| APPLIANCE RECYCLING CENTERS OF AMERICA INC /MN ITEM 1A RISK FACTORS An investment in our Common Stock involves a high degree of risk |
| You should carefully consider the risks described below with respect to an investment in our shares |
| If any of the following risks actually occur, our business, financial condition, operating results or cash provided by operations could be materially harmed |
| As a result, the trading price of our Common Stock could decline, and you might lose all or part of your investment |
| When evaluating an investment in our Common Stock, you should also refer to the other information in this report, including our financial statements and related notes |
| Risks Related to ARCA Our strategy of opening new retail stores has resulted in net losses in recent periods |
| Our primary growth strategy is to open new retail stores |
| We evaluate demographic, economic and financial information in considering a new store location |
| We primarily look in markets in which we currently have operations, for additional operational and marketing efficiencies of scale |
| New stores take time to become profitable; we cannot assure you that any individual current or future store will attain or maintain projected profitability |
| Our full financial information is set out in the financial statements and related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations |
| We expect this dependence on retail sales to continue in the future |
| Most of our revenues are derived from retail sales of appliances from our ApplianceSmart retail stores |
| We currently operate thirteen ApplianceSmart stores |
| Retail revenues have lower profit margins than recycling revenues |
| We believe that our future economic results will be heavily dependent on our retail stores |
| In fiscal 2003, 2004 and 2005, approximately 80prca, 79prca and 83prca, respectively, of our revenues were from retail sales |
| We currently expect that retail revenues will account for approximately 87prca of total revenues for 2006 |
| However, we cannot assure you that sales from our stores will grow at the rates we currently anticipate |
| Our revenues from recycling contracts have declined, and future revenues from this source are very difficult to project |
| In the past, our business was dependent largely upon our ability to obtain new contracts and continue existing contracts for appliance recycling services with utility companies |
| Contracts with these entities generally have initial terms of one to four years, with renewal options and early termination clauses |
| The recycling and byproducts portion of our business has diminished from approximately 50prca of total revenues in fiscal 2001 to 12 ______________________________________________________________________ 16dtta7prca of total revenues in fiscal 2005, partially due to decreased sponsorship of energy conservation programs by utilities |
| However, we are still dependent on certain customers for a large portion of our revenues |
| Generally, recycling revenues have a higher gross profit than retail revenues |
| Our major utility customer, Southern California Edison Company (Edison), accounted for approximately 9prca of revenues for 2003, 2004 and 2005 |
| The loss or material reduction of business from Edison, or any major customer, could adversely affect our net revenues and profitability |
| We have submitted a proposal for the continuation of Edison’s refrigerator recycling program for the years 2006-2008 |
| If awarded to us, the contract would not provide for a minimum number of refrigerators to be recycled, and the timing and amount of revenues would be dependent on Edison’s advertising |
| We cannot assure you that our existing recycling contracts will be continued or renewed, that existing customers, including Edison, will continue to use our services at current levels, or that we will be successful in obtaining new recycling contracts |
| Our revenues from recycling contracts are subject to seasonal fluctuations and are dependent on the utilities’ advertising and promotional activities, which are outside our control |
| In our business with utility companies, we experience seasonal fluctuations that impact our operating results |
| Our recycling revenues are generally higher during the second and third calendar quarters and lower in the first and fourth calendar quarters, due largely to advertising and promotional activity schedules managed by the utilities |
| We expect that we will continue to experience such seasonal fluctuations in recycling revenues |
| We experience less seasonal fluctuation in our retail business |
| We may need new capital to fully execute our growth strategy |
| Our business involves providing comprehensive, integrated appliance recycling services and developing a chain of retail stores |
| This commitment will require a significant continuing investment in capital equipment and leasehold improvements and could require additional investment in real estate |
| Our total capital requirements will depend, among the other things discussed in this annual report, on the number of recycling centers and the number and size of retail stores operating during 2006 |
| Currently, we have thirteen retail stores and four recycling centers in operation |
| If our revenues are lower than anticipated or our expenses are higher than anticipated or our current line of credit cannot be maintained, we will require additional capital to finance our operations |
| Even if we are able to maintain our current line of credit, we may need additional equity or other capital in the future |
| Sources of additional financing, if needed in the future, may include further debt financing or the sale of equity (including the issuance of preferred stock) or other securities |
| We cannot assure you that any additional sources of financing or new capital will be available to us, or available on acceptable terms, or permitted by the terms of our current debt |
| In addition, if we sell additional equity to raise funds, all outstanding shares of Common Stock will be diluted |
| A decline in general economic conditions could lead to reduced consumer demand for our products and have an adverse effect on our liquidity and profitability |
| Since purchases of our merchandise are dependent upon discretionary spending by our retail customers, our financial performance is sensitive to changes in overall economic conditions that affect consumer spending |
| Consumer spending habits are affected by, among other things, prevailing economic conditions, levels of employment, salaries and wage rates, consumer confidence and consumer perception of economic conditions |
| A general or perceived slowdown in the United States economy or uncertainty as to the economic outlook could reduce discretionary spending or cause a shift in consumer discretionary spending to other products |
| Any of these factors would likely cause us to delay or slow our expansion plans, reduce net sales and potentially result 13 ______________________________________________________________________ in excess inventories |
| This could, in turn, lead to increased merchandise markdowns and related costs associated with higher levels of inventory that could adversely affect our liquidity and profitability |
| Our market share may be adversely impacted at any time by a significant number of competitors |
| Competition for our retail stores comes from retailers of new and used appliances |
| Each of our separate locations will compete not only with local and national chains of new appliance retailers, many of whom have been in business longer than we have and who may have significantly greater assets, but will also be required to compete with numerous independently owned retailers of used appliances |
| A number of our retail operations have been opened within the past 24 months; therefore, we cannot assure you that we will be able to compete effectively in any such market |
| While recycling revenues could become a smaller part of our business for the foreseeable future, many factors, including existing and proposed governmental regulation, may affect competition in the industry |
| We generally compete with two or three companies based in the geographic area to be served and they generally offer some of the services we provide |
| We expect our primary competition for contracts with existing or new customers to come from entrepreneurs entering the appliance recycling business, energy management consultants, current recycling companies, major waste hauling companies, scrap metal processors and used appliance dealers |
| In addition, some of our customers, such as utility companies, may operate appliance recycling programs internally rather than contracting with us or other third parties |
| We cannot assure you that we will be able to compete profitably in any of our chosen markets |
| Changes in governmental regulations relating to our recycling business could increase our costs of operations and adversely affect our business |
| Our appliance recycling centers are subject to various federal, state and local laws, regulations and licensing requirements related to the collection, processing and recycling of household appliances |
| These requirements may vary by market location and include, for example laws, concerning the management of hazardous materials and the 1990 Amendments to the Clean Air Act, which require us to recapture CFC refrigerants from appliances to prevent the release of CFCs into the atmosphere |
| We have registered our centers with the EPA as hazardous waste generators and have obtained required licenses from appropriate state and local authorities |
| We have agreements with approved and licensed hazardous waste companies for transportation and recycling or disposal of hazardous materials generated through our recycling processes |
| As is the case with all companies handling hazardous materials, under some circumstances we may be subject to contingent liability |
| In 1992, Congress adopted the Federal Energy Policy Act of 1992 to encourage energy efficiency |
| One component of this Act allows for deregulation of the nation’s energy providers, including the electric utility industry |
| The immediate impact of the potential of industry deregulation caused utility companies across the US to suspend their plans for implementing appliance recycling programs like ours |
| Our lender has the right to demand payment in full of the borrowings under our line of credit at any time |
| If it were to do so, we would not be able to pursue our growth strategy and our operations would be severely limited unless and until new financing was obtained |
| We have an dlra8dtta0 million line of credit with a stated maturity date of December 31, 2007 |
| The line of credit also provides that the lender may demand payment in full of the entire outstanding balance of the loan at any time |
| We have pledged substantially all our assets to secure payments under the line |
| The line requires that we meet certain financial covenants, provides payment penalties for noncompliance and prepayment, limits the amount of other debt we can incur, limits the amount of spending on fixed assets, and limits payments of dividends |
| At 14 ______________________________________________________________________ March 3, 2006, borrowings of dlra5cmam719cmam000 were outstanding under the line of credit, and we had unused borrowing capacity of dlra71cmam000 |
| We may not be able to operate successfully if we lose key personnel, are unable to hire qualified personnel, or experience turnover of our management team |
| We believe our operations are materially dependent upon the continued services of our present management |
| The loss of services of one or more members of present management, including Edward R (Jack) Cameron, our founder, Chairman of the Board and current CEO, could adversely affect our business |
| We do not have employment contracts with present management |
| We maintain key person insurance on the life of Mr |
| A competitor recently obtained a patent that covers appliance recycling methods and systems that we believe were developed by us |
| We are seeking a permanent injunction barring the use of the patent in marketing their recycling services |
| We may incur substantial costs in pursuing this injunction, which could have an adverse effect on our results of operations |
| In December 2004, we filed suit in the US District Court for the Central District of California alleging that JACO Environmental, Inc |
| and a former consultant of the company fraudulently obtained a patent (US Patent Nodtta 6cmam732cmam416) in May 2004 covering appliance recycling methods and systems originally developed by us beginning in 1987 and used in serving more than forty electric utility appliance recycling programs since that time |
| In September 2005, we received a legally binding document in which JACO states it will not sue us or any of our customers for violating JACO’s recycling patent |
| Therefore, our recycling operations will continue with our current contracts without interruption |
| We are continuing to seek a permanent injunction barring JACO from using the patent to market JACO’s recycling services, due to our belief that the patent is invalid and unenforceable |
| We are also asking the court for unspecified damages related to charges that JACO, in using the patent to promote its services, has engaged in unfair competition and false and misleading advertising under federal and California statutes |
| Also, we may incur substantial costs in pursuing this injunction, which could have an adverse effect on our results of operations |
| Risks Related to Our Common Stock If an active trading market for our Common Stock does not develop, the value and liquidity of your investment in our Common Stock could be adversely affected |
| On February 22, 2006, our Common Stock began trading on the Nasdaq Capital Market |
| Previously, it was traded on the OTC Bulletin Board and the trading volumes were low |
| There may be only a limited market for any shares of Common Stock that you purchase |
| The public sale of our Common Stock by the selling shareholders or by other shareholders could adversely affect the price of our Common Stock |
| The trading volumes in our Common Stock are low compared to the number of shares that may be sold by the selling shareholders |
| Sales of substantial amounts of Common Stock into the public market by the selling shareholders or by our other shareholders could adversely affect the market price for our Common Stock |
| Our principal shareholders own a large percentage of our voting stock, which will allow them to control substantially all matters requiring shareholder approval |
| Currently, Edward R (Jack) Cameron, Chairman and CEO, owns approximately 8prca of our outstanding shares of Common Stock |
| Our officers and directors together hold approximately 17prca, including any options or 15 ______________________________________________________________________ warrants they may hold |
| One of our principal lenders, Medallion Capital, Inc, owns approximately 13prca of our outstanding shares |
| Medallion also has a non-voting right to attend and participate in all Board meetings |
| beneficially owns approximately 16prca of our outstanding shares |
| beneficially owns approximately 9prca of our outstanding shares |
| Because of such ownership, our management and principal shareholders may be able to significantly affect our corporate decisions, including the election of the Board of Directors |