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 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 scientifically made 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 fire, 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. 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. In addition, 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 six months of 2009 were 46% less than net sales during the same period of 2008. To reduce the impact of reduced sales to our net profit, we achieved a $2.5 million reduction in operating expenses in the first six months of 2009 as a result of very tight cost control, a reduction in headcount, and decreased expenses for sales and marketing programs. Net loss for the first six months of 2009 was $2.5 million, or $0.13 per diluted common share, compared with a net loss of $1.8 million, or $0.10 per diluted common share, for the same period of 2008. Net loss for the first six months of 2008 benefited from an $858,000 income tax benefit. We did not recognize an income tax benefit for our operating losses during the first six 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. In addition, we recently 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. We are also currently engaged in an active search for a new Chief Executive Officer with applicable industry experience to lead us in defining new sales and marketing strategies and positioning our product. We have also broadened the marketing opportunity for our current customers to have more flexibility in marketing and selling to different segments of the market, including bridal, anniversary, and gift-giving. 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 accomplish the improvements we seek. However, we believe that, with the right leadership team, we can define a strategic roadmap that can improve our business significantly.

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. 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 for the Three Months Ended June 30, 2009 and June 30, 2008

The following table sets forth certain statements of operations data for the
periods indicated:



                                    Three Months Ended             Three Months Ended
                                       June 30, 2009                  June 30, 2008
                                                    % of                           % of
                                   Dollars         Revenue        Dollars         Revenue
  Net sales                      $  1,320,207        100.0 %    $  3,639,677        100.0 %
  Cost of goods sold                  649,654         49.2 %       1,550,504         42.6 %


  Gross profit                        670,553         50.8 %       2,089,173         57.4 %

  Operating expenses                1,852,586        140.3 %       3,688,534        101.3 %


  Loss from operations             (1,182,033 )      -89.5 %      (1,599,361 )      -43.9 %

  Interest income                       8,587          0.6 %          26,164          0.7 %


  Loss before income taxes         (1,173,446 )      -88.9 %      (1,573,197 )      -43.2 %

  Income tax benefit (expense)        (17,815 )       -1.3 %         494,707         13.6 %


  Net loss                       $ (1,191,261 )      -90.2 %    $ (1,078,490 )      -29.6 %


  Net loss per common share      $      (0.06 )                 $      (0.06 )

Net Sales

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



                              Three Months Ended
                                   June 30,                     Change
                              2009          2008         Dollars         Percent
         Loose jewels      $   994,650   $ 3,454,911   $ (2,460,261 )        -71 %
         Jewelry               322,323       146,122        176,201          121 %
         Other                   3,234        38,644        (35,410 )        -92 %

         Total net sales   $ 1,320,207   $ 3,639,677   $ (2,319,470 )        -64 %

Net sales were $1,320,000 for the three months ended June 30, 2009 compared to $3,640,000 for the three months ended June 30, 2008, a decrease of $2,319,000 or 64%. Carat sales of moissanite jewels and jewelry decreased 67% to approximately 7,000 carats from 21,000 carats. Sales of moissanite jewelry represented 24% of total net sales compared to 4% 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 latter part of 2009 unless we can identify alternate channels for this inventory. The average selling price per carat for our sales of loose jewels remained relatively consistent between the periods. U.S. net sales accounted for approximately 52% and 62% of net sales during the three months ended June 30, 2009 and 2008, respectively.

U.S. net sales and carat shipments, which do not include shipments of consigned inventory, decreased by 69% and 78%, respectively, for the three months ended June 30, 2009 as compared to the three months ended June 30, 2008. U.S. sales decreased primarily due to the ongoing significant slowdown in the retail environment, reduced sales and excessive inventory of moissanite jewelry at retailers, reduced purchases from jewelry manufacturers serving major retailers that sell moissanite jewelry, and the effect of a special pricing promotion we held in March 2009 that accelerated some planned second quarter purchases into the first quarter. 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 saw no significant orders during the three months ended June 30, 2009 from our 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 months ended June 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 have decided not to continue carrying moissanite jewelry. As other former retailers of Reeves Park potentially transition to new manufacturers, we will likely 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 months ended June 30, 2009, and it accounted for almost 10% of our sales during the same period of 2008.

Our two largest customers during the three months ended June 30, 2009 accounted for 21% and 14%, respectively, of our sales compared to 0% and 4%, respectively, during the same period of 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.

International net sales and carat shipments, which do not include shipments of consigned inventory, decreased by 55% and 53%, respectively, for the three months ended June 30, 2009 as compared to the three months ended June 30, 2008. International sales decreased primarily due to reduced sales to India and the United Kingdom. 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 months ended June 30, 2009 were located in Italy, Hong Kong, and the United Kingdom.

Gross Profit

Gross profit for the three months ended June 30, 2009 and 2008 are as follows:



                                 Three Months Ended
                                      June 30,                        Change
                               2009            2008            Dollars         Percent
      Gross profit           $ 670,553      $ 2,089,173      $ (1,418,620 )        -68 %
      Percent of net sales        50.8 %           57.4 %

Gross profit was $671,000 for the three months ended June 30, 2009 compared to $2,089,000 for the three months

ended June 30, 2008, a decrease of $1,419,000 or 68%. As a percentage of sales, gross profit decreased to 51% from 57% in the same period of 2008. The decreased gross profit percentage was primarily caused by an increased allocation of expenses, previously capitalized as a cost of inventory, to cost of sales as a result of reduced manufacturing activities; and a $100,000 increase to our jewelry scrap value reserve estimate due to a certain customer's recent decision to cancel remaining scheduled trunk shows after September 2009. The decreased gross profit percentage was offset in part by the write-off during the three months ended June 30, 2008 of a portion of the consigned jewels returned to us in damaged condition by K&G Creations, or K&G, that resulted in an approximate 4% reduction in our gross profit percentage during that period.

Operating Expenses

Sales and Marketing

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



                                 Three Months Ended
                                      June 30,                        Change
                               2009            2008            Dollars         Percent
      Sales and marketing    $ 496,425      $ 1,897,024      $ (1,400,599 )        -74 %
      Percent of net sales        37.6 %           52.1 %

Sales and marketing expenses were $496,000 for the three months ended June 30, 2009 compared to $1,897,000 for the three months ended June 30, 2008, a decrease of $1,401,000 or 74%. As a percentage of sales, these expenses decreased to 38% from 52% in the same period of 2008. The decrease in expenses is primarily due to a $518,000 decrease in advertising expenses and a $474,000 decrease in compensation costs. 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. Our co-op advertising expense decreased by $316,000 due to lower sales. Our direct advertising costs decreased by $202,000 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 in our continuing effort to reduce costs.

General and Administrative

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



                                     Three Months Ended
                                          June 30,                        Change
                                   2009             2008           Dollars        Percent
   General and administrative   $ 1,220,650      $ 1,782,423      $ (561,773 )        -32 %
   Percent of net sales                92.5 %           49.0 %

General and administrative expenses were $1,221,000 for the three months ended June 30, 2009 compared to $1,782,000 for the three months ended June 30, 2008, a decrease of $562,000 or 32%. As a percentage of sales, these expenses increased to 93% from 49% in the same period of 2008. The decrease in expenses is primarily due to a $457,000 reduction in bad debt expense and a $248,000 decrease in compensation costs, offset in part by $225,000 in fees paid to Bird Capital Group, Inc., or BCG, under its February 2009 management services agreement with us, or the BCG Agreement. During the three months ended June 30, 2008, we increased our allowance for bad debts by $475,000 to fully reserve the outstanding balance due from K&G. The decrease in compensation costs is primarily attributable to headcount reductions in our continuing effort to reduce costs. We expect general and administrative expenses to decrease in the latter half of 2009 from the level of expenses incurred during the first half of 2009 as a result of our termination of the BCG Agreement.

Research and Development

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



                                     Three Months Ended
                                          June 30,                    Change
                                      2009          2008         Dollars    Percent
        Research and development   $  135,511      $ 9,087      $ 126,424     1,391 %
        Percent of net sales             10.3 %        0.2 %

Research and development expenses were $136,000 for the three months ended June 30, 2009 compared to $9,000 for the three months ended June 30, 2008, an increase of $126,000 or 1,391%. As a percentage of sales, these expenses increased to 10% from less than 1% in the same period of 2008. Of the increase in expenses, $100,000 is 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 be significantly less in the latter half of 2009 as we focus on reducing our current inventory levels.

Interest Income

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



                                  Three Months Ended
                                       June 30,                      Change
                                  2009           2008         Dollars       Percent
         Interest income        $   8,587      $ 26,164      $ (17,577 )        -67 %
         Percent of net sales         0.6 %         0.7 %

Interest income was $9,000 for the three months ended June 30, 2009 compared to $26,000 for the three months ended June 30, 2008, a decrease of $18,000 or 67%. This decrease resulted primarily from a lower interest rate earned on our cash balances.

Results of Operations for the Six Months Ended June 30, 2009 and June 30, 2008

The following table sets forth certain statements of operations data for the
periods indicated:



                                     Six Months Ended               Six Months Ended
                                       June 30, 2009                  June 30, 2008
                                                    % of                           % of
                                   Dollars         Revenue        Dollars         Revenue
  Net sales                      $  3,805,395        100.0 %    $  7,043,560        100.0 %
  Cost of goods sold                1,731,963         45.5 %       2,707,591         38.4 %


  Gross profit                      2,073,432         54.5 %       4,335,969         61.6 %

  Operating expenses                4,505,124        118.4 %       7,044,916        100.0 %


  Loss from operations             (2,431,692 )      -63.9 %      (2,708,947 )      -38.4 %

  Interest income                      18,848          0.5 %          74,723          1.0 %


  Loss before income taxes         (2,412,844 )      -63.4 %      (2,634,224 )      -37.4 %

  Income tax benefit (expense)        (44,917 )       -1.2 %         857,649         12.2 %

Net loss per common share $ (0.13 ) $ (0.10 )

Net Sales

Net sales for the six months ended June 30, 2009 and 2008 comprise the following:

                               Six Months Ended
                                   June 30,                     Change
                              2009          2008         Dollars         Percent
         Loose jewels      $ 3,023,619   $ 6,768,376   $ (3,744,757 )        -55 %
         Jewelry               770,471       194,011        576,460          297 %
         Other                  11,305        81,173        (69,868 )        -86 %

         Total net sales   $ 3,805,395   $ 7,043,560   $ (3,238,165 )        -46 %

Net sales were $3,805,000 for the six months ended June 30, 2009 compared to $7,044,000 for the six months ended June 30, 2008, a decrease of $3,238,000 or 46%. Carat sales of moissanite jewels and jewelry decreased 49% to approximately 20,000 carats from 39,000 carats. Sales of moissanite jewelry represented 20% of total net sales 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 latter part of 2009 unless we can identify alternate channels for this inventory. The average selling price per carat for our sales of loose jewels decreased 8% primarily as a result of sales promotions in the first quarter of 2009. U.S. net sales accounted for approximately 64% and 66% of net sales during the six months ended June 30, 2009 and 2008, respectively.

U.S. net sales and carat shipments, which do not include shipments of consigned inventory, decreased by 48% and 60%, respectively, for the six months ended June 30, 2009 as compared to the six months ended June 30, 2008. U.S. sales decreased 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 saw no significant orders during the six months ended June 30, 2009 from our 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 six months ended June 30, 2009 was the termination of our manufacturing agreement with Reeves Park during the . . .