The term “disclosure controls and procedures,” as defined in
Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and
other procedures of a company that are designed to ensure that


24
 Table of Contents


information
required to be disclosed by a company in the reports that it files or submits
under the Exchange Act is recorded, processed, summarized, and reported within
the time periods specified in the SEC’s rules and forms. Disclosure controls and
procedures include, without limitation, controls and procedures designed to
ensure that information required to be disclosed by a company in the reports
that it files or submits under the Exchange Act is accumulated and communicated
to the company’s management, including its principal executive and principal
financial officers, as appropriate, to allow timely decisions regarding required
disclosure. Management recognizes that any controls and procedures, no matter
how well designed and operated, can provide only reasonable assurance of
achieving the desired control objectives, as ours are designed to do, and
management necessarily applies its judgment in evaluating the cost-benefit
relationship of possible controls and procedures. Based on such evaluation, our
Chief Executive Officer and Chief Financial Officer concluded that, as of the
end of the period covered by this Quarterly Report on Form 10-Q, our disclosure
controls and procedures were effective at the reasonable assurance
level.





We
routinely review our internal control over financial reporting and from time to
time make changes intended to enhance the effectiveness of our internal control
over financial reporting. We will continue to evaluate the effectiveness of our
disclosure controls and procedures and internal control over financial reporting
on an ongoing basis and will take action as appropriate. During the three months
ended September 30, 2009, we made no changes to our internal control over
financial reporting, as such term is defined in Rules 13a-15(f) and 15d-15(f)
under the Exchange Act, that we believe materially affected, or are reasonably
likely to materially affect, our internal control over financial reporting. As
our recently appointed Chief Financial Officer reviews our existing internal
control over financial reporting processes, changes to our internal control over
financial reporting may be implemented in future quarters.





PART
II – OTHER INFORMATION





Item
1.Legal Proceedings





There are
no material pending legal proceedings to which we are a party or to which any of
our property is subject. Please refer to Part I, Item 3 of our Annual Report on
Form 10-K for the fiscal year ended December 31, 2008 and Part II, Item 1 of our
Quarterly Reports on Form 10-Q for the quarterly periods ended March 31, 2009
and June 30, 2009 for a description of our previously reported material legal
proceedings.





Item
1A.Risk
Factors





The
following discussion addresses some of the risks and uncertainties that could
cause, or contribute to causing, actual results to differ materially from
expectations. In evaluating our business, you should pay particular attention to
the descriptions of risks and uncertainties described below. If any of these
risks actually occur, our business, financial condition, or results of
operations could be materially and adversely affected.





Our company is in
a state of flux and our success is contingent upon achieving multiple critical
objectives. Our company has undergone significant changes in the past
nine months. On February 5, 2009, we ended our employment relationship with
three executive officers: Dennis M. Reed, who had served as President and Chief
Marketing Officer since March 2007 and principal executive officer since July
2008; Carl A. Mielke, Senior Vice President of Sales; and Steven L. Abate, Vice
President of Operations. On June 7, 2009, Neil Boss, the Controller of our
company since 2002, resigned as our principal accounting officer and principal
financial officer effective on June 23, 2009, the date Timothy Krist was
appointed our new Chief Financial Officer. On June 22, 2009, we dismissed
Deloitte & Touche LLP as our independent registered public accounting firm
and engaged FROST, PLLC as our independent registered public accounting firm for
the fiscal year ending December 31, 2009. On June 26, 2009, the Board appointed
Dr. Charles D. Lein to serve as a director of the Company. On July 2, 2009, we,
BCG, and Richard A. Bird mutually agreed to terminate the management services
agreement with BCG, including the resignation of Mr. Bird as our Chief Executive
Officer and a member of our Board of Directors. Our current Chairman of the
Board, George R. Cattermole, was appointed our Interim Chief Executive Officer
on July 17, 2009 while the search for a permanent Chief Executive Officer was
being conducted by our Board. On October 12, 2009, we appointed Thomas G. Pautz
as our Vice President, Sales and Marketing. On November 5, 2009, we appointed
Randy N. McCullough as our new President and Chief Executive Officer and H.
Marvin Beasley as a new member of our Board of Directors. These changes have
been disruptive to our business as the new personnel and
independent


25
 Table of Contents


registered
public accounting firm become acclimated to our processes and our unique
business circumstances.





Our
business strategy is also currently under review and subject to restructuring as
we attempt to more effectively position moissanite against diamonds and diamond
substitutes, such as cubic zirconia, in the highly competitive jewelry market
while also continuing to identify opportunities to reduce operating
expenses.





In
addition, we face the risk of loss of certain of our employees who may be
uncomfortable with our current state of flux, which may further impact our
future operations.





We
believe our success will depend to a significant extent on our new executive
management team’s ability to develop and implement a successful business
strategy; to successfully lead and motivate our employees; and to work
effectively with other members of our management team, our Board, and other
stakeholders in our company. There can be no assurance that our changes in
management will lead to an improvement in our results of operations. If the
leadership transition is not successful, we may experience further disruption to
our operations, which may have a material adverse affect on our business and
financial condition.





A further decline
in sales could continue to have a material adverse effect on us and our results
of operations. Our annual sales declined from $40.7 million in 2006 to
$27.8 million in 2007 to $14.7 million in 2008. In addition, we have experienced
significant sales declines during the first nine months of 2009 from the same
period in 2008. These sales declines and the resulting operating losses in 2008
and the first nine months of 2009 have adversely impacted our relationships with
our suppliers and customers, and they have affected our ability to retain key
employees. Due to the large inventory position we currently have, we reduced our
manufacturing levels in 2008 and the first nine months of 2009, and we expect
further reductions in future years until our inventory position is more in line
with our sales. We have made no raw material purchases in 2009, and deferred
purchase commitments have resulted in significant price increases that will
likely affect future gross margin percentages. We have no assurance that the
quality of the raw material crystals we receive in the future will not be
affected by the reduced purchase levels or that our raw material suppliers will
be able to timely deliver increased quantities to us should we require a return
to a higher level of purchases.





In
addition, we have significantly reduced the amount of jewels we faceted during
the first nine months of 2009. We believe our primary supplier of faceting
services, John M. Bachman, Inc., or JMB, is substantially dependent on our
business to fund its operations. To eliminate our minimum monthly commitments
for faceting services, we terminated our agreement with JMB in 2008, but we are
currently operating with JMB on an “as needed” basis. We cannot be assured that
JMB will be able to continue providing services to us with our reduced faceting
levels.





Our common stock
is currently subject to potential delisting from the NASDAQ Global Select
Market. On August 18, 2008, we received a notice from the Listing
Qualifications Department of The NASDAQ Stock Market LLC, or NASDAQ, indicating
that our common stock is subject to potential delisting from the NASDAQ Global
Select Market because, for the preceding 30 consecutive business days, the bid
price of our common stock had closed below the minimum $1.00 closing bid price
requirement for continued listing on the NASDAQ Global Select Market. As a
result of the recent extraordinary market conditions, NASDAQ temporarily
suspended its enforcement of the minimum $1.00 closing bid price requirement and
announced that it would not take any action to delist any security failing to
meet the bid price requirement between October 16, 2008 and July 31, 2009. On
July 14, 2009, we received a second notice from the Listing Qualifications
Department of NASDAQ informing us that, based on discussions with the SEC,
NASDAQ expects no further extensions of the suspension and, as a result, we have
until December 2, 2009 to regain compliance with the minimum $1.00 closing bid
price requirement for continued listing on the NASDAQ Global Select Market,
barring any further suspensions of these rules. In order to regain compliance,
the closing bid price of our common stock must be at least $1.00 for 10
consecutive business days prior to December 2, 2009. While we are currently
evaluating options that would enable us to remain listed on the NASDAQ Global
Select Market, it appears likely that our common stock will be delisted from the
NASDAQ Global Select Market given our current stock price and the limited
remaining time in which to meet the minimum $1.00 closing bid price
requirement.





If our
common stock is delisted from the NASDAQ Global Select Market, shares of our
common stock would likely trade on the OTC Bulletin Board, or OTCBB, or in the
Pink Sheets market. If this were to occur, selling our common stock could be
more difficult because smaller quantities of shares would likely be bought and
sold,


26
 Table of Contents


transactions
could be delayed, and security analysts’ coverage of us may be reduced. In
addition, in the event our common stock is delisted, broker-dealers have certain
regulatory burdens imposed upon them, which may discourage broker-dealers from
effecting transactions in our common stock, further limiting the liquidity of
the shares. These factors could result in lower prices and larger spreads in the
bid and ask prices for shares of our common stock.





Our business and
our results of operations could be materially adversely affected as a result of
general economic and market conditions, including the current economic
crisis. Global financial markets have been experiencing extreme
disruptions, including severely diminished liquidity and credit availability,
declines in consumer confidence, declines in economic growth, increases in
unemployment rates, and uncertainty about economic stability. We are unable to
predict the likely duration and severity of the current disruptions in the
financial markets and the adverse global economic conditions, and if the current
uncertainty continues or economic conditions further deteriorate, our business
and results of operations could be materially and adversely affected. The
consequences of such adverse effects could include interruptions or delays in
our suppliers’ performance of our contracts, reductions and delays in customer
purchases, delays in or the inability of customers to obtain financing to
purchase our products, and bankruptcy of customers and/or
suppliers.





Luxury
products, such as fine jewelry, are discretionary purchases for consumers. The
recent reduction in consumer discretionary spending, largely attributed to the
conditions described above, has affected our industry more significantly than
many other industries. Consumer discretionary spending is strongly affected by
economic factors outside our control, including the condition of financial
markets, consumer credit availability, prevailing interest rates, energy costs,
employment levels, salary levels, and tax rates. A continued reduction in
discretionary consumer spending could have a material adverse affect on our
business and financial condition.





Our future
financial performance depends upon increased consumer acceptance and growth of
sales of our products. We believe that most consumers are not generally
aware of the existence and attributes of moissanite jewels and that the consumer
market for moissanite jewels is in the early stages of development. Total
moissanite jewelry retail sales have historically been less than 1% of the total
jewelry market. The degree of future market acceptance and demand are subject to
a significant amount of uncertainty. Our future financial performance will
depend, in part, upon greater consumer acceptance of moissanite jewels as
distinct from all other jewels based on their fire, brilliance, luster,
durability, and rarity. In addition, consumer acceptance may be affected by
retail jewelers’ and jewelry manufacturers’ acceptance of moissanite jewels. We
primarily market loose jewels, which jewelry distributors, manufacturers, and
retailers set in jewelry and in turn distribute or sell to
consumers.


The
quality, design, and workmanship of the jewelry settings selected by retail
jewelers, which is not within our control, could affect consumers’ perception
and acceptance of our jewels. Thus, our future financial performance may be
affected by:





·
            the
      willingness and ability of our jewelry distributors and other jewelry
      suppliers, manufacturers, and designers to market and promote moissanite
      jewels to the retail jewelry trade;


·
            the
      willingness of distributors, retailers, and others in the channel of
      distribution to purchase loose moissanite jewels and the willingness of
      manufacturers, designers, and retail jewelers to undertake setting of the
      loose jewels;


·
            the
      ability of manufacturers, designers, and retail jewelers to select jewelry
      settings that encourage consumer acceptance of and demand for our
      jewels;


·
            the
      ability of jewelry manufacturers and retail jewelers to set loose
      moissanite jewels in jewelry with high quality workmanship;
      and


·
            the
      ability of retail jewelers to effectively market and sell moissanite
      jewelry to consumers.


If our
products do not receive greater market acceptance, our business, operating
results, and financial condition would be materially and adversely
affected.





We expect to
remain dependent upon Cree for the supply of most of our SiC crystals for the
foreseeable future. If we are unable to obtain sufficient, high-quality
SiC crystals from Cree, and we have a significant increase in demand for our
jewel, then we may not be able to meet that demand. Cree has certain proprietary
rights relating to its process for growing large single crystals of SiC and its
process for growing near-colorless SiC crystals. Under our
exclusive


27
 Table of Contents


supply
agreement with Cree, we are obligated to buy from Cree, and Cree is obligated to
sell to us, at least 50%, by dollar volume, of our requirements for SiC material
for the production of gemstones in each calendar quarter through June 2015. In
February 2005, we entered into an exclusive supply agreement with Norstel, which
was amended in April 2008 and October 2008, as a secondary supplier of SiC
crystals. However, Norstel has not demonstrated to date the ability to
consistently grow high-quality SiC crystals that meet our
requirements.





Cree has
improved its production processes and is currently producing SiC crystals
sufficient to meet our requirements. However, there can be no assurance that
Cree will be able to continue to produce and supply us with SiC crystals of
sufficient quality, sizes, and volumes that we desire or that we will
successfully negotiate purchase commitments that enable us to manage our
inventories and raw material costs effectively. In addition, although Norstel
represents a potential additional source of supply, it has not yet proven to
have the capability to produce significant quantities of SiC crystals of
suitable quality and sizes, and there can be no assurance that it will ever
develop these capabilities.




For the sale of
our jewels in North America, we are currently substantially dependent on a
limited number of distributors and jewelry manufacturers. We anticipate
that the majority of the moissanite jewels that we sell in North America will be
distributed through a limited number of manufacturers and distributors, and
therefore, we are substantially dependent upon these companies for distribution
of moissanite jewels in North America. During the nine months ended September
30, 2009, our four largest domestic customers collectively accounted for 43% of
net sales. In late 2007, we terminated our manufacturing agreement with K&G
Creations (one of our largest customers in 2007) and in 2008 we terminated our
manufacturing agreement with Reeves Park (one of our largest customers in 2007
and 2008). This disruption in our distribution model was significant and we have
not yet, to date, replaced the sales volume lost as a result of these
events.





We face intense
competition in the worldwide jewelry industry. The jewelry industry is
highly competitive and we compete with numerous other jewelry products,
including diamonds and cubic zirconia, among others. In addition, despite the
positioning of moissanite as a unique jewel, we face competition from treated
diamonds, synthetic diamonds, and companies developing other synthetic jewelry
technologies. A substantial number of companies supply products to the jewelry
industry, many of which we believe have greater financial resources than we do.
Competitors could develop new or improved technologies that may render the
pricing point for moissanite noncompetitive, which would have an adverse effect
on our business, results of operations, and financial condition.





The financial
difficulties or insolvency of one or more of our major customers could adversely
affect results. We are subject to a concentration of credit risk
amongst our major customers and a default by any of these customers on their
debts to us could have a material adverse effect on our financial position.
Future sales and our ability to collect accounts receivable depend, in part, on
the financial strength of customers. We estimate an allowance for accounts for
which collectibility is at risk and this allowance adversely impacts
profitability. In the event customers experience greater than anticipated
financial difficulties or insolvency, profitability would be expected to be
adversely impacted by our failure to collect accounts receivable in excess of
the estimated allowance. Given the current economic environment, constrained
access to capital and general market contractions may heighten our exposure to
customer default.





We are subject to
certain risks due to our international distribution channels and vendors.
We currently have approximately 25 international distributors for moissanite
jewels covering substantially all of Western Europe, Australia, India, and
certain countries in Southeast Asia and the Middle East. Our long-term strategy
is to expand the number of international markets for our products. In addition,
we expect to continue to use certain companies based outside the United States
to facet our moissanite jewels. Due to our reliance on development of foreign
markets and use of foreign vendors, we are subject to the risks of conducting
business outside of the United States. These risks include the
following:





·
            the
      adverse effects on United States-based companies operating in foreign
      markets that might result from war, terrorism, changes in diplomatic,
      trade, or business relationships or other political, social, religious, or
      economic instability;


·
            the
      continuing adverse economic effects of the global financial
      crisis;


·
            unexpected
      changes in, or impositions of, legislative or regulatory
      requirements;


·
            delays
      resulting from difficulty in obtaining export
  licenses;


28
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·
            tariffs
      and other trade barriers and restrictions;
and


·
            the
      burdens of complying with a variety of foreign laws and other factors
      beyond our control.





Additionally,
while the majority of our foreign transactions are denominated in U.S. dollars,
foreign currency fluctuations could impact demand for our products or the
ability of our foreign suppliers to continue to perform. Further, some of these
distributors operate relatively small businesses and may not have the financial
stability to assure their continuing presence in their markets. There can be no
assurance that the foregoing factors will not adversely affect our operations in
the future or require us to modify our anticipated business
practices.





We rely upon our
ability to protect our intellectual property. We have United States
product and method patents for moissanite jewels under which we believe that we
have broad, exclusive rights to manufacture, use, and sell moissanite jewels in
the United States. We have these same patents in a number of foreign
jurisdictions. We believe that these patents create substantial technological
barriers to our potential competitors.





At the
present time, we are also dependent on Cree’s technology for the production of
SiC crystals. Cree is exclusively licensed to use a patent concerning a process
for growing large single crystals of SiC, has certain patents of its own
relating to growth of large single crystals of SiC, and has a patent for a
process for growing near-colorless SiC crystals. If Norstel becomes a
significant additional source of supply, we will also become dependent on its
technology.





There can
be no assurance that any patents issued to or licensed by or to us, Cree, or
Norstel will provide any significant commercial protection, or that we, Cree, or
Norstel will have sufficient resources to protect our respective patents or that
any patents will be upheld by a court should we or our suppliers seek to enforce
our respective rights against an infringer. Our South Korean patent is no longer
valid as a result of a ruling by the South Korean Patent Court, and there can be
no assurance that we will not incur similar outcomes in the future. In addition,
the existence of valid patents does not prevent other companies from
independently developing competing technologies. Existing producers of SiC
crystals or others may refine existing processes for growing SiC crystals or
develop new technologies for growing large single crystals of SiC or colorless
SiC crystals in a manner that does not infringe patents owned or licensed by us,
Cree, or Norstel.





As a
result of the foregoing factors, existing and potential competitors may be able
to develop products that are competitive with or superior to our products, and
such competition could have a material adverse effect on our business, operating
results, and financial condition.





Governmental
regulation and oversight might adversely impact our operations. We are
subject to governmental regulations in the manufacture and sale of moissanite
jewels. In particular, the Federal Trade Commission has the power to restrict
the offer and sale of products that could deceive or have the tendency or effect
of misleading or deceiving purchasers or prospective purchasers with regard to
its type, kind, quality, character, origin, or other characteristics. We may be
under close scrutiny both by governmental agencies and by competitors in the
gemstone industry, any of which may challenge our promotion and marketing of our
moissanite jewel products. If our production or marketing of moissanite jewels
is challenged by governmental agencies or competitors, or if regulations are
issued that restrict our ability to market our products, our business, operating
results, and financial condition could be materially adversely
affected.





Sales of
moissanite jewelry could be dependent upon the pricing of precious metals, which
is beyond our control. Any increases in the market price of precious
metals (primarily gold) could affect the pricing and sales of jewelry
incorporating moissanite jewels. The majority of price increases in precious
metals are passed on to the consumer in the form of higher prices for finished
jewelry. These higher prices could have a negative impact on the sell-through of
moissanite jewelry at the retail level. From the beginning of 2006 through the
nine months ended September 30, 2009, the price of gold has increased
significantly (approximately 89%), resulting in higher retail price points for
gold jewelry. This has had a negative impact on both sales of moissanite jewelry
and the jewelry industry as a whole. We currently encourage our customers to set
moissanite jewels in jewelry with a gold quality of 14 Karat or higher or in
platinum. Due to high gold prices, we are currently reassessing this strategy
and relaxing our Brand Identity Guidelines to allow our customers to set
moissanite jewels in settings made from other materials, including
silver.


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Some
anti-takeover provisions of our charter documents, agreements, and plans may
delay or prevent a takeover of our company .A number of provisions of our
articles of incorporation and bylaws impact matters of corporate governance and
the rights of shareholders. Certain of these provisions have an anti-takeover
effect and may delay or prevent takeover attempts not first approved by the
Board of Directors (including takeovers that certain shareholders may deem to be
in their best interests). These provisions also could delay or frustrate the
removal of incumbent directors or the assumption of control by shareholders. We
believe that these provisions are appropriate to protect our interests and the
interests of all of our shareholders.





Under the
terms of our exclusive supply agreement with Cree, we are prohibited from
entering into an exclusive marketing or distribution agreement with DeBeers or
its affiliates or any party whose primary business is the development,
manufacture, marketing or sale of diamond gemstones or any non-gemstone and
non-jewelry industry competitor of Cree. The agreement also prohibits us from
entering into certain merger, acquisition, sale of assets or similar
transactions with a prohibited party. These provisions of the agreement could
limit the price that third parties might be willing to pay in the future for
some or all of the shares of our common stock. In addition, this agreement could
prevent us from entering into certain potentially profitable transactions with
such prohibited parties.





On
February 21, 1999, we adopted a Shareholder Rights Plan, or the Rights Plan,
under which all shareholders of record as of March 8, 1999, received rights to
purchase shares of a new series of preferred stock. Each share of common stock
issued after March 8, 1999 has received the same rights. The Rights Plan, as
modified by an amendment dated February 18, 2009, remains in full force and
effect.





The
Rights Plan is designed to enable all of our shareholders to realize the full
value of their investment and to provide for fair and equal treatment for all
shareholders in the event that an unsolicited attempt is made to acquire us. The
adoption of the Rights Plan is intended as a means to guard against abusive
takeover tactics and is not in response to any particular proposal. The rights,
which expire in 2019, will be exercisable only if a person or group acquires 20%
or more of our common stock or announces a tender offer for 20% or more of the
common stock. If a person or group acquires 20% or more of our common stock, all
shareholders except the purchaser will be entitled to acquire our common stock
at a 50% discount. The effect will be to discourage acquisitions of more than
20% of our common stock without negotiations with our Board of
Directors.





The
rights will trade with our common stock, unless and until they are separated
upon the occurrence of certain future events. Our Board of Directors may redeem
the rights prior to the expiration of a specified period following the
acquisition of more than 20% of our common stock.





If we fail to
evaluate, implement, and integrate strategic opportunities successfully, our
business may suffer. From time to time we evaluate strategic
opportunities available to us for product, technology, or business acquisitions
or dispositions. If we choose to make acquisitions or dispositions, we face
certain risks, such as failure of an acquired business to meet our performance
expectations, diversion of management attention, retention of existing customers
of our current and acquired business, and difficulty in integrating or
separating a business’s operations, personnel, and financial and operating
systems. We may not be able to successfully address these risks or any other
problems that arise from future acquisitions or dispositions. Any failure to
successfully evaluate strategic opportunities and address risks or other
problems that arise related to any acquisition or disposition could adversely
affect our business, results of operations, and financial
condition.





Item
6.                                Exhibits





The
following exhibits are being filed herewith and are numbered in accordance with
Item 601 of Regulation S-K:


30
 Table of Contents





Exhibit No.
            Description10.1
            Mutual
      Termination and Release Agreement, made and entered into on July 2, 2009,
      by and among Charles & Colvard, Ltd., Bird Capital Group, Inc. and
      Richard A. Bird (incorporated herein by reference to Exhibit 10.131 to our
      Current Report on Form 8-K, filed with the SEC on July 9,
      2009)10.2
            Consulting
      Agreement, made and entered into as of July 2, 2009, by and among Charles
      & Colvard, Ltd. and Bird Capital Group, Inc. (incorporated herein by
      reference to Exhibit 10.132 to our Current Report on Form 8-K, filed with
      the SEC on July 9, 2009)10.3
            Summary
      of Compensation Arrangement with George R. Cattermole31.1
            Certification
      by Chief Executive Officer pursuant to Rule 13a-14(a) under the Securities
      Exchange Act of 1934, as adopted pursuant to Section 302 of the
      Sarbanes-Oxley Act of 200231.2
            Certification
      by Chief Financial Officer pursuant to Rule 13a-14(a) under the Securities
      Exchange Act of 1934, as adopted pursuant to Section 302 of the
      Sarbanes-Oxley Act of 200232.1
            Certification
      by Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted
      pursuant to Section 906 of the Sarbanes-Oxley Act of
  200232.2
            Certification
      by Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted
      pursuant to Section 906 of the Sarbanes-Oxley Act of
  2002







31
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SIGNATURES





Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.





CHARLES
      & COLVARD, LTD.By:
            /s/
      Randy N. McCulloughNovember
      16, 2009
            
            Randy
      N. McCulloughPresident
      and Chief Executive OfficerBy:
            /s/
      Timothy L. KristNovember
      16, 2009
            
            Timothy
      L. KristChief
      Financial Officer(Principal
      Financial Officer and Principal Accounting
  Officer)


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EXHIBIT
INDEX





Exhibit No.
            Description10.1
            Mutual
      Termination and Release Agreement, made and entered into on July 2, 2009,
      by and among Charles & Colvard, Ltd., Bird Capital Group, Inc. and
      Richard A. Bird (incorporated herein by reference to Exhibit 10.131 to our
      Current Report on Form 8-K, filed with the SEC on July 9,
      2009)10.2
            Consulting
      Agreement, made and entered into as of July 2, 2009, by and among Charles
      & Colvard, Ltd. and Bird Capital Group, Inc. (incorporated herein by
      reference to Exhibit 10.132 to our Current Report on Form 8-K, filed with
      the SEC on July 9, 2009)10.3
            Summary
      of Compensation Arrangement with George R. Cattermole31.1
            Certification
      by Chief Executive Officer pursuant to Rule 13a-14(a) under the Securities
      Exchange Act of 1934, as adopted pursuant to Section 302 of the
      Sarbanes-Oxley Act of 200231.2
            Certification
      by Chief Financial Officer pursuant to Rule 13a-14(a) under the Securities
      Exchange Act of 1934, as adopted pursuant to Section 302 of the
      Sarbanes-Oxley Act of 200232.1
            Certification
      by Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted
      pursuant to Section 906 of the Sarbanes-Oxley Act of
  200232.2
            Certification
      by Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted
      pursuant to Section 906 of the Sarbanes-Oxley Act of
  2002