| CHARLES & COLVARD LTD ITEM 1A RISK FACTORS In addition to the other information in this Form 10-K, you should carefully consider the following important factors that in some cases have affected, and in the future could affect, our actual performance and results and could cause our actual results of operations to differ materially from those expressed in any of our forward-looking statements |
| Our business operations could be adversely affected if we do not manage our growth effectively |
| Our strategy will require us to achieve rapid growth while limiting expenditures and motivating our employee base |
| Periods of rapid growth may place a significant strain on our personnel and other resources |
| We will continue to be required to manage multiple relationships with various customers and other third parties |
| Our strategy is to rapidly commercialize moissanite jewels by building consumer brand awareness and growing distribution channels for our jewels |
| The timing of or potential for a significant increase in revenues is dependent on increasing market acceptance of moissanite jewels and increasing distribution and sales |
| Our business may also be subject to risks inherent in rapid increases in sales and production levels |
| Likewise, our products are subject to risks inherent in the development and marketing of new products, including unforeseen design, manufacturing or other problems or failure to develop market acceptance |
| Failure by us to expand distribution and achieve market acceptance of our products or to develop the ability to produce our products in higher quantities, while maintaining quality, would have a material adverse effect on our business, operating results and financial condition |
| Accordingly, our prospects must be considered in light of the risks and difficulties frequently encountered by companies in a growth stage of development, particularly operating in the early stages of manufacturing and distributing unproven products |
| If we are unable to manage growth effectively, our business, financial condition and results of operations would be materially adversely affected |
| Our future financial performance depends upon continued growth and consumer acceptance of our products |
| We believe that many retail jewelers and most consumers are not generally aware of the existence and attributes of moissanite jewels |
| The market for moissanite jewels among retail jewelers and consumers is in the early stages of development, as we shipped approximately 255cmam000 carats during the year ended December 31, 2005 |
| The degree of future market acceptance and demand are subject to a significant amount of uncertainty |
| Our future financial performance will depend upon greater consumer acceptance of the Company’s moissanite jewels as distinct from all other jewels based on their fire, brilliance, luster, durability and rarity |
| In addition, consumer acceptance may be impacted by retail jewelers’ and jewelry manufacturers’ acceptance of moissanite jewels |
| The quality, design and workmanship of the jewelry settings selected by retail jewelers, which is not within our control, could impact our consumers’ perception and acceptance of our jewels |
| Thus, our future financial performance may be impacted 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 |
| 16 ______________________________________________________________________ [17]Table of Contents If our products do not receive greater market acceptance, our business, operating results and financial condition would be materially adversely affected |
| We are substantially dependent on the sale of our jewels in North America through K&G Creations (a jewelry manufacturer and distributor), Reeves Park (a jewelry manufacturer) and Stuller Settings, Inc |
| (a jewelry distributor and manufacturer) as well as a limited number of other distributors and jewelry manufacturers |
| We anticipate that the majority of the moissanite jewels that we sell in North America will be distributed through K&G Creations, Reeves Park and Stuller as well as a limited number of other manufacturers and distributors, and therefore, we are substantially dependent upon these companies for distribution of moissanite jewels in North America |
| Through our efforts with Reeves Park, JCPenney was the first national retail chain to carry moissanite jewelry |
| Through our efforts with K&G Creations moissanite jewelry was rolled out to a portion of the department stores whose jewelry counters are leased to Finlay Enterprises |
| We expect that, at least over the short-term, we will remain dependent on our ability and that of our manufacturing customers to maintain and enhance the JCPenney and Finlay programs |
| A prolonged economic downturn and the uncertainties caused by war or terrorism could adversely affect our operations |
| Purchases of jewelry, including purchases of our products, may be affected by any prolonged, negative trends in the general economy that adversely affect consumer spending |
| Any reduction in consumer confidence or disposable income may adversely affect jewelry companies, in general, and our Company, in particular, more significantly than companies that rely less on discretionary consumer spending |
| Further, the affect that war and possible additional terrorist attacks may have on consumers and the economies of the United States, as well as other countries in which our products are sold, is unpredictable and uncertain |
| Any significant reduction in demand for our products would have a material adverse affect on our results of operations and could, if it continued, have a material adverse affect on our financial condition |
| We are subject to certain risks due to our international distribution channels and vendors |
| Charles & Colvard created moissanite jewels are currently being distributed in substantially all of Western Europe, Australia, India, and certain countries in Southeast Asia and the Middle East |
| We currently have a total of approximately 25 international distributors |
| 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; • unexpected changes in, or impositions of, legislative or regulatory requirements; • delays resulting from difficulty in obtaining export licenses; • 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 all foreign transactions are denominated in US 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 currently depend upon Cree for the supply of a substantial majority of our SiC crystals |
| We currently depend on Cree for the supply of a substantial majority of SiC crystals that we use in our 17 ______________________________________________________________________ [18]Table of Contents business |
| Cree has certain proprietary rights relating to its process for growing large single crystals of SiC and its process for growing colorless SiC crystals |
| Under our Exclusive Supply Agreement with Cree, we are obligated to buy from Cree, and Cree is obligated to sell to us, at least 50prca, by dollar volume, of our requirements for SiC material for the production of gemstones in each calendar quarter |
| In February 2005, we entered into an Exclusive Supply Agreement with Norstel AB, however, Norstel AB has only demonstrated that it can produce suitable raw material in limited quantities and is not expected to produce significant amounts of moissanite at least until after mid-2006 when its new plant which is currently under construction is scheduled to become operational |
| In November 2005, we signed an agreement with Intrinsic Semiconductor who has not as yet proven that they can produce significant amounts of moissanite at a quality acceptable to us |
| Therefore, we remain dependant on Cree for a substantial majority of our principal raw material |
| While Cree has improved its production processes and is currently producing SiC crystals sufficient to meet our requirements, we experienced difficulties in the past in obtaining crystals from Cree in the quality, sizes and volumes that we desired |
| We from time to time enter into purchase agreements with Cree with respect to our purchase commitments and the specific timing, pricing and other terms of future delivery of SiC crystals |
| There can be no assurance that Cree will be able to continue to produce and supply us with raw materials of sufficient quality, sizes and volumes that we desire nor that we will successfully negotiate purchase commitments that enable us to manage our inventories and raw material costs effectively |
| In addition, although Norstel AB and Intrinsic Semiconductor represent potential additional sources of supply, Norstel AB and Intrinsic Semiconductor do not presently have the capacity to produce significant quantities of SiC of suitable quality and sizes, and there can be no assurance that they will ever develop these capabilities |
| 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 |
| We also have other patents and patent applications pending related to certain methods of producing moissanite jewels and related technologies |
| There can be no assurance that any other patents will be granted or that any issued patent will have any commercial or competitive value |
| 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 colorless SiC crystals |
| If Norstel AB and Intrinsic Semiconductor become significant additional sources of supply, we will also become dependent on their technology |
| There can be no assurance that any patents issued to or licensed by or to us, Cree, Norstel AB, or Intrinsic Semiconductor will provide any significant commercial protection, that we, Cree, Norstel AB, or Intrinsic Semiconductor will have sufficient resources to prosecute 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 |
| The existence of valid patents does not prevent other companies from independently developing competing technologies as evidenced by our agreements with Norstel AB and Intrinsic Semiconductor |
| Existing producers of SiC 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 or Cree |
| In addition, existing producers of SiC, existing producers of other synthetic or natural gemstones or other parties may develop new technologies for producing moissanite jewels in a manner that does not infringe patents owned or licensed by us or Cree |
| 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 |
| 18 ______________________________________________________________________ [19]Table of Contents Our success depends upon our ability to identify, reach agreements with and work successfully with third parties |
| In addition to our current dependence on Cree and on third party distribution channels, our prospects depend upon our ability to identify, reach agreements with and work successfully with other third parties |
| In particular, we rely on third parties to facet our jewels |
| Faceting moissanite jewels requires different techniques than faceting diamond and other gemstones |
| There can be no assurance that we can maintain our relationships with our faceting vendors on terms satisfactory to us or that faceting vendors will continue to be able to provide faceting services in the quality and quantities required by us or that we will be able to find suitable replacements if we are unable to maintain such relationships |
| Our failure to achieve any of the above would 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 |
| Our reputation amongst jewelers and consumers could be damaged if low-quality gemstones or synthetics are marketed as moissanite |
| It is possible that low-quality gemstones or other synthetics could be marketed as moissanite |
| The sale of low-quality products as moissanite could damage our ability to foster the perception of moissanite as a unique jewel that compares favorably to other fine gemstones like diamond, ruby and emerald |
| This could damage our reputation among retail jewelers and consumers and result in a loss of consumer confidence in our products |
| The introduction of low-quality imitation moissanite jewels and our inability to limit the adverse effects thereof could have a material adverse effect on our business, operating results and financial condition |
| 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 all of our shareholders |
| Under the terms of the Exclusive Supply Agreement, 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 Exclusive Supply Agreement with Cree 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 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 |
| 19 ______________________________________________________________________ [20]Table of Contents 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 2009, will be exercisable only if a person or group acquires 20prca or more of our common stock or announces a tender offer for 20prca or more of the common stock |
| If a person or group acquires 20prca or more of our common stock, all shareholders except the purchaser will be entitled to acquire our common stock at a 50prca discount |
| The effect will be to discourage acquisitions of more than 20prca of our common stock without negotiations with the Board of Directors of the Company |
| 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 20prca of our common stock |