Charles & Colvard, Ltd. 2006 Annual Reportmedia.corporate-ir.net/media_files/IROL/95/95566/ar/ar_2006.pdf · Charles & Colvard, Ltd. 2 Letter to Shareholders 5 Selected Financial

CHARLES & COLVARD®

2006ANNUAL REPORT

ON THE COVER:

Designs by izzy for Quadamas

TABLE OF CONTENTS

1

Charles & Colvard, Ltd.

2 Letter to Shareholders

5 Selected Financial Data

6 Management’s Discussion & Analysis of Financial Condition & Results of Operations

12 Quantitative and Qualitative Disclosures About Market Risk

13 Management’s Annual Report on Internal Control over Financial Reporting

14 Report of Independent Registered Public Accounting Firm

16 Consolidated Financial Statements

20 Notes to Consolidated Financial Statements

28 Stock Performance Graph

Corporate Information

Annual Report 2006

Dear Shareholders:

During 2006, we broadened our manufacturing customer base, increased consumer awareness,introduced our beautiful jewel - Charles & Colvard created Moissanite™ - into a number of new retailchains and grew our overall level of profitability, all of which we believe has established a baseline forfuture growth. These accomplishments occurred while one of our largest manufacturing customers wasnegatively impacted by mergers and consolidation at the department store level, and the closing of theShopatHome television network. The net effect was that our revenues decreased to $40.7 millioncompared to $43.5 million in the prior year. However, our gross margins for 2006 remained very strong,increasing to 73.5% of sales compared to 66.8% in the prior year, and we ended the year with net incomeof $6.1 million, or $0.33 per diluted share.

DOMESTIC SALES

Orders from our manufacturing customers, other than from the one manufacturer discussed above,remained healthy throughout the year. We continued to make progress with new retailers which furtherincreased our distribution and expanded our overall customer base. We continued to work aggressivelyto add new points of distribution among mall jewelers, department stores, independent sellers, anddistance sellers, which include television shopping channels as well as catalog and internet sellers, andwe believe our efforts will result in continued improvement to our business going forward.

In 2006, we expanded our overall door count and introduced our product into many new, high profilelocations. We continued to work to broaden our customer base through our various channels ofdistribution. During 2006, Samuel Aaron International and Alarama, two domestic jewelrymanufacturers, became more significant direct customers. Both are large, well-established suppliers tothe North American jewelry market and both sell to a majority of the major North American jewelryretailers.

As the number of retailers selling moissanite jewelry has grown and we have gained distribution withprominent regional and national outlets, we believe we are beginning to see the benefit of ourdistribution model. By combining the manufacturers’strength in jewelry design and program executionwith our beautiful jewel, our distribution message is that we can provide a compelling revenue pipelineto retailers. During 2006, several manufacturers successfully introduced or expanded their distributionof moissanite with multi-door chains. Based on the results of a 2005 test distribution of moissanite,Helzberg Diamonds began distribution at all 270 of its stores during 2006. Each of the Zales Outlet andPeoples & Mappins Jewelers (both of which are divisions of Zale Corporation) initiated trunk showsduring 2006, which resulted in an in-case program at 28 and 41 stores at December 31, 2006,respectively. In October 2006, test distribution of moissanite jewelry manufactured by Samuel AaronInternational began in 208 stores of the 800-door department store chain, Kohl’s. We also began testingmoissanite during 2006 at 22 Chicago locations of the 900-door department store chain, Sears. Inaddition, the Home Shopping Network (HSN) aired 9 hours of moissanite jewelry shows during 2006and has agreed to increase the number of hours of moissanite jewelry shows to 25 during 2007.

INTERNATIONAL SALES

We have successfully grown distribution of moissanite jewelry through various foreign TV retailers,which is similar to the early distribution of moissanite jewelry in the United States. Specifically, we havedeveloped relationships with our manufacturing customers that supply moissanite jewelry to IdealWorld Shopping in the UK, VIVA TV Network in Taiwan, HSE in Germany, Jupiter Shop Channel inJapan, and M6 Boutique La Chaine in France. We believe that we are positioned for future growth inthis distribution channel.

We have also continued our investment in the Asian market. Our Hong Kong office is working onobtaining business relationships that will expand our distribution through Southeast Asia. One of thosemanufacturing customers, Aaron Shum Jewelry, Ltd., is supplying the test distribution at Gordon’s

LETTER TO SHAREHOLDERS

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Jewelers in the United States and has successfully introduced fine moissanite jewelry to its retail outletsin the United Arab Emirates.

MARKETING

Over the past year, we have worked diligently to raise consumer appreciation and awareness ofmoissanite jewels both domestically and abroad. A recently completed third-party study shows that ourefforts in this area continue to be effective. In 2006, consumer awareness for moissanite within the U.S.increased from 7.8% at the end of 2005 to 10.5% at the end of 2006. We will continue to workambitiously to build consumer awareness and demand for moissanite jewelry in the coming quarters todrive sales within our multiple channels of distribution.

Our marketing and public relations efforts in 2007 will focus on increasing moissanite awareness,interest and purchase intent at the consumer level, which we believe will increase demand formoissanite jewels within our primary market – self-purchasing women. We intend to increase consumeradvertising, promotion, product placement opportunities, sponsorship opportunities and an expandedpublicity/public relations effort, headed by a new public relations firm, continuous sales training for thesales associates at the retail level, and individually tailored sales and marketing programs designed forspecific retailers in order to increase moissanite awareness.

In 2006, Charles & Colvard participated as a major sponsor for three significant jewelry trade events: theInternational Gemological Research Conference (GRC) during the Gemological Institute of America’sSymposium; CIBJO: The World Jewellery Confederation; and the CEO Summit sponsored by the U.S.trade leadership conference.

We expect that Charles & Colvard will continue to participate in the leading worldwide jewelry tradeshows, either as a sponsor, exhibitor or a participant assisting our manufacturing customers. In 2006,we exhibited in the JCK Invitational in New York, Baselworld 2006 in Switzerland, Hong Kong JewelleryShow and the JCK Las Vegas show. We also participated in the Great Britain Jewellery Fair inBirmingham, UK, the More Show (Italy), and attended the Jewelers of America shows in New Yorkduring 2006. In 2007, we plan to exhibit at Baselworld 2007, JCK Las Vegas, and the Hong KongJewellery Shows and we will assist our manufacturing customers as a participant in other internationaljewelry trade expositions.

We plan to continue our marketing message into 2007 as the jewelry trade has increasingly acceptedselling this new moissanite jewelry category. Moreover, we believe that no other jewel occupies themarketing niche called “reward for achievement”, specifically focusing on women self-purchasers. Weexpect to continue marketing moissanite to its primary consumer market, the self-purchasing woman,and positioning moissanite as the perfect reward or indulgence for a woman celebrating herachievements, large or small, personal or professional.

FOCUS ON THE FUTURE

I believe that we have made good progress in establishing Charles & Colvard created Moissanite as anentirely new category of fine jewelry in the minds of the merchants of the jewelry industry bydemonstrating that when our jewel is properly positioned, described and sold at retail counters,consumers happily purchase moissanite jewelry. Our challenge is to now build on that accomplishmentby growing awareness and demand for our jewel both in North America and internationally.

Looking ahead, we intend to strengthen our marketing position by continuing to increase domesticdistribution and will continue to engage other domestic retailers in conversations as well.Internationally, we have seen an increase in the number of contacts initiated by jewelry manufacturersand retailers in foreign markets and we will continue to engage those companies in meaningfuldiscussions about how we can expand our distribution in various off-shore markets. Increased access toboth markets can contribute to our future growth.


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We also expect to add new direct manufacturing customers who can provide Charles & Colvard accessto new retail points of distribution both internationally and in North America. By adding a smallnumber of established and well-respected jewelry manufacturers, we believe we can accelerate ourgrowth.

It is important that we grow the overall awareness and the demand for moissanite jewelry as we increasedistribution so that each of the retailers can enjoy increasing sales volumes going forward. In that effort,we will work with existing moissanite retailers and their jewelry suppliers, our direct customers, tobroaden their existing moissanite collections to offer more styles at the correct price points. We willspend appropriately to support our direct customers and those retailers who have fully adopted ourpositioning in this effort. We will continue to concentrate our efforts and resources to work withcustomers who have strong jewelry counters and who support the moissanite category of fine jewelry bydedicating good display space, allowing us to train their sales associates and actively participating in thesales and promotional activities that we plan and execute in cooperation with the retailer and theirmoissanite jewelry supplier. Our experience has repeatedly confirmed that once a retailer understandsthat our product can improve their overall margins and increase their average sales price withoutcannibalizing existing revenue streams, they become strong believers in the category and in our brand.Conversely, where we have not been allowed direct access to the retailers, and did not have a direct rolein creating and executing the training of sales associates and the marketing effort, typically thoseretailers have not been successful over time and several have reportedly exited the moissanite category.

Charles & Colvard has a tremendous opportunity to raise awareness of and enhance our marketopportunity for moissanite jewelry in the coming fiscal year. Our commitment to overall growth,operational excellence and product quality requires the hard work and talent of all our dedicatedemployees, manufacturers and distributors. I appreciate their commitment and would also like to thankour loyal shareholders and customers for their continued support.

Robert S. ThomasChairman & Chief Executive Officer

SELECTED FINANCIAL DATA

The following selected statement of operations data for the years ended December 31, 2006, 2005 and 2004, and the selected balancesheet data at December 31, 2006 and 2005 have been derived from, and are qualified by reference to, our consolidated financial statementsincluded elsewhere in this report which have been audited by Deloitte & Touche LLP, our independent registered public accounting firm.The selected statement of operations data for the years ended December 31, 2003 and 2002 and the selected balance sheet data atDecember 31, 2004, 2003 and 2002 have been derived from audited consolidated financial statements not included herein. The selectedfinancial data set forth below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition andResults of Operations”and the Financial Statements and Notes thereto included elsewhere in this report.

Year Ended December 31, 2006 2005 2004 2003 2002STATEMENTS OF OPERATIONS DATA

Net sales $40,712,085 $ 43,544,090 $ 23,917,045 $ 17,240,383 $ 16,513,515

Cost of goods sold 10,795,224 14,463,410 8,570,448 6,575,931 6,586,925

Gross profit 29,916,861 29,080,680 15,346,597 10,664,452 9,926,590

Operating expenses:

Marketing and sales (1) 16,106,506 15,566,179 9,287,549 6,080,829 4,967,215

General and administrative (1) 4,307,749 4,168,902 3,006,647 2,462,404 2,401,087

Research and development 73,226 215,778 14,076 26,702 7,259

Other --- --- --- --- (450)

Total operating expenses 20,487,481 19,950,859 12,308,272 8,569,935 7,375,111

Operating income 9,429,380 9,129,821 3,038,325 2,094,517 2,551,479

Interest income 741,161 503,761 138,223 112,359 199,084

Income before taxes 10,170,541 9,633,582 3,176,548 2,206,876 2,750,563

Income tax expense (benefit) (2) 4,065,206 3,758,915 1,564,256 1,163,501 (6,657,874)

Net income $ 6,105,335 $ 5,874,667 $ 1,612,292 $ 1,043,375 $ 9,408,437

Net income per share (3)

Basic $ 0.34 $ 0.33 $ 0.09 $ 0.06 $ 0.54

Diluted $ 0.33 $ 0.31 $ 0.09 $ 0.06 $ 0.53

Weighted-average common shares (3)

Basic 18,160,218 18,008,855 17,467,173 17,362,745 17,528,473

Diluted 18,662,770 18,963,111 18,007,726 17,777,309 17,907,982

December 31, 2006 2005 2004 2003 2002BALANCE SHEET DATA

Cash and equivalents $13,762,786 $ 21,003,551 $ 12,873,847 $ 11,559,123 $ 13,282,245

Working capital 45,818,879 53,750,810 42,116,284 37,745,292 36,236,017

Total assets 66,001,973 63,538,226 50,635,625 46,447,288 45,948,762

Long term debt --- --- --- --- ---

Shareholders’ equity 59,276,915 57,965,618 47,258,397 44,123,957 43,751,551

Cash dividends per share (3) 0.08 0.038 --- --- ---

1. Share-based compensation for 2006, 2005, 2004, 2003, and 2002 was $324,477, $1,064,617, $70,672, $34,283, and $92,497, respectively. See Note 2 and Note 9 of Notesto Financial Statements.

2. The Company recorded a one-time $6.7 million non-operating and non-cash addition to earnings during 2002, due to the expected realization of deferred income tax assets.

3. Share and per-share data for all periods presented reflect the effect of the 5% stock dividend distributed on July 15, 2005 and the one share for every four shares ownedstock split, effected in the form of a 25% stock dividend, distributed on January 30, 2006.

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All statements, trend analysis and otherinformation contained in the followingdiscussion relative to markets for ourproducts and trends in revenue, grossmargins and anticipated expense levels, aswell as other statements, including wordssuch as “anticipate,” “believe,” “plan,”“estimate,” “expect” and “intend” and other similar expressions constituteforward-looking statements. Our business is subject to business and economic risks and uncertainties, and our actual results of operations may differ materiallyfrom those expressed or implied in theforward-looking statements. The followingdiscussion describes some, but not all, ofthe factors that could cause thesedifferences.

OVERVIEW

We manufacture, market and distributeCharles & Colvard created Moissanitejewels (also called moissanite) for sale inthe worldwide jewelry market. Moissanite,also known by its chemical name, siliconcarbide (SiC), is a rare, naturally occurringmineral found primarily in meteors. As thesole manufacturer of scientifically-mademoissanite jewels, our strategy is toestablish Charles & Colvard as a reputable,high-quality and sophisticated brand andposition moissanite as a unique jewel,distinct from all others based on itsexceptional fire, brilliance, luster, durabilityand rarity. Moissanite is marketed to itsprimary target market, the self-purchasingwoman, as the perfect reward or indulgencefor a woman celebrating her achievements,whether personal or professional, big orsmall. Moissanite is also marketed to thejewelry trade as a new jewelry category witha unique business opportunity.

We began shipping moissanite to U.S. retailjewelers and international distributorsduring the second quarter of 1998. Duringthe second quarter of 2000, we changed ourU.S. distribution model to sell throughjewel distributors and jewelrymanufacturers rather than directly to retailstores. To assist our customers in gaining new or expanded distribution atcertain retail locations, we have offeredjewels on consignment to our customers ona limited basis.

In October 2000, we established a wholly-owned subsidiary in Hong Kong, Charles &Colvard (HK) Ltd., for the purpose ofgaining better access to the important FarEastern markets. The importance of havinga presence in this market is twofold; Hong

Kong is the headquarters city for a verylarge number of jewelry manufacturingcompanies with sales and distributionworldwide, and Hong Kong is the gatewayto the markets of mainland China. Toenhance our presence in this market, weestablished a Charles & Colvard controlledcompany in China in August 2003.

Our goal in each of the three years endedDecember 31, 2006 was to increase revenuethrough an increased investment in salesand marketing expenses, while maintainingprofitability. Our sales in 2004 were 39%higher than 2003 while our sales &marketing expenses were 53% higher than2003. Our sales during 2005 were 82%higher than sales in 2004, while our sales &marketing expenses were 68% higher than2004. Our sales in 2004 and 2005 werefavorably impacted by our relationshipswith two major jewelry retailers, JCPenneyand Finlay Enterprises, Inc. In a joint effortwith our manufacturing customer, ReevesPark, we launched a Charles & Colvardmoissanite jewelry category at 462JCPenney retail locations in October 2004.In March 2005, JCPenney began offeringmoissanite in 241 additional stores. Finlay,supplied by our manufacturing customerK&G Creations, operates leaseddepartment store jewelry locations inchains such as Boston Store, Macy’s,Dillard’s, Bloomingdale’s, and Belks. Finlayinitially offered moissanite jewelry in 31 stores on February 28, 2005.During 2005, moissanite jewelry expandedto approximately 210 Finlay leaseddepartment store jewelry counters. Furtherexpansion occurred in Finlay in 2006 to atotal of 229 leased department store jewelrycounters.

During 2005, we conducted testdistribution at two national fine jewelrystores (Helzberg Jewelers & Gordon’sJewelers) via one-day trunk show events.Helzberg Jewelers, a fine jewelry chain withover 270 stores, began testing moissanitejewelry in September 2005 and Gordon’sJewelers, a fine jewelry division of ZaleCorporation with over 285 stores, begantesting in October 2005. Based on theresults of the test distribution, Helzbergbegan an in-case program of finemoissanite jewelry during 2006 at all of itslocations. The tests at Gordon’s continuedthrough 2006. Additionally, other divisionsof the Zale Corporation that held trunkshows in 2006 are the 130-store Zale Outletchain in the United States and Peoples &Mappins Jewelers, which have a combined168 stores in Canada. The Zale Outletchain started an in-case program in 20 of itsstores during the second quarter of 2006,

and the program is now in 28 of its stores.Peoples & Mappins Jewelers began testingan in-case program in 41 of its storesduring the fourth quarter of 2006.

During 2006, our sales decreased by 7%despite a 3% increase in sales & marketingexpenses. The sales decrease during 2006was due primarily to the large orders placedby K&G Creations and Reeves Park in 2005that were required for the initial rollout ofmoissanite jewelry into Finlay jewelrycounters and the rollout into 241 additional JCPenney stores. The dollaramount of orders received in 2006 for newdistribution was less than the amount wereceived in 2005.

We continue to work to broaden ourcustomer base through our variouschannels of distribution. During 2006,Samuel Aaron International (“SAI”) andAlarama, two domestic jewelrymanufacturers, became more significantdirect customers. Both are large, well-established suppliers to the NorthAmerican jewelry market and both sell to amajority of the major North Americanjewelry retailers.

In October 2006, distribution of moissanitejewelry began in 208 stores of the 800-doordepartment store chain, Kohl’s. SAI is themanufacturer for this test distribution. Wealso began testing moissanite during 2006at 22 Chicago locations at the 900-doordepartment store chain, Sears. In February2007, Kohl’s expanded their distributioninto 79 additional stores in California andSears has indicated their interest in adding115 additional stores during the first half of2007. Also in 2006, the Home ShoppingNetwork (HSN) aired 9 hours of moissanitejewelry shows. During 2007, HSN hasagreed to increase the number of hours ofmoissanite jewelry shows to 25. In January2007, Landau reduced the number ofoutlets selling moissanite jewelry fromapproximately 70 doors to 5 doors. Webelieve that this reduction was due toaccount relationships maintained byLandau with the jewelry manufacturer andnot a reflection on the success of moissanitejewelry sales.

Our goal for 2007 is to grow revenue whileremaining profitable by increasingawareness and demand for our jewel,moissanite. Our domestic sales andmarketing efforts will include, but not belimited to, increasing moissanite awarenessand desire for ownership at the consumerlevel, through increased consumeradvertising, promotion, sponsorship

MANAGEMENT’S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION & RESULTS OF OPERATIONS

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opportunities, and an expanded publicrelations effort headed by a new publicrelations firm, continuous sales training forthe sales associates at the retail level, andindividually tailored efforts for specificretailers.

Internationally, in 2007 we will maintainour commitment to Asia and commitadditional resources in the UnitedKingdom and continental Europe. Weunderstand and accept that our growth inthose markets will likely continue to beslow, but by insisting that our distributionpartners understand and support ourmarketing positioning we believe that theywill start to gain a meaningful presence formoissanite jewelry in their markets.

RESULTS OF OPERATIONS

The following table is intended to illustratea tabular analysis of certain ConsolidatedStatement of Operations data as apercentage of sales for all periodspresented. A detailed explanation of ourresults of operations follows this table:

Year Ended December 31, 2006 2005 2004

Sales $ 40,712,085 $ 43,544,090 $ 23,917,045100% 100% 100%

Gross profit 29,916,861 29,080,680 15,346,59773% 67% 64%

Marketing & 16,106,506 15,566,179 9,287,549sales expenses 40% 36% 39%

General & 4,307,749 4,168,902 3,006,647administrative 11% 10% 13%expenses

Operating 9,429,380 9,129,821 3,038,325income 23% 21% 13%

Net 6,105,335 5,874,667 1,612,292income 15% 13% 7%

Year ended December 31, 2006compared with Year endedDecember 31, 2005.

Net sales were $40,712,085 for the yearended December 31, 2006 compared to$43,544,090 for the year ended December31, 2005, a decrease of $2,832,005 or 7%.Shipments of moissanite jewels, excludingconsigned jewels, decreased 4% toapproximately 245,000 carats from 255,000carats. The average selling price per caratdecreased by 3% due to a product mix inwhich a greater percentage of smaller sizejewels, which have a lower price per carat,were sold. U.S. sales accounted for

approximately 88% and 93% of salesduring the year ended December 31, 2006and 2005, respectively.

U.S. net sales and carat shipments,excluding consigned jewels, decreased by11% and 8%, respectively, for the yearended December 31, 2006 as compared tothe year ended December 31, 2005.Decreased U.S. carat shipments are dueprimarily to large orders placed by K&GCreations and Reeves Park in 2005 for theinitial rollout of moissanite jewelry intoFinlay jewelry counters and the rollout into241 additional JCPenney stores, which werenot repeated in 2006. The dollar amount oforders received in 2006 for new distributionwas less than the amount we received in2005. The timing and size of additionalrollouts at new or existing retailers couldhave a significant effect on our results ofoperations in a given period. Our threelargest customers during the year endedDecember 31, 2006, Reeves Park, K&GCreations, and SAI accounted for 37%, 21%and 13%, respectively, of our sales ascompared to 39%, 39%, and 1%,respectively, for 2005. We expect that, atleast in the short-term, we will remaindependent on our ability and that of ourlargest manufacturing customers tomaintain and enhance their retailprograms. While we believe our currentrelationships with these customers andretailers are good, a loss of any of thesecustomer or retailer relationships couldhave a material adverse effect on our resultsof operations.

International net sales and carat shipmentsincreased by 47% and 48%, respectively, forthe year ended December 31, 2006 ascompared to 2005. International salesincreased due to increased sales into HongKong, Canada, United Kingdom,Indonesia, and India, partially offset bylower sales in Taiwan. It should be notedthat a portion of our increased internationalsales is due to jewels sold internationallythat will be re-imported to North Americanretailers.

Our gross profit margin was 73.5% for theyear ended December 31, 2006 compared to66.8% for the year ended December 31,2005. The increased gross profit marginpercentage was primarily caused by lowerproduction costs in the first-in, first-outaccounting period relieved from inventoryin the year ended December 31, 2006compared to the production costs for therelated inventories sold in the year endedDecember 31, 2005, partially offset by a 3%decrease in the average selling price percarat. Future gross profit margins willfluctuate based upon the costs being

relieved from inventory under our first-in,first-out accounting policy and our averageselling price per carat. Depending on thesizes shipped in any specific period andwith possible fluctuations quarter toquarter, we expect that our annual grossprofit margin percentage going forward willfall in a range between 65% and 75%.

Marketing and sales expenses were$16,106,506 for the year ended December31, 2006 compared to $15,566,179 for theyear ended December 31, 2005, an increaseof $540,327 or 3%. As a percentage of sales,these expenses increased to 40% from 36%in 2005. The primary reasons for theincrease in expenses were a $996,000increase in advertising expenses, $236,000increase in travel costs, and $191,000 ofweb page design costs, partially offset by$1,061,000 of decreased stock optioncompensation expense on optionspreviously issued to sales consultants fornew business development. The Companyexpects total marketing and sales expensesin 2007 to be higher than the totalmarketing and sales expenses incurredduring 2006. While we are trying tomanage our total sales and marketingexpense for the year to approximate thesame percentage of sales achieved in 2006,it is subject to the level of revenue achievedin 2007.

General and administrative expenses were$4,307,749 for the year ended December31, 2006 compared to $4,168,902 for theyear ended December 31, 2005, an increaseof $138,847 or 3%. As a percentage of sales,these expenses increased to 11% from 10%in the same period of 2005. The increase inexpenses was primarily due to $200,000 ofone-time compensation costs recordedduring the year ended December 31, 2006associated with the change in status of EarlHines, Senior Vice President ofManufacturing, from a full-time to a part-time employee, $178,000 of costs associatedwith the May 2006 grant of restricted stockto the non-employee members of ourBoard of Directors, $169,000 of increasedsalaries, partially offset by $445,000 of lowercosts accrued in 2006 under ourmanagement incentive plan versus 2005.

Research and development expenses were$73,226 for the year ended December 31,2006 compared to $215,778 for the yearended December 31, 2005, a decrease of$142,552 or 66%. The costs incurred in2005 relate to our efforts in developingalternate sources of raw material. Aportion of the material we receive fromNorstel AB in 2007 will be expensed asresearch and development expense. Thelevel of expense will depend upon the


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amount of material they are able to deliver.Based on current estimates of the materialwe will receive from Norstel in 2007, weexpect research and development expenseto remain less than 1% of annual sales.

Interest income was $741,161 for the yearended December 31, 2006 compared to$503,761 for the year ended December 31,2005, an increase of $237,400 or 47%. Thisincrease resulted from a higher interest rateearned on our cash balances.

Our effective income tax rate for the yearended December 31, 2006 was 40%compared to 39% for the year endedDecember 31, 2005. Our statutory tax rateis 38.5% and consists of the Federal incometax rate of 34% and the North Carolinastate income tax rate of 4.5%, net of thefederal benefit. Our effective income taxrate is higher than our statutory rateprimarily due to our inability to currentlyrecognize an income tax benefit for ouroperating losses in Hong Kong and China,partially offset by lower state income taxdue to the apportionment of incomeamong state jurisdictions. We cannotrecognize the income tax benefit of ourlosses in Hong Kong and China due to theuncertainty of generating sufficient futuretaxable income in these tax jurisdictions tooffset the existing losses. Our effectiveincome tax rate is higher than the sameperiod in 2005 primarily due to a greater taxbenefit in 2005 over 2006 related to theapportionment of taxable income amongstate jurisdictions.

Year ended December 31, 2005compared with Year endedDecember 31, 2004.

Net sales were $43,544,090 for the yearended December 31, 2005 compared to$23,917,045 for the year ended December31, 2004, an increase of $19,627,045 or 82%.Shipments of moissanite jewels, excludingconsigned jewels, increased 88% toapproximately 255,000 carats from 136,000carats. The average selling price per caratdecreased by 4% due to a product mix inwhich a greater percentage of smaller sizejewels, which have a lower price per carat,were sold. U.S. sales accounted forapproximately 93% and 87% of salesduring the years ended December 31, 2005and 2004, respectively.

U.S. net sales and carat shipments,excluding consigned jewels, increased by93% and 99%, respectively, for the yearended December 31, 2005 as compared tothe year ended December 31, 2004.

Increased U.S. shipments are due primarilyto the fourth quarter 2004 JCPenney launchas well as the rollout into additionalJCPenney stores on March 1, 2005 and the2005 rollout to a portion of the jewelrydepartments leased by Finlay Enterprises.As a result, our two largest customers, K&GCreations (the supplier of Finlay) andReeves Park (the supplier of JCPenney),each accounted for 39% of our sales during the year ended December 31, 2005 as compared to 34% and 24%,respectively, during 2004. Our third largestcustomer, Stuller, accounted for 9% of oursales during 2005 as compared to 21%during 2004.

International net sales and carat shipmentsincreased by 5% and 6%, respectively forthe year ended December 31, 2005 ascompared to 2004. The increase resultedprimarily from increased sales into Taiwan,Indonesia, and the United Kingdom,partially offset by decreased sales intoSingapore and Korea.

Our gross profit margin was 66.8% for theyear ended December 31, 2005 compared to64.2% for the year ended December 31,2004. The increased gross profit marginpercentage was primarily caused by lowerproduction costs in the FIFO periodrelieved from inventory, partially offset by a4% decrease in the average selling price per carat caused by a product mix inwhich a greater percentage of smaller sizejewels, which have a lower price per carat,were sold.

Marketing and sales expenses were$15,566,179 for the year ended December31, 2005 compared to $9,287,549 for theyear ended December 31, 2004, an increaseof $6,278,630 or 68%. As a percentage ofsales, these expenses decreased to 36%from 39% in 2004. The primary reasons forthe increase in expenses are $2,032,000 ofincreased co-op advertising expense,$1,940,000 of increased print advertising,and $1,000,000 of increased stock optioncompensation expense on optionspreviously issued to sales consultants fornew business development. Our co-opadvertising program reimburses a portionof our customers’marketing costs based onthe amount of their purchases from us, andis subject to the customer providing usdocumentation of all advertising copy thatincludes the Company’s products. Theincrease in co-op advertising is due toincreased sales and the program beingoffered to a major customer in 2005, whowas not in the program in 2004.

General and administrative expenses were

$4,168,902 for the year ended December31, 2005 compared to $3,006,647 for theyear ended December 31, 2004, an increase of $1,162,255 or 39%. As a percentage ofsales, these expenses decreased to 10%from 13% in 2004. The increase in expensesis primarily due to $531,000 of increasedcompensation costs and a $339,000increase in professional and accountingservices. The increased compensation costsare primarily due to $382,000 of increasedcosts associated with our ExecutiveCompensation Plan, which providesincentives to senior management to meetor exceed certain goals. The increasedprofessional and accounting fees primarilyrelate to costs associated with compliancewith the Sarbanes-Oxley Act of 2002 andrelated SEC rulemaking.

Research and development expenses were$215,778 for the year ended December 31,2005 compared to $14,076 for the yearended December 31, 2004. The costsincurred in 2005 relate to our efforts indeveloping alternate sources of rawmaterial.

Interest income was $503,761 for the yearended December 31, 2005 compared to$138,223 for the year ended December 31,2004, an increase of $365,538 or 264%. Thisincrease resulted from a higher interest rateearned on our cash balances, as well aslarger cash balances.

Our effective income tax rate for the yearended December 31, 2005 was 39%compared to 49% for the year endedDecember 31, 2004. Our statutory tax rateconsists of the Federal income tax rate of34% and North Carolina income tax rate of4.5%, net of the federal benefit. Oureffective income tax rate is higher than ourstatutory rate primarily due to our inabilityto currently recognize an income tax benefitfor our operating losses in Hong Kong andChina. We cannot recognize this incometax benefit due to the uncertainty ofgenerating sufficient future taxable incomein these tax jurisdictions to offset theexisting losses. The decreased effective taxrate in 2005 compared to 2004 is primarilydue to foreign operating losses being asmaller percentage of pre-tax income. Our2004 effective income tax rate was favorablyimpacted by an increase in the research taxcredits expected to be realized and our 2005effective income tax rate was favorablyimpacted by a reduction in state income taxexpense caused by a change in theapportionment of taxable income amongstate jurisdictions.


9

LIQUIDITY AND CAPITAL RESOURCESAt December 31, 2006, we hadapproximately $13.8 million of cash andcash equivalents and $45.8 million ofworking capital as compared to $21.0million of cash and cash equivalents and$53.8 million of working capital atDecember 31, 2005. As further describedbelow, cash and cash equivalents decreasedduring the year ended December 31, 2006primarily as a result of stock repurchases of $4,059,719, $1,786,654 of cash used by operations, and cash dividends of $1,480,360.

Cash and inventory account for 69% of ourcurrent assets. Our principal sources ofliquidity are cash on hand and cashgenerated by operations. During the yearended December 31, 2006, $1,786,654 ofcash was used by operations primarily as aresult of an $8,894,147 increase in inventoryand a $3,054,150 increase in receivables,partially offset by net income of $6,105,335,deferred income taxes of $2,486,960 and a$1,536,921 increase in accounts payable.

We purchased $14.7 million of raw materialduring the year ended December 31, 2006and are building inventory to prepare foranticipated future sales growth.Management considers its investment ininventory essential to be able to meet theorders of its expanding customer base andto fulfill requests from our customers forconsigned inventory. It is management’sopinion that inventory turnover shouldincrease due to forecasted sales increases,thereby not requiring a significant use ofworking capital. Management expects toreduce its 2007 raw material purchasesfrom the amount purchased in 2006. TheCompany’s raw material inventories ofsilicon carbide crystals are purchased underexclusive supply agreements with a limitednumber of suppliers. Because the supplyagreements restrict the sale of these crystalsto only the Company, the suppliersnegotiate minimum purchasecommitments with the Company that mayresult in periodic levels of raw and in-process inventories that are higher than theCompany might otherwise maintain. Theseagreements coupled with lower thanexpected 2006 sales resulted in $11.8million of our inventories being classified aslong-term assets at December 31, 2006.

Income tax payments for the year endedDecember 31, 2006 were limited to$876,652 due to the utilization of a portionof the Company's net operating loss("NOL") carryforwards to offset the taxableincome generated during that period by our

U.S. operations. During the year endedDecember 31, 2006, we fully utilized ourU.S. NOL carryforward. As a result, webegan making federal income tax paymentsfor the tax year ended December 31, 2006.As of December 31, 2006, our federalincome tax liability is $413,387. Prior to2006, federal income tax payments werelimited to alternative minimum taxpayments. Depending on our levels ofincome in future periods, our cash flowfrom operations will be negativelyimpacted by increased tax payments overprior periods. As of December 31, 2006, wehad a North Carolina NOL carryforward ofapproximately $4.4 million, which expiresbetween 2012 and 2015.

Periodically, the Company sells jewels tocustomers on “memo” terms. Forshipments on “memo” terms, the customerassumes the risk of loss and has an absoluteright of return for a specified period. TheCompany does not recognize revenue onthese transactions until the earlier of (1) thecustomer informing the Company that theywill keep the jewels or (2) the expiration ofthe memo period. Any jewels shipped toour customers on “memo” terms areclassified as inventory on consignment onthe Company’s consolidated balancesheets. The $2,024,000 of inventory onconsignment at December 31, 2006represents potential revenue ofapproximately $7,842,000 and potentialgross profit of approximately $5,818,000based on the average cost per carat ofinventory at December 31, 2006.

On June 6, 1997, the Company entered intoan Amended and Restated ExclusiveSupply Agreement with Cree. Theexclusive supply agreement had an initialterm of ten years that was extended inJanuary 2005 to July 2015. In connectionwith the exclusive supply agreement, theCompany has committed to purchase aminimum of 50% (by dollar volume) of itsrequirements for SiC crystals from Cree. Ifthe Company’s orders require Cree toexpand beyond specified production levels,the Company must commit to purchasecertain minimum quantities. In December2006, we agreed with Cree on a frameworkfor purchases for 2007. Our price per gramfor purchases from Cree during 2007 isincreasing by approximately 10% over whatwe paid per gram in 2006 and for eachquarter during calendar year 2007, theCompany has committed to purchaseapproximately $3,200,000 of usablematerial. Although the amount of usablematerial to be purchased by the Companyis expected to remain constant eachquarter, the Company's cost per quarter forthe usable material may be less than

$3,200,000 depending upon the quality ofthe usable material provided by Creeduring that quarter. We purchasedapproximately $14,600,000 of raw material from Cree during the year endedDecember 31, 2006.

In February 2005, we entered into anExclusive Supply Agreement with NorstelAB (formerly Jesperator AB) for the supplyof SiC crystals for use in the manufacturingof moissanite jewels. In March 2007, wesigned an amended agreement withNorstel AB that extended the term toDecember 31, 2009. Under the terms of theamended contract, our remainingminimum commitment under theagreement is $7.8 million, of whichapproximately $465,000 will be expensed asresearch and development. In addition, wehave advanced $400,000 towards thepurchase of certain equipment. Thisadvance is scheduled to be repaid startingJanuary 2007 through a 20% reduction onthe invoice for subsequent purchases of SiCcrystals. Effective October 1, 2007, we willreceive a 35% reduction on the invoice forsubsequent purchases of SiC crystals untilthe advance is repaid. The minimumpurchase commitment during 2007 is$1,600,000, of which approximately$275,000 will be expensed as research anddevelopment. Purchases from Norstelduring the year ended December 31, 2006were less than $25,000.

In November 2005, we entered into anexclusive supply agreement with IntrinsicSemiconductor, Inc. for the supply of SiCcrystals for use in the manufacturing ofmoissanite jewels. The initial term of thecontract was for two years, and includedminimum purchase commitments of usablematerial of approximately $2,200,000,subject to Intrinsic Semiconductor meetingminimum quality standards. On June 26,2006, Cree announced that it has signed adefinitive agreement to acquire IntrinsicSemiconductor, Inc. In October 2006, ouragreement with Intrinsic Semiconductorwas terminated.

In May 2005, we entered into an eighthamendment to our agreement with John M.Bachman, Inc. (“JMB”), the supplier of themajority of the faceting services used by theCompany. Pursuant to the terms of theamendment, the Company provided JMBwith a cash advance of $135,000 that wasused by JMB to expand its affiliate’sproduction facility and procure additionalequipment and labor as needed to enableJMB and its affiliate to satisfy the requestedincrease in production volumes. The cashadvance was repaid to the Companythrough reduced charges for facetingservices provided to the Company. As of


10

December 31, 2006, the advance has beencompletely repaid.

On April 18, 2006, the Company declared a$0.08 per share cash dividend that wasdistributed on June 15, 2006 toshareholders of record on May 31, 2006.Pursuant to this dividend, total cash of$1,456,080 was distributed. The Companyexpects to review the dividend policy on anannual basis and payment of futuredividends will be dependent on the facts and circumstances at the time of that review.

In March 2006, the Board of Directorsauthorized a repurchase program for up to1,000,000 shares of the Company’scommon stock. Repurchases can be madein the open market at prevailing prices or inprivately negotiated transactions at pricesat or below prevailing open market prices.This program expires in March 2007. Therewere 415,000 shares repurchased under thisprogram during the year ended December31, 2006 at an average price of $9.78 pershare, or an aggregate of $4,059,719.

Based on our cash and cash equivalents andother working capital, managementbelieves that our existing capital resourcesare adequate to satisfy our capitalrequirements for at least the next 12months and management does not believethat we will need additional sources ofcapital for the foreseeable future.

Net Operating Loss Carryforward

At December 31, 2006, the Company has aNorth Carolina tax NOL carryforward ofapproximately $4.4 million, expiringthrough 2015, which can be offset againstfuture state taxable income. The Companyexpects to fully utilize this NOL before anyof it expires.

As of December 31, 2006, there wasapproximately $4.1 million in NOLcarryforwards in Hong Kong. Inaccordance with the Hong Kong tax codethese amounts can be carried forwardindefinitely to offset future taxable incomein Hong Kong. As of December 31, 2006,there was approximately $451,000 in NOLcarryforwards in China. In accordance withthe China tax code these amounts can becarried forward five years to offset futuretaxable income in China. The NOLcarryforwards begin expiring in 2008. Dueto the uncertainty of generating sufficientfuture taxable income in Hong Kong andChina to utilize these NOLs, we haveestablished a valuation allowance againstthis deferred income tax asset.

Contractual Obligations andCommercial CommitmentsOur contractual obligations consist of ourpurchase commitments with Cree andNorstel AB, the operating lease on ourmanufacturing and administrative facility inMorrisville, NC and the operating leases forour companies in Hong Kong and China.Below are the amounts of thesecommitments in tabular form.

Critical Accounting Policies and EstimatesThe preparation of financial statements inconformity with accounting principlesgenerally accepted in the United States ofAmerica requires management to makeestimates and assumptions that affect thereported amounts of assets and liabilitiesand disclosure of contingent assets andliabilities at the date of the financialstatements and the reported amounts ofrevenues and expenses during thereporting period. Actual results could differfrom those estimates. The most significantestimates impacting our consolidatedfinancial statements relate to valuation ofinventories, accounts receivable reserves,and co-op advertising. We also have otherpolicies that we consider key accountingpolicies, the most significant of which is ourpolicy for revenue recognition; however,this policy typically does not require us tomake estimates or judgments that aredifficult or subjective.

Inventories are stated at the lower of cost ormarket determined on a first in, first outbasis. Our inventories consist primarily ofcolorless moissanite jewels that meetrigorous grading criteria and are of cuts andsizes most commonly used in the jewelryindustry. Moissanite jewels that do not


Contractual Obligations

Purchase PurchasePayments Commitments- Operating Commitments-Due by Period Cree Leases Norstel Total

2007 $ 12,800,000(1) $ 232,000 $ 1,637,000 $ 14,669,000

2008-2009 $ ---(2) $ 326,000 $ 6,151,000 $ 6,477,000

2010-2011 $ ---(2) $ 255,000 $ --- $ 255,000

2012 & Beyond $ ---(2) $ --- $ --- $ ---

Total $ 12,800,000 $ 813,000 $ 7,788,000(3) $ 21,401,000

(1) During 2007, we have committed to purchase approximately $3,200,000 of raw material each quarter.

(2) Under our Exclusive Supply Agreement with Cree, we are obligated to buy from Cree, and Cree is obligated tosell to us, at least 50%, by dollar volume, of our requirements for SiC material for the production of gemstones ineach calendar quarter.

(3) Approximately $465,000 of this total commitment will be expensed as research and development -- $275,000 in2007 and $190,000 in 2008.

meet our grading criteria and therefore arenot deemed to be saleable are not includedin inventories. We carry only a limitedamount of moissanite jewels in finishedjewelry settings. As a result, our inventoriesdo not degrade in quality over time and arenot subject to fashion trends. Ourdistribution channels include two of thelargest suppliers of jewelry-related productsto the jewelry industry, jewelrymanufacturers, traditional retail stores,home shopping channels and catalogs.Consequently, significant amounts ofinventories must be maintained at all times.During 2002, we established a lower of costor market reserve of $400,000 to allow for aportion of the finished goods inventory tobe re-cut. There are certain jewels ininventory that can be re-cut to achievehigher quality standards. The reserve isnecessary to allow for the carat weight lossduring the re-cutting process. To determinethis reserve, we estimated the amount ofinventory that is anticipated to be re-cutand the amount of weight loss that willoccur during the process. Since theestablishment of this reserve, we have notyet re-cut any jewels. At December 31,2006, the reserve remained at $400,000.

Estimates are used to determine theamount of two reserves against accountsreceivable. First, an “Allowance forDoubtful Accounts”is established to reduceaccounts receivable to an amount expectedto be collected. Based on our collectionhistory, we determine a percentage basedon the age of the receivable that we deemcollectible. The allowance is then calculatedby applying the appropriate percentage toeach of our receivables. Any increases ordecreases to this allowance are charged orcredited to general and administrativeexpenses. This allowance for doubtfulaccounts was $195,000 and $120,000 atDecember 31, 2006 and 2005, respectively.The second reserve against accountsreceivable is the “Allowance for Returns”.At the time revenue is recognized, weestimate future returns and reduce salesand accounts receivable by this estimatedamount. This amount is estimated usingthe historical return rate for our Companyand considers any contractual returnprivileges granted to customers. Theallowance for returns was $265,000 and$105,000 at December 31, 2006 and 2005,respectively. The increase in the reserve in2006 is primarily due to expanded returnrights given to certain accounts in 2006 tosupport new retail business.

We offer a co-op advertising program tomany of our customers that reimburses aportion of their marketing costs based ontheir net purchases from us. At the end of

any given period, we estimate the amountof co-op advertising expense that has notyet been submitted for credit by ourcustomers. These amounts were $1,275,041and $1,364,007 at December 31, 2006 and 2005, respectively. We estimate thisamount based on our historical experiencewith each customer, and the relatedcontractual arrangements to provide certain levels of co-op advertising for our customers.

Revenue is generally recognized whenproducts are shipped. Our standardpayment terms are generally between 30and 60 days for jewel distributors andgenerally between 60 to 90 days for jewelrymanufacturers. In limited circumstances,the Company may extend terms of 120days. Some customers are required toprepay prior to shipment. For all jewelsshipped, title passes upon shipment of thejewels from our facility (i.e., FOB-shippingpoint). Periodically, the Company sellsproduct to customers on “memo”terms. Forshipments on memo terms, the customerassumes the risk of loss and has an absoluteright of return for a specified period. Ourcustomers are generally required to makepayments on memo shipments within 30days upon the customer informing theCompany that they will keep the product.Accordingly, the Company does notrecognize revenue on these memotransactions until the earlier of (1) thecustomer informing the Company that theywill keep the product or (2) the expirationof the right of return period. All “memo”shipments are shown on our balance sheetsas inventory on consignment.

Newly Adopted Accounting PronouncementsIn December 2004, FAS No. 123R, Share-Based Payment, was issued as a revision toFAS No. 123, Accounting for Stock-BasedCompensation. This statement supercededAPB Opinion No. 25, Accounting for StockIssued to Employees, and amends FAS No.95, Statement of Cash Flows. Generally, theapproach in FAS No. 123R is similar to theapproach described in FAS No. 123;however, FAS No. 123R requires that allshare-based payments to employees,including grants of employee stock options,be recognized in the income statementbased on their fair values. Pro formadisclosure is no longer an alternative. FASNo. 123R also requires the benefits ofincome tax deductions in excess ofrecognized compensation cost to bereported as a financing cash flow, ratherthan as an operating cash flow as requiredunder FAS No. 95.

FAS No. 123R was adopted by theCompany on January 1, 2006. Prior to thatdate, the Company accounted for share-based payments to employees using theintrinsic value method in accordance withAPB Opinion No. 25 and, since theCompany granted employee stock optionswith an exercise price that was equivalentto market value at the date of grant, theCompany generally recognized nocompensation cost for employee stockoptions. Had the Company adopted FASNo. 123R in prior periods, the impact ofthat standard would have approximated theimpact of FAS No. 123 as described in thedisclosure of pro forma net income andearnings per share in Note 2 of theseconsolidated financial statements.

As a result of the adoption of FAS No. 123R, the Company recordedcompensation expense due to share-basedemployee compensation awards during theyear ended December 31, 2006 of $377,964in operating expenses, which is before anincome tax benefit of $106,799, resulting ina decrease to net income of $271,165. Inaddition, there was $7,585 of share-basedemployee compensation capitalized asinventory costs during the year endedDecember 31, 2006.There was no change inthe way the Company accounted for stockoptions granted to consultants.

The Company receives an income taxdeduction for certain stock option exerciseswhen the options are exercised, generallyfor the excess of the stock price on the dateof exercise over the option price. Prior tothe adoption of FAS No. 123R, theCompany presented all tax benefitsresulting from the exercise of stock optionsas an operating cash inflow in its Statementof Cash Flows. FAS No. 123R requires thebenefits of tax deductions in excess of thegrant date fair value for those options to beclassified as financing cash inflows ratherthan operating cash inflows, on aprospective basis. The income tax benefitsfrom the exercise of stock options duringthe year ended December 31, 2006 havebeen reflected as “Excess tax benefits fromshare-based payment arrangements”on theConsolidated Statement of Cash Flows. Forthe year ended December 31, 2006, suchamount was $173,783, resulting in adecrease in cash from operations andincrease in cash provided by financingactivities of this amount.

In November 2004, FAS No. 151, InventoryCosts, was issued. This statement amendsthe guidance in Accounting ResearchBulletin No. 43, Chapter 4, Inventory Pricing,to clarify the accounting for abnormalamounts of idle facility expense, freight,handling costs, and wasted material. FAS


11


12

151 requires that those items be recognizedas current period charges. In addition, FAS151 requires the allocation of fixedproduction overheads to inventory basedon the normal capacity of the productionfacilities. The provisions of this statementwere effective for inventory costs incurredduring fiscal years beginning after June 15,2005. The adoption of FAS 151 had noeffect on the Company’s consolidatedfinancial statements.

Newly Issued Accounting Pronouncements In July 2006, the Financial AccountingStandards Board (FASB) issued FASInterpretation No. 48 (FIN 48), Accountingfor Uncertainty in Income Taxes, whichprescribes a recognition threshold andmeasurement process for recording in thefinancial statements uncertain tax positionstaken or expected to be taken in a taxreturn. Additionally, FIN 48 providesguidance on the recognition, classification,accounting in interim periods anddisclosure requirements for uncertain taxpositions. The accounting provisions of FIN48 were effective for the Company onJanuary 1, 2007. The Company is in theprocess of determining the effect that theadoption of FIN 48 will have on its financialstatements.

Off-Balance Sheet ArrangementsWe have not engaged in any off-balancesheet financing arrangements.

We believe that our exposure to market riskfor changes in interest rates is not materialto our financial condition or results ofoperations because our investments arelimited to highly liquid instruments withmaturities of three months or less. AtDecember 31, 2006, the majority of our cashwas in short-term investments classified ascash and equivalents. The majority of ourtransactions with international customersand suppliers are denominated in U.S.dollars and, as such, we also do not believethat our exposure to fluctuations in anyforeign currency exchange rate are material to our financial condition or results of operations.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

13

The management of Charles & Colvard, Ltd. (the “Company”) is responsible for establishing and

maintaining effective internal control over financial reporting of the Company.The internal control

system is designed to provide reasonable assurance regarding the reliability of financial reporting

and the preparation of financial statements for external purposes in accordance with accounting

principles generally accepted in the United States of America.

The Company’s internal control over financial reporting includes those policies and procedures

that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect

the transactions and dispositions of the assets of the Company; (ii) provide reasonable assurance

that transactions are recorded as necessary to permit preparation of financial statements in

accordance with generally accepted accounting principles, and that receipts and expenditures of

the Company are being made only in accordance with authorizations of management and

directors of the Company; and (iii) provide reasonable assurance regarding prevention or timely

detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have

a material effect on the financial statements.

Because of its inherent limitations, a system of internal control over financial reporting can provide

only reasonable assurance and may not prevent or detect misstatements. Further, because of

changes in conditions, effectiveness of internal control over financial reporting may vary over time.

Management conducted an evaluation of the effectiveness of the Company’s system of internal

control over financial reporting based on the framework in Internal Control-Integrated Framework

issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

Based on this evaluation, management determined that the Company’s system of internal control

over financial reporting was effective as of December 31, 2006.

Management’s assessment of the effectiveness of the Company’s internal control over financial

reporting has been audited by Deloitte & Touche LLP, an independent registered public accounting

firm, as stated in their report which is included herein.

MANAGEMENT’S ANNUAL REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

14

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Shareholders ofCharles & Colvard, Ltd.Morrisville, North Carolina

We have audited the accompanying consolidated balance sheets of Charles & Colvard, Ltd. and subsidiary (the “Company”) asof December 31, 2006 and 2005, and the related consolidated statements of operations, shareholders’equity and comprehensiveincome, and cash flows for each of the three years in the period ended December 31, 2006. We also have audited management’sassessment, included in the accompanying management’s annual report on internal control over financial reporting, that theCompany maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established inInternal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.The Company’s management is responsible for these financial statements, for maintaining effective internal control overfinancial reporting, and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility isto express an opinion on these financial statements, an opinion on management’s assessment, and an opinion on theeffectiveness of the Company’s internal control over financial reporting based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financialstatements are free of material misstatement and whether effective internal control over financial reporting was maintained inall material respects. Our audit of the financial statements included examining, on a test basis, evidence supporting the amountsand disclosures in the financial statements, assessing the accounting principles used and significant estimates made bymanagement, and evaluating the overall financial statement presentation. Our audit of internal control over financial reportingincluded obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testingand evaluating the design and operating effectiveness of internal control, and performing such other procedures as weconsidered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’sprincipal executive and principal financial officers, or persons performing similar functions, and effected by the company’s boardof directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reportingand the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenanceof records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company;(2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements inaccordance with generally accepted accounting principles and that receipts and expenditures of the company are being madeonly in accordance with authorizations of management and directors of the company; and (3) provide reasonable assuranceregarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could havea material effect on the financial statements.

Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or impropermanagement override of controls, material misstatements due to error or fraud may not be prevented or detected on a timelybasis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods aresubject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliancewith the policies or procedures may deteriorate.

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

15

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financialposition of Charles & Colvard, Ltd. and subsidiary as of December 31, 2006 and 2005, and the results of their operations andtheir cash flows for each of the three years in the period ended December 31, 2006, in conformity with accounting principlesgenerally accepted in the United States of America. Also, in our opinion, management’s assessment that the Companymaintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects,based on the criteria established in Internal Control—Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission. Furthermore, in our opinion, the Company maintained, in all material respects,effective internal control over financial reporting as of December 31, 2006, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

As discussed in Note 1 to the consolidated financial statements, effective January 1, 2006, the Company adopted Statement ofFinancial Accounting Standards No. 123R, Share-Based Payment.

Raleigh, North CarolinaMarch 9, 2007

16

CONSOLIDATED FINANCIAL STATEMENTS


Net sales $ 40,712,085 $ 43,544,090 $ 23,917,045

Cost of goods sold 10,795,224 14,463,410 8,570,448

Gross profit 29,916,861 29,080,680 15,346,597

Operating expenses:

Marketing and sales 16,106,506 15,566,179 9,287,549

General and administrative 4,307,749 4,168,902 3,006,647

Research and development 73,226 215,778 14,076

Total operating expenses 20,487,481 19,950,859 12,308,272

Operating income 9,429,380 9,129,821 3,038,325

Interest income 741,161 503,761 138,223

Income before taxes 10,170,541 9,633,582 3,176,548

Income tax expense (Note 10) 4,065,206 3,758,915 1,564,256

Net income $ 6,105,335 $ 5,874,667 $ 1,612,292

Net income per share (Note 2)

Basic $ 0.34 $ 0.33 $ 0.09

Diluted $ 0.33 $ 0.31 $ 0.09

Weighted-average common shares (Note 2)

Basic 18,160,218 18,008,855 17,467,173

Diluted 18,662,770 18,963,111 18,007,726

Share and per share data for all periods presented reflect the effect of the 5% stock dividend distributed on July 15, 2005,and the one share for every four shares owned stock split, effected in the form of a 25% stock dividend, distributed onJanuary 30, 2006.

See notes to consolidated financial statements.

ConsolidatedStatements

of Operations

17


December 31, 2006 2005

ASSETS

Current Assets:

Cash and equivalents $13,762,786 $21,003,551

Accounts receivable, net of allowance for doubtful accounts

of $195,000 and $120,000, respectively 14,320,672 11,236,486

Interest receivable 16,381 46,417

Notes receivable 376,030 250,272

Inventory (Note 3) 20,677,215 23,168,028

Inventory on consignment (Note 4) 2,023,542 2,446,722

Prepaid expenses and other assets 783,989 571,277

Deferred income taxes (Note 10) 583,322 600,665

Total current assets 52,543,937 59,323,418

Long Term Assets:

Note receivable 23,970 263,710

Inventory (Note 3) 11,808,140 ---

Furniture and equipment, net (Note 5) 651,134 496,336

Patent and license rights, net (Note 5) 288,171 298,524

Deferred income taxes (Note 10) 686,621 3,156,238

Total long term assets 13,458,036 4,214,808

Total assets $66,001,973 $63,538,226

LIABILITIES AND SHAREHOLDERS’ EQUITY

Current Liabilities:

Accounts payable:

Cree, Inc. (Note 11) $ 1,598,956 $ 1,341,187

Other 2,870,752 1,591,600

Income taxes payable 413,387 8,757

Accrued payroll 322,383 1,050,013

Accrued co-op advertising 1,275,041 1,364,007

Accrued expenses and other liabilities 244,539 217,044

Total current liabilities 6,725,058 5,572,608

Commitments and contingencies (Note 11)

Shareholders’ Equity (Notes 6 and 7)

Common stock, no par value; 50,000,000 shares authorized;

17,977,923 and 18,299,354 shares issued and outstanding at

December 31, 2006 and 2005, respectively 52,494,309 57,785,576

Additional paid-in capital—stock options 5,807,879 5,313,044

Accumulated other comprehensive loss - Foreign currency translation (457) (2,851)

Retained earnings (deficit) 975,184 (5,130,151)

Total shareholders’ equity 59,276,915 57,965,618

Total liabilities and shareholders’ equity $66,001,973 $63,538,226


ConsolidatedBalance Sheets


AdditionalCommon Stock Paid-in Accumulated

Number Capital - other Retained Total Total Of Stock comprehensive earnings Shareholders' Comprehensive

Shares Amount Options loss (Deficit) Equity Income

Balance at January 1, 2004 17,342,099 $ 54,333,287 $ 2,407,780 --- $ (12,617,110) $ 44,123,957

Share-based compensation --- --- 70,672 --- --- 70,672

Stock options exercised 447,106 2,396,742 (995,998) --- --- 1,400,744

Tax effect of stock options --- --- 285,666 --- --- 285,666

Shares repurchased (60,870) (234,934) --- --- --- (234,934)

Net Income --- --- --- --- 1,612,292 1,612,292 $ 1,612,292

Total comprehensive income 1,612,292

Balance at December 31, 2004 17,728,335 56,495,095 1,768,120 --- (11,004,818) 47,258,397

Share-based compensation --- --- 1,064,617 --- --- 1,064,617

Stock options exercised 571,019 1,989,790 (221,725) --- --- 1,768,065

Cash dividend - $0.038 per share --- (688,022) --- --- --- (688,022)

Stock dividend -cash in lieu of fractional shares --- (11,287) --- --- --- (11,287)

Tax effect of stock options --- --- 2,702,032 --- --- 2,702,032

Foreign currency translation --- --- --- (2,851) --- (2,851) (2,851)

Net Income --- --- --- --- 5,874,667 5,874,667 5,874,667

Total comprehensive income 5,871,816

Balance at December 31, 2005 18,299,354 57,785,576 5,313,044 (2,851) (5,130,151) 57,965,618

Share-based compensation --- --- 324,477 --- --- 324,477

Stock options exercised 66,192 248,812 (3,425) --- --- 245,387

Issuance of restricted stock 27,377 --- --- --- --- ---

Shares repurchased (415,000) (4,059,719) --- --- --- (4,059,719)

Cash dividend - $.08 per share --- (1,456,080) --- --- --- (1,456,080)

Stock dividend –cash in lieu of fractional shares --- (24,280) --- --- --- (24,280)

Tax effect of stock options --- --- 173,783 --- --- 173,783

Foreign currency translation --- -- --- 2,394 --- 2,394 2,394

Net Income --- --- --- --- 6,105,335 6,105,335 6,105,335

Total comprehensive income $ 6,107,729

Balance at December 31, 2006 17,977,923 $ 52,494,309 $ 5,807,879 $ (457) $ 975,184 $ 59,276,915

Share and per share data for all periods presented reflect the effect of the 5% stock dividend distributed on July 15, 2005, and the one share forevery four shares owned stock split, effected in the form of a 25% stock dividend, distributed on January 30, 2006.


18

ConsolidatedStatements ofShareholders’

Equity andComprehensive

Income

19



OPERATING ACTIVITIES

Net income $ 6,105,335 $ 5,874,667 $ 1,612,292

Adjustments to reconcile net income to net cash provided by (used in) operating activities:

Depreciation and amortization 188,757 247,441 197,194

Share-based compensation 316,892 1,064,617 70,672

Loss on disposal of furniture and equipment --- 12,282 14,772

Provision for uncollectible accounts 78,990 20,000 (30,000)

Provision for returns 160,000 (115,000) 140,000

Tax effect of stock options --- 2,702,032 285,666

Provision for deferred income taxes 2,486,960 967,897 1,160,319

Changes in assets and liabilities:

Accounts receivable (3,323,176) (4,134,432) (3,414,959)

Interest receivable 30,036 (31,619) (8,006)

Inventory (8,772,580) (912,074) (636,684)

Prepaid expenses and other assets (212,712) (131,906) 60,071

Accounts payable 1,539,315 701,143 911,334

Accrued co-op advertising (88,966) 1,156,007 (155,000)

Accrued payroll (727,630) 492,212 392,858

Income taxes payable 404,630 8,757 ---

Accrued expenses and other liabilities 27,495 (165,590) 352,975

Deferred gross profit --- --- (448,270)

Net cash provided by (used in) operating activities (1,786,654) 7,756,434 505,234

INVESTING ACTIVITIES

Purchases of furniture and equipment (309,139) (207,290) (238,407)

Proceeds from sale of furniture and equipment --- 60,000 ---

Advance to John M. Bachman, Inc. --- (135,000) ---

Advance to Norstel AB --- (400,000) ---

Other (24,063) (13,196) (117,913)

Net cash used in investing activities (333,202) (695,486) (356,320)

FINANCING ACTIVITIES

Proceeds from exercise of stock options 245,387 1,768,065 1,400,744

Payment of cash dividends (1,480,360) (699,309) ---

Excess tax benefits from share-based payment arrangements 173,783 --- ---

Purchase of common stock (4,059,719) --- (234,934)

Net cash provided by (used in) financing activities (5,120,909) 1,068,756 1,165,810

Net change in cash and equivalents (7,240,765) 8,129,704 1,314,724

Cash and equivalents at beginning of year 21,003,551 12,873,847 11,559,123

Cash and equivalents at end of year $13,762,786 $21,003,551 $12,873,847

SUPPLEMENTAL SCHEDULE OF CASH FLOW DATA

Cash paid for income taxes $ 876,652 $ 86,000 $ 67,500

SUPPLEMENTAL NON-CASH INVESTING ACTIVITY:

Reduction of notes receivable $ 113,982 $ --- $ ---


ConsolidatedStatements

of Cash Flows

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004

1. ORGANIZATION ANDBASIS OF PRESENTATION

Charles & Colvard, Ltd. (“the Company”),was incorporated in North Carolina on June28, 1995 and manufactures, markets anddistributes Charles & Colvard createdMoissanite jewels (hereinafter referred to asmoissanite or moissanite jewels) for sale inthe worldwide jewelry market. Moissanite,also known by its chemical name, siliconcarbide (SiC), is a rare, naturally occurringmineral found primarily in meteors.Moissanite is being positioned as a uniquejewel, distinct from all other jewels basedon its fire, brilliance, luster, durability andrarity. From its inception in June 1995through June 1998, the Company was adevelopment stage enterprise that devotedits resources to fund research anddevelopment of colorless, scientificallymade moissanite jewels. The Companybegan shipping moissanite during 1998 andsells worldwide to jewel distributors andjewelry manufacturers.

All of the Company’s activities are within asingle business segment. The followingtables present certain data by geographicarea:

Net Sales Year Ended December 31, 2006 2005 2004

United States $ 36,021,806 $ 40,355,545 $20,885,841

International 4,690,279 3,188,545 3,031,204

Total $ 40,712,085 $ 43,544,090 $23,917,045

Furniture and equipment, netDecember 31, 2006 2005

United States $ 596,873 $ 436,060

International (All in Asia) 54,261 60,276

Total $ 651,134 $ 496,336

2. SUMMARY OF SIGNIFICANTACCOUNTING POLICIES

Principles of ConsolidationThe accompanying consolidated financialstatements include the accounts of theCompany and its wholly owned subsidiaryin Hong Kong, Charles & Colvard (HK),Ltd. These consolidated financialstatements also include the accounts of aCharles & Colvard controlled company inChina, Guangzhou Charles & ColvardTrading Limited, a Chinese Corporation.The Company is the beneficial owner of theentire interest in the controlled company,and has consolidated the accounts of thecontrolled company in its consolidatedfinancial statements. All inter-company

accounts have been eliminated.

Cash and EquivalentsThe Company considers all money marketaccounts and investments purchased withan original maturity of three months or lessto be cash equivalents.

InventoryInventories are stated at the lower of cost ormarket determined on a first in, first outbasis. Inventory costs include directmaterial and labor, inbound freight,purchasing and receiving costs, inspectioncosts and warehousing costs. A significantamount of inventory must be maintained atall times to be prepared to react to possiblecustomer demand for large purchases andfor a variety of jewel styles. In addition, theCompany has entered into certainagreements to consign inventory for new orexpanding retail opportunities. Theseconsignments require a significant amountof inventory to be maintained. Anyinventory on hand in excess of theCompany’s current requirements based onhistorical and anticipated level of sales isclassified as long-term on the Company’sconsolidated balance sheets.

The Company currently sells one grade ofjewel. The grade is classified as “very good”and consists of near colorless jewels thatmeet certain standards. Only “very good”jewels are valued in inventory. There is asubstantial amount of jewels, includingcolored jewels that have not met theCompany’s quality standards and are notvalued in inventory. As market conditionschange, including the influences ofcustomer demand, there may be a marketfor a portion of this unvalued inventory thatmanagement may pursue in the future.

Obsolescence is not a factor in theCompany’s inventory valuation. TheCompany’s jewels do not degrade over timeand inventory generally consists of the cutsand sizes most commonly used in thejewelry industry. All inventories arecarefully reviewed for quality standardsbefore they are entered into finished goods.As the quality of the Company’s rawmaterial has improved, so have thestandards used to evaluate finished goods.To ensure the Company’s inventory meetsour current standards, the Companyreviews the inventory on an ongoing basis.The Company has provided a reserve toallow for certain jewels of a slightly lesserquality in its finished goods inventory to bere-cut to increase their quality and/or tosatisfy certain cuts/sizes demanded by itscustomers. The need for adjustments tothis reserve is evaluated on a period-by-

period basis. More details on this reserveare included in Footnote 3.

The Company has a limited amount ofjewelry in inventory and does not activelymarket its jewelry inventory. Jewelryinventory value is calculated as the amountthe Company would obtain by melting thegold in the jewelry and putting the jewelsback into its loose stone inventory. Moredetails on this reserve are included inFootnote 3.

Furniture and Equipment

Furniture and equipment is recorded at costand depreciated on the straight-linemethod based on estimated useful lives oftwo to 12 years. Leasehold improvementsare amortized on the straight-line methodover the life of the related lease. The rangeof useful lives for each category of furnitureand equipment is as follows:

• Machinery and equipment 5-12 years• Computer equipment 2-5 years• Furniture and fixtures 3-10 years• Leasehold improvements over the life of

our existing operating leases

Patents and License RightsThe Company capitalizes costs associatedwith obtaining patents issued or pendingfor inventions and license rights related tothe manufacture of moissanite jewels. Suchcosts are amortized over the life of thepatent (generally 17 years). The Companyalso capitalizes licenses it obtains for theuse of certain advertising images. Suchcosts are amortized over the period of thelicense.

Accounting for Long-Lived AssetsThe Company evaluates the recoverabilityof its long-lived assets for financialimpairment whenever events or changes incircumstances indicate that the carryingvalue of such assets may not be fullyrecoverable. Based on these evaluations,there were no significant adjustments tothe carrying value of long-lived assets in2006, 2005 or 2004.

Concentrations of Credit RiskFinancial instruments that potentiallysubject the Company to concentrations ofcredit risk are primarily cash equivalentsand trade receivables. The Companymaintains cash and cash equivalents withhigh quality financial institutions andinvests in low risk securities, primarilymoney market funds.

Trade receivables potentially subject the

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Company to credit risk. The Company’sstandard payment terms for jeweldistributors are generally between 30 and60 days and for jewelry manufacturers aregenerally between 60 to 90 days. In limitedcircumstances, the Company may extendterms of 120 days. The Company extendscredit to its customers based upon anevaluation of the customer’s financialcondition and credit history and generallydoes not require collateral.

One customer accounted for 55% and 71%of the Company’s receivables at December31, 2006 and 2005, respectively, and for37%, 39%, and 24% of the Company’s salesduring the years ended December 31, 2006,2005, and 2004. A second customeraccounted for 21% and 2% of theCompany’s receivables at December 31,2006 and 2005, respectively, and for 13%,1%, and 1% of the Company’s sales duringthe years ended December 31, 2006, 2005,and 2004. A third customer accounted for11% and 20% of the Company’s receivablesat December 31, 2006 and 2005,respectively, and for 21%, 39%, and 34% ofthe Company’s sales during the yearsended December 31, 2006, 2005, and 2004.

Foreign Currency TranslationThe assets and liabilities of the Company’snon-U.S. operations, whose local currencyis the functional currency, are translatedinto U.S. dollars at exchange rates in effecton the balance sheet dates. Revenues andexpenses are translated using the averageexchange rates in effect during the year.Foreign currency translation adjustmentsare reflected as a separate component ofshareholders’ equity in the accompanyingconsolidated balance sheets in accumulatedother comprehensive loss.

Revenue RecognitionRevenue is generally recognized whenproducts are shipped. At the time revenueis recognized an allowance for estimatedreturns is established. Any increase ordecrease in the allowance for returns ischarged against net sales. The Company’sstandard payment terms for jeweldistributors are generally between 30 and60 days and for jewelry manufacturers aregenerally between 60 to 90 days. In limitedcircumstances, the Company may extendterms of 120 days. Some customers arerequired to prepay prior to shipment. Forall jewels shipped title passes uponshipment of the jewels from the Company’sfacility (i.e., FOB-shipping point). TheCompany’s return policy is that jewels canonly be returned for credit within 30 days ofshipment and must be returned for a validreason (quality problems or a shipment of

the wrong jewels). Some customers have acontractual right to return a certainpercentage of sales for any reason. In theseinstances, we only recognize revenue whenthe contractual right to return is exhausted.Periodically, the Company sells product tocustomers on “memo” terms. Forshipments on memo terms, the customerassumes the risk of loss and has an absoluteright of return for a specified period. TheCompany’s customers are generallyrequired to make payments on memoshipments within 30 days upon thecustomer informing the Company that theywill keep the product. Accordingly, theCompany does not recognize revenue onthese memo transactions until the earlier of(1) the customer informing the Companythat they will keep the product or (2) theexpiration of the right of return period. The$2,024,000 of inventory on consignment atDecember 31, 2006 represents potentialrevenue of approximately $7,842,000 andpotential gross profit of approximately$5,818,000 based on the average cost percarat of inventory at December 31, 2006. AtDecember 31, 2006 the remaining lengthsof the right of return periods for the related“memo” shipments range from one totwelve months. From time to time, we dogrant extensions to our customers of theright of return period depending on thefacts and circumstances of the request.

Advertising CostsAdvertising production costs are expensedas incurred. Media placement costs areexpensed the first time the advertisingappears. Advertising expenses for the yearsended December 31, 2006, 2005, and 2004amounted to approximately $11,000,000,$9,800,000, and $5,700,000, respectively.

The Company also offers a co-opadvertising program to its customers thatreimburses a portion of their marketingcosts based on the customers’net purchasesfrom the Company and is subject to thecustomer providing documentation of alladvertising performed that includes theCompany’s product. For the years endedDecember 31, 2006, 2005 and 2004, theseamounts were $3,670,000, $3,667,000, and$1,635,000, respectively, and are included asa component of marketing and salesexpenses. These co-op advertisingexpenses are included in the advertisingexpense amounts disclosed in theparagraph above.

Marketing and Sales Marketing and sales expenses are expensedas incurred. These costs include allexpenses of promoting and selling theCompany’s product and include such items

as marketing and sales personnel,advertising, travel, rent, trade shows,market research, and sales commissions.

General and Administrative General and administrative expenses areexpensed as incurred. These costs includeadministrative personnel, legal, investorrelations, professional fees, Board ofDirectors fees, insurance, bad debts andrent.

Research and DevelopmentAll research and development costs areexpensed as incurred.

Share-Based CompensationEffective January 1, 2006, the Companyadopted Statement of Financial AccountingStandards (FAS) No. 123R, Share-BasedPayment, which requires all share-basedpayments to employees, including grants ofemployee stock options, to be recognized inthe income statement based on their fairvalues. The Company adopted FAS No.123R using the modified-prospectivemethod, which requires compensation costto be recorded for all unvested stock awardsas of December 31, 2005 by recognizing theunamortized grant date fair value of theseawards over the remaining service periodsof those awards with no restatement ofprior periods. The Company uses theBlack-Scholes-Merton valuation model todetermine the fair value of stock options.The fair value of other stock compensationawards is determined by the market price ofthe Company’s common stock on the dateof grant. The expense associated withshare-based compensation is recognizedon a straight line basis over the serviceperiod of each award.

Prior to 2006, the Company measuredcompensation costs related to stock optionsand other share-based compensationawards to employees using the intrinsicvalue of the equity instrument granted (i.e.,the excess of the market price of the stockto be issued over the exercise price of theequity instrument at the date of grant)rather than the fair value of the equityinstrument. Accordingly, because the stockoption grant price for employees equaledthe market price on the date of grant, nocompensation expense was recognized bythe Company for stock options awarded toemployees. In December 2005, theCompany accelerated the vesting of certainoutstanding stock options held by currentemployees and non-employee directors. Asa result of this vesting acceleration, theCompany recorded $54,019 of expense inthe year ended December 31, 2005. The


only share-based compensation recordedby the Company prior to 2006, other thanthe expense for the vesting acceleration,was due to stock options granted to outsideconsultants. The Company has accountedfor stock options granted to consultantsusing the fair value method for all periodspresented.

The following table summarizes thecomponents of the Company’s share-basedcompensation included in reported netincome for the three years ended December31, 2006 as follows:

Year Ended December 31, 2006 2005 2004Employee Stock Options $ 200,059 $ 54,019 $ ---Consultant Stock Options (61,072) 1,010,598 70,672Restricted Stock Awards 177,905 --- ---Income Tax Benefit (84,683) (386,371) (27,247)Total $ 232,209 $ 678,246 $ 43,425

In addition, $7,585 of share-basedcompensation was capitalized as a cost ofinventory during the year ended December31, 2006. A $61,072 reduction in previouslyrecognized compensation cost onconsultant stock options was recognizedduring the year ended December 31, 2006due to a reduction in the fair value of stockawards issued to consultants.

As of December 31, 2006, the unrecognizedshare-based compensation expense relatedto non-vested stock options isapproximately $515,000, which is expectedto be recognized over a weighted averageperiod of approximately 25 months.

In May 2006, the Company granted its non-employee board members an aggregate of27,377 shares of restricted stock. The boardmembers cannot sell these shares untiltheir one-year term on the board expires inMay 2007. The fair value of the restrictedstock granted was $305,000 based on theclosing market price of the Company’scommon stock on May 19, 2006. These arethe only restricted stock awards currentlyoutstanding for the Company. As ofDecember 31, 2006 unrecognizedcompensation expense related to non-vested restricted stock was $127,095 whichwill be amortized on a straight line basisthrough May 2007.

Had compensation expense prior toJanuary 1, 2006 for all share-basedcompensation been determined consistentwith the provisions of FAS 123, rather thanAPB 25, the Company’s net income andincome per share for the years ended

December 31, 2005 and 2004 would havebeen recorded to the pro forma amountsindicated below. Disclosures for the yearended December 31, 2006 are notpresented because the amounts for share-based compensation have been recognizedin the consolidated financial statements forthat period.

Year Ended December 31, 2005 2004

Net income:

As reported $ 5,874,667 $ 1,612,292

Deduct – total share-based compensation expense under fair value method for all awards, net of income tax 1,707,331 334,744

Pro forma net income $ 4,167,336 $ 1,277,548

Basic net income per share:

As reported $ 0.33 $ 0.09Pro forma 0.23 0.07

Diluted net income per share:

As reported $ 0.31 $ 0.09Pro forma 0.22 0.07

The fair value of each option grant isestimated on the grant date using a Black-Scholes-Merton option pricing model. Thevaluations of options granted during thethree years ended December 31, 2006 werebased on the following assumptions:

Year Ended December 31, 2006 2005 2004Weighted-average grant date fair value $ 6.39 $ 6.83 $ 2.61Weighted-average expected lives (in years) 4.00 5.94 7.00Weighted-average risk-free interest rate 4.60% 4.22% 3.612%Dividend yield 0% 0% 0%Volatility factor .646 .884 .912

The expected life of an option representsthe estimated period of time until exerciseoccurs and the Company generally uses themidpoint of the vesting period and the lifeof the grant to estimate the expected life ofan option. This methodology is notmaterially different from the Company’shistorical data on exercise timing. The risk-free interest rate is based on the impliedyields on U.S. Treasury zero-coupon issuesover the expected life of the option.Although the Company has recently issueddividends, a dividend yield was not useddue to the uncertainty of future dividendpayments. Expected volatility is based onthe historical volatility of the Company’sstock.

Use of EstimatesThe preparation of financial statements in

conformity with accounting principlesgenerally accepted in the United States ofAmerica requires management to makeestimates and assumptions that affect thereported amounts of assets and liabilities,disclosure of contingent assets andliabilities at the date of the financialstatements and the reported amounts ofrevenues and expenses during thereporting period. Actual results could differfrom those estimates.

Income TaxesDeferred income taxes are recognized forthe income tax consequences of“temporary” differences by applyingenacted statutory income tax ratesapplicable to future years to differencesbetween the financial statement carryingamounts and the income tax bases ofexisting assets and liabilities. Valuationallowances are established when necessaryto reduce deferred income tax assets to theamount that is likely to be realized.

Net Income Per ShareBasic net income per share computationsare based on the weighted-averagecommon shares outstanding. Diluted netincome per share computations include thedilutive effect, if any, of stock options usingthe treasury stock method. The followingtable reconciles the differences between thebasic and diluted earnings per sharepresentations:

Years Ended December 31, 2006 2005 2004Numerator:

Net Income $ 6,105,335 $ 5,874,667 $ 1,612,292Denominator:Weighted Average Shares Outstanding

Basic 18,160,218 18,008,855 17,467,173Stock Options 502,552 954,256 540,553Diluted 18,662,770 18,963,111 18,007,726

Net Income Per Share:Basic $ 0.34 $ 0.33 $ 0.09Diluted $ 0.33 $ 0.31 $ 0.09

For the years ended December 31, 2006,2005, and 2004, stock options to purchaseapproximately 310,000, 12,000, and 755,000shares, respectively, were excluded from thecomputation of diluted net income pershare because the options’ exercise pricewas greater than the average market priceof the common shares. During 2006,approximately 957,000 common stockoptions with an exercise price less than theaverage market price were included in thecomputation of diluted earnings per share.The weighted-average dilutive impact of


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23

these options, net of 455,000 treasuryshares assumed to be repurchased, was502,552 shares. During 2005,approximately 1,442,000 common stockoptions with an exercise price less than theaverage market price were included in thecomputation of diluted earnings per share.The weighted-average dilutive impact ofthese options, net of 487,000 treasuryshares assumed to be repurchased, was954,256 shares. During 2004,approximately 1,509,000 common stockoptions with an exercise price less than theaverage market price were included in thecomputation of diluted earnings per share.The weighted-average dilutive impact ofthese options, net of 919,000 treasuryshares assumed to be repurchased, was540,553 shares.

Stock Dividends and Stock SplitsOn May 23, 2005, the Company declared a5% stock dividend distributed on July 15,2005. On December 21, 2005, theCompany declared a one share for everyfour shares owned stock split, effected inthe form of a 25% stock dividend,distributed on January 30, 2006. All shareand per share amounts for all periodspresented in these financial statements andfootnotes reflect these transactions.

Newly Adopted AccountingPronouncementsIn December 2004, FAS No. 123R, Share-Based Payment, was issued as a revision toFAS No. 123, Accounting for Stock-BasedCompensation. This statement supercededAPB Opinion No. 25, Accounting for StockIssued to Employees, and amends FAS No.95, Statement of Cash Flows. Generally, theapproach in FAS No. 123R is similar to theapproach described in FAS No. 123;however, FAS No. 123R requires that allshare-based payments to employees,including grants of employee stock options,be recognized in the income statementbased on their fair values. Pro formadisclosure is no longer an alternative. FASNo. 123R also requires the benefits ofincome tax deductions in excess ofrecognized compensation cost to bereported as a financing cash flow, ratherthan as an operating cash flow as requiredunder FAS No. 95.

FAS No. 123R was adopted by theCompany on January 1, 2006. Prior to thatdate, the Company accounted for share-based payments to employees using theintrinsic value method in accordance withAPB Opinion No. 25 and, since theCompany granted employee stock optionswith an exercise price that was equivalentto market value at the date of grant, the

Company generally recognized nocompensation cost for employee stockoptions. Had the Company adopted FASNo. 123R in prior periods, the impact ofthat standard would have approximated theimpact of FAS No. 123 as described in thedisclosure of pro forma net income andearnings per share in Note 2 of theseconsolidated financial statements.

As a result of the adoption of FAS No.123R, the Company recordedcompensation expense due to share-basedemployee compensation awards during theyear ended December 31, 2006 of $377,964in operating expenses, which is before anincome tax benefit of $106,799, resulting ina decrease to net income of $271,165. Inaddition, there was $7,585 of share-basedemployee compensation capitalized asinventory costs during the year endedDecember 31, 2006.There was no change inthe way the Company accounted for stockoptions granted to consultants.

The Company receives an income taxdeduction for certain stock option exerciseswhen the options are exercised, generallyfor the excess of the stock price on the dateof exercise over the option price. Prior tothe adoption of FAS No. 123R, theCompany presented all tax benefitsresulting from the exercise of stock optionsas an operating cash inflow in its Statementof Cash Flows. FAS No. 123R requires thebenefits of tax deductions in excess of thegrant date fair value for those options to beclassified as financing cash inflows ratherthan operating cash inflows, on aprospective basis. The income tax benefitsfrom the exercise of stock options duringthe year ended December 31, 2006 havebeen reflected as “Excess tax benefits fromshare-based payment arrangements”on theConsolidated Statement of Cash Flows. Forthe year ended December 31, 2006, suchamount was $173,783 resulting in adecrease in cash from operations andincrease in cash provided by financingactivities of this amount.

In November 2004, FAS No. 151, InventoryCosts, was issued. This statement amendsthe guidance in Accounting ResearchBulletin No. 43, Chapter 4, Inventory Pricing,to clarify the accounting for abnormalamounts of idle facility expense, freight,handling costs, and wasted material. FAS151 requires that those items be recognizedas current period charges. In addition, FAS151 requires the allocation of fixedproduction overheads to inventory basedon the normal capacity of the productionfacilities. The provisions of this statementwere effective for inventory costs incurredduring fiscal years beginning after June 15,2005. The adoption of FAS 151 had no

effect on the Company’s consolidatedfinancial statements.

Newly Issued AccountingPronouncementsIn July 2006, the Financial AccountingStandards Board (FASB) issued FASInterpretation No. 48 (FIN 48), Accountingfor Uncertainty in Income Taxes, whichprescribes a recognition threshold andmeasurement process for recording in thefinancial statements uncertain tax positionstaken or expected to be taken in a taxreturn. Additionally, FIN 48 providesguidance on the recognition, classification,accounting in interim periods anddisclosure requirements for uncertain taxpositions. The accounting provisions of FIN48 became effective for the Companybeginning on January 1, 2007. TheCompany is in the process of determiningthe effect that the adoption of FIN 48 willhave on its financial statements.

3. INVENTORIES

Inventories consisted of the following:

December 31, 2006 2005Raw materials $ 2,590,782 $ 1,526,099Work-in-process 13,102,777 9,026,266Finished goods 16,791,796 12,615,663Total Inventory $ 32,485,355 $ 23,168,028

Finished goods are shown net of a reservefor excess jewelry inventory of $40,000 and$95,000 at December 31, 2006 andDecember 31, 2005, respectively. TheCompany does not actively market itsjewelry inventory. Jewelry inventory valueis determined as the amount we wouldobtain by melting the gold in the jewelryand putting the jewels back into loose stoneinventory. The reserve was decreasedduring the year ended December 31, 2006as a portion of the jewelry inventory wassold. In addition, finished goods are shownnet of a lower of cost or market reserve of$400,000 at December 31, 2006 andDecember 31, 2005. This reserve wasestablished to allow for the carat weightloss associated with the re-cutting of aportion of the finished goods inventory.There are certain jewels in inventory thatmay be re-cut to achieve higher qualitystandards.

The Company’s raw material inventories ofsilicon carbide crystals are purchased underexclusive supply agreements with a limited number of suppliers. Because thesupply agreements restrict the sale of these crystals to only the Company, thesuppliers negotiate minimum purchase


commitments with the Company that mayresult in periodic levels of raw and in-process inventories that are higher than theCompany might otherwise maintain. Theseagreements coupled with lower thanexpected 2006 sales resulted in $11.8million of our inventories being classified aslong-term assets at December 31, 2006.

4. INVENTORY ONCONSIGNMENT

Periodically, the Company sells product tocustomers on “memo” terms. Forshipments on “memo” terms, the customerassumes the risk of loss and has an absoluteright of return for a specified period. TheCompany does not recognize revenue onthese transactions until the earlier of (1) thecustomer informing the Company that theywill keep the product or (2) the expirationof the memo period. The $2,024,000 ofinventory on consignment at December 31,2006 represents potential revenue ofapproximately $7,842,000 and potentialgross profit of approximately $5,818,000based on the average cost per carat ofinventory at December 31, 2006.

5. FURNITURE ANDEQUIPMENT AND PATENTAND LICENSE RIGHTS

Furniture and equipment, net ofaccumulated depreciation, is summarizedas follows:

December 31, 2006 2005

Machinery and equipment $ 394,473 $ 355,122

Computer equipment 708,127 597,854

Furniture and fixtures 324,894 325,204

Leasehold improvements 97,090 97,090

Construction in progress 167,694 21,694

Total 1,692,278 1,396,964

Accumulated depreciation (1,041,144) (900,628)

Total furniture and equipment, net $ 651,134 $ 496,336

Depreciation expense for 2006, 2005, and2004 was $154,341, $163,316, and $152,826,respectively.

Patent and license rights, net ofaccumulated amortization, is summarizedas follows:

December 31, 2006 2005

Patent and license rights $ 478,043 $ 531,144

Accumulated amortization (189,872) (232,620)

Patent and license rights, net $ 288,171 $ 298,524

Amortization expense for 2006, 2005, and2004 was $34,416, $84,125, and $44,368,respectively. Amortization expense onexisting patent and license rights is

estimated to be $32,000 for 2007, and$31,000 per year for 2008 through 2011.

6. COMMON STOCKIn December 2003, the Board of Directorsauthorized a follow-on repurchase programfor up to 1,181,250 shares of the Company’scommon stock. This program expired inDecember 2004. During the year endedDecember 31, 2004, there were 60,870shares repurchased at an average price of$3.86.

In March 2006, the Board of Directorsauthorized a repurchase program for up to1,000,000 shares of the Company’scommon stock. Repurchases were made inthe open market at prevailing prices or inprivately negotiated transactions at pricesat or below prevailing open market prices.This program expires in March 2007.During the year ended December 31, 2006,there were 415,000 shares repurchasedunder the program at an average price of$9.78.

7. PREFERRED STOCKThe Company has authorized 10 millionshares of preferred stock, no par value. Thepreferred stock may be issued from time totime in one or more series. No shares ofpreferred stock have been issued as ofDecember 31, 2006.

On February 21, 1999 the Companyadopted a Shareholder Rights Plan underwhich all shareholders of record as ofMarch 8, 1999 received rights to purchaseshares of a new series of Preferred Stock.The adoption of this plan is intended as ameans to guard against abusive takeovertactics. The rights will be exercisable only ifa person or group acquires or announces atender offer to acquire 20% or more of theCompany’s common stock. Under the planall shareholders except the purchaser willbe entitled to acquire the Company’scommon stock at a 50% discount. Therights will trade with the Company’scommon stock, unless and until they areseparated upon the occurrence of certainfuture events.

8. DIVIDENDSOn May 23, 2005, the Company declared a$0.038 per share cash dividend and a 5%stock dividend both distributed on July 15,2005. Pursuant to these dividends, totalcash of $699,309 and 859,457 shares of ourcommon stock were distributed toshareholders. The stock dividend providedshareholders as of the record date oneshare for every 20 shares owned and cash inlieu of fractional shares.

On December 21, 2005, the Companydeclared a one share for every four sharesowned stock split, effected in the form of a25% stock dividend, distributed on January30, 2006. Pursuant to this dividend, totalcash of $24,280 and 3,658,999 shares of ourcommon stock were distributed toshareholders. The stock dividend providedshareholders one share for every fourshares owned and cash in lieu of fractionalshares.

On April 18, 2006, the Company declared a$0.08 per share cash dividend distributedon June 15, 2006. Pursuant to this dividend,total cash of $1,456,080 was distributed toshareholders.

All share and per share amounts for allperiods presented in these financialstatements and footnotes reflect the effectof both the 5% stock dividend and the stocksplit transactions.

9. COMPENSATION

Stock Option PlansIn 1996, the Company adopted the 1996Stock Option Plan of Charles & Colvard,Ltd., (the “1996 Option Plan”) under whichoptions to acquire 1,020,402 commonshares, reduced by the number of optionsgranted outside the 1996 Option Plan, maybe granted to key employees, directors andindependent consultants. Under the 1996Option Plan, both incentive and non-qualified options may be granted underterms and conditions established by theCompensation Committee of the Board ofDirectors. The exercise price for incentiveoptions will be the fair market value of therelated common stock on the date theoption is granted. Options granted underthe 1996 Option Plan generally vest equallyover a three-year period and have terms of10 years. The Company currently has noplans to award additional options under the1996 Option Plan.

In 1997, the Company adopted the 1997Omnibus Stock Plan of Charles & Colvard,Ltd., (the “1997 Omnibus Plan”). The 1997Omnibus Plan authorizes the Company togrant stock options, stock appreciationrights and restricted awards (collectively,“awards”) to selected employees,independent contractors and directors ofthe Company and related corporations inorder to promote a closer identification oftheir interests with those of the Companyand its shareholders. The maximumnumber of shares of common stock forwhich awards may be granted under the1997 Omnibus Plan may be increased fromtime to time to a number of shares equal to


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(i) 20% of the shares of common stockoutstanding as of that time less (ii) thenumber of shares of common stock subjectto outstanding options under the 1996Option Plan. The number of shares reservedfor issuance under the 1997 Omnibus Planmay also be adjusted upon certain eventsaffecting the Company’s capitalization. Alloptions granted under the 1997 OmnibusPlan have an exercise price equal to themarket price of our common stock on thedate the option is granted. Options grantedto employees under the 1997 Omnibus Plangenerally vest over three years and haveterms of up to 10 years, with the exception ofoptions granted in 2005 under the ExecutiveCompensation Plan (which is governed byand subject to the 1997 Omnibus Plan) thatvested immediately and options granted in2006 under the Executive CompensationPlan that vest at the end of 3 years. Optionsgranted to the Board of Directors under the1997 Omnibus Plan generally vest over oneyear and have terms of up to 10 years. Theterms of options granted to outsideconsultants vary depending on the specificgrant, but the terms will be no longer than10 years. Restricted stock awards granted tomembers of the Board of Directors vest atthe end of one year. The Board of Directorshas reserved 2,271,821 shares for issuanceunder the 1997 Omnibus Plan.

The 1997 Omnibus Plan expires in 2007. TheCompany will present a new stock optionplan for shareholder approval at the May2007 Annual Shareholders Meeting.

Effective December 21, 2005, the Companyaccelerated the vesting of certainoutstanding stock options held by currentemployees and non-employee directors inorder to reduce the impact of newaccounting regulations that became effectivein 2006. As a result of this vestingacceleration, options to purchaseapproximately 134,000 shares of theCompany’s common stock that wouldotherwise have vested at various timeswithin the next three years became fullyvested. The decision to accelerate theseunvested options, which managementbelieves is in the best interest of theCompany and its shareholders, was madeprimarily to reduce compensation expensethat would be recorded in future periodssubsequent to December 31, 2005. TheCompany recorded approximately $54,000of expense in the year ended December 31,2005 as the result of the accelerated vesting. The acceleration of the vesting ofthese stock options reduced futurecompensation expense by approximately$522,000, of which $369,000 would haveoccurred in 2006.

The aggregate intrinsic value of optionsoutstanding, exercisable, vested or expectedto vest at December 31, 2006 was$3,174,957, $3,173,493 and $3,174,957,respectively. This amount is beforeapplicable income taxes and represents theclosing stock price of the Company’scommon stock at December 31, 2006 lessthe grant price, multiplied by the number ofoptions that have a grant price that is lessthan the closing stock price. This amountrepresents the amount that would havebeen received by the optionees had theseoptions been exercised on that date. Duringthe years ended December 31, 2006, 2005,and 2004, the aggregate intrinsic value ofoptions exercised was $493,047, $7,697,083,and $981,450, respectively.

The following is a summary of activity forrestricted stock granted by the Company:

Numberof Grant Date

Shares Fair ValueNon-vested at January 1, 2006 --- $ ---Granted 27,377 $ 11.14Vested --- $ ---Cancelled --- $ ---Non-vested at December 31, 2006 27,377 $ 11.14


The following is a summary of activity for the Company's two stock option plans:1996 Option Plan 1997 Omnibus Plan

Weighted- Weighted-Number Average Number Average

Of Exercise Of ExerciseShares Price Shares Price

2004Outstanding at the beginning of the year 433,452 $ 3.13 1,647,810 $ 5.25

Granted --- --- 189,770 4.62Exercised (250,869) 3.20 (196,185) 3.08Canceled (34,714) 3.25 (222,275) 9.64

Outstanding at end of year 147,869 2.99 1,419,120 4.77

2005Granted --- --- 308,356 9.33Exercised (83,573) 2.84 (487,375) 3.14Canceled --- --- (99,418) 10.56

Outstanding at end of year 64,296 3.18 1,140,683 6.20

2006Granted --- --- 116,424 12.11Exercised (14,927) 2.09 (51,265) 4.18Canceled --- --- (3,523) 10.10

Outstanding at end of year 49,369 $ 3.51 1,202,319 $ 6.84

The following summarizes information about stock options at December 31, 2006:

Options Outstanding Options Exercisable Options Vested or Expected to Vest

Weighted- Weighted Weighted-Average Weighted- Average Weighted- Average Weighted-

Outstanding Remaining Average Outstanding Remaining Average Outstanding Remaining Averageas of Contractual Exercise as of Contractual Exercise as of Contractual Exercise

12/31/2006 Life Price 12/31/2006 Life Price 12/31/2006 Life Price

1,251,688 4.0 $ 6.71 1,134,796 4.0 $ 6.16 1,247,786 4.0 $ 6.69

OtherIn February 2004, the Company amendedthe 2001 Executive Compensation Plan sothat it would be effective during 2004. Thisplan offered key employees of theCompany incentive awards in the form ofcash payments and/or stock option grantsbased upon the Company’s attainment ofcertain performance goals. For 2004,$210,000 in cash payments were recordedas operating expenses and 115,000 stockoptions were granted under the plan. Nocompensation expense was recorded in theaccompanying financial statements for thestock options granted under the plan.

In April 2005, the Company adopted twoincentive plans for 2005, the ManagementIncentive Plan (2005) (the “2005Management Plan”) and the Quarterly &Annual Incentive Plan for Non-OfficerEmployees (2005) (the “2005 Non-OfficerEmployees Plan”). The principal purpose ofeach of the plans was to provide incentivesto meet or exceed certain Company goalsfor 2005. Both plans provide for cash andequity awards. For 2005, $775,000 in cashpayments under the 2005 ManagementPlan and $107,000 in cash payments underthe 2005 Non-Officer Employees Plan were recorded as operating expenses.During 2005, 9,900 options were issuedunder the 2005 Non-Officer EmployeesPlan, as the Company met certain quarterlygoals. In February 2006, there were 105,000stock options granted under the 2005Management Plan and 2,600 stock optionsgranted under the 2005 Non-OfficerEmployees Plan. The options grantedunder the 2005 Management Plan vest atthe end of 3 years and the options grantedunder the 2005 Non-Officer EmployeesPlan vest ratably over 3 years.

In February 2006, the Company approvedtwo incentive plans for 2006, theManagement Incentive Plan (2006) (the“2006 Management Plan”) and theQuarterly & Annual Incentive Plan forNon-Officer Employees (2006) (the “2006Non-Officer Employees Plan”). Theprincipal purpose of each of the plans is toprovide incentives to meet or exceed certainCompany goals for 2006. Both plansprovide for cash and equity awards. Allequity awards, if any, will be made pursuantto the Company’s 1997 Omnibus StockPlan (as amended). The specific criteriaused to determine whether any eligibleparticipant will receive an award includethe Company’s net sales and net incomeand, for participants under the 2006Management Plan and for certain directorlevel employees under the 2006 Non-Officer Employee Plan, other key objectivesas set by the Company. During 2006,$83,205 in cash payments were recorded as

operating expense and 200 stock optionswere granted under the plans.

In February 2007, the Company approvedtwo incentive plans for 2007, theManagement Incentive Plan (2007) (the“2007 Management Plan”) and theQuarterly & Annual Incentive Plan forNon-Officer Employees (2007) (the “2007Non-Officer Employees Plan”). Theprincipal purpose and operative provisionsare substantially similar to the terms of the2006 Management Plan and the 2006 Non-Officer Employees Plan discussed in theparagraph above.

10. INCOME TAXESThe Company accounts for income taxesunder the liability method. Under theliability method, deferred income taxes arerecognized for the income taxconsequences of “temporary differences”byapplying enacted statutory income tax ratesapplicable to future years to differencesbetween the financial statement carryingamounts and the income tax bases ofexisting assets and liabilities.

The components of income tax expense arethe following.

Year Ended December 31, 2006 2005 2004Current

Federal $ 1,568,023 $ 2,638,747 $ 378,747State 10,223 152,271 25,190

1,578,246 2,791,018 403,937Deferred

Federal 2,120,961 749,340 876,411State 365,999 218,557 283,908

2,486,960 967,897 1,160,319$ 4,065,206 $ 3,758,915 $ 1,564,256

Significant components of the Company’sdeferred income tax assets and liabilities areas follows:

December 31, 2006 2005

Current

Reserves and accruals $ 355,883 $ 250,869

Deferred inter-company profit 227,439 349,796

Total Short-Term 583,322 600,665

Long-TermFederal and state net operating loss (“NOL”) carryforwards 198,000 2,002,000

Hong Kong and China NOL carryforwards 864,000 694,000

Benefit of research tax credits --- 665,000

Alternative minimum tax credit --- 227,000

Share-based compensation 540,000 456,000

Depreciation (51,379) (70,581)

Valuation allowance (864,000) (817,181)

Total long term 686,621 3,156,238

Total deferred income tax assets, net $ 1,269,943 $ 3,756,903

A reconciliation between expected incometaxes, computed at the statutory federalincome tax rate (34%) applied to pretaxaccounting income, and the income taxesincluded in the statements of operations foreach of the three years ended December 31,2006 follows:

December 31, 2006 2005 2004

Anticipated income tax expense at the statutory federal rate $ 3,458,000 $ 3,275,000 $ 1,080,000

State income tax expense, net of federal tax effect 248,000 244,000 193,000

Effect of foreignoperations 131,000 140,000 131,000

Research tax credits --- --- (249,000)

Apportionment of state income tax 2,000 (97,000) ---

Increase in contingent liability 123,181 --- ---

Other 56,206 15,915 31,075

Increase in valuation allowance 46,819 181,000 378,181

Income tax expense $ 4,065,206 $ 3,758,915 $ 1,564,256

During 2005, the Company completed adetailed review of its activities in certainstates. As a result, the Company began toapportion income among certain state taxjurisdictions. During the year endedDecember 31, 2005, the Companyrecognized an income tax benefit of $97,000due to the change in apportionment.

After a detailed review in 2004 of theCompany’s research activities, the amountof the research credits expected to berealized was increased in 2004. Theincrease in the valuation allowance during2006, 2005, and 2004 is primarily due to theestablishment of reserves for the incometax benefit of losses in Hong Kong andChina. Valuation allowances have beenestablished for the income tax benefits ofthe losses incurred in Hong Kong andChina as it is uncertain if sufficient futuretaxable income will be generated in thesecountries to offset the existing losses. Aportion ($123,181) of the increase in thevaluation allowance during 2004 was due tocertain of the research credits claimed inthe Company’s income tax returns that arenot expected to be realized. During 2006,this portion of the research credits wasreclassed to a contingent liability as theresearch and development credits havenow been fully used on the Company’sincome tax returns.

At December 31, 2006, the Company has aNorth Carolina Tax NOL carryforward ofapproximately $4.4 million, expiring


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through 2015, which can be offset againstfuture state taxable income. The Companyexpects to fully utilize this NOL before anyof it expires.

As of December 31, 2006, there wasapproximately $4.1 million in NOLcarryforwards in Hong Kong. Inaccordance with the Hong Kong tax codethese amounts can be carried forwardindefinitely to offset future taxable incomein Hong Kong. As of December 31, 2006,there was approximately $451,000 in NOLcarryforwards in China. In accordance withthe China tax code these amounts can becarried forward 5 years to offset futuretaxable income in China. The NOLcarryforwards begin expiring in 2008. Dueto the uncertainty of generating sufficientfuture taxable income in Hong Kong andChina to utilize these NOLs, the Companyestablished a valuation allowance againstthis deferred income tax asset.

11. COMMITMENTS ANDCONTINGENCIES

Operating LeasesIn March 2004, the Company entered into aseven year lease, beginning in August 2004,for approximately 16,500 square feet ofmixed use space from an unaffiliated thirdparty at a base cost of $11,727 per month,plus additional rentals based on theCompany’s proportionate share of thelessor’s operating costs. Terms of the leaseprovide for escalations of the base monthlyrent throughout the lease term, up to$13,546 at August 1, 2010. The lease alsoset forth twelve different months (August2004-September 2004 and August 2005-May 2006) throughout the term where norent was payable and a $74,000 movingallowance that was paid to the Company.The Company recognizes rent expense on astraight line basis, giving consideration tothe free rent periods and the movingallowance paid to the Company. At theCompany’s discretion, the lease can beextended for three successive five yearperiods. Finally, the lease provides theCompany the right to terminate the lease atthe end of five years for $192,000.

The Company also maintains otheroperating leases in Hong Kong and Chinawhich expire at various dates from March2007 to October 2008.

The future minimum lease payments of theCompany are as follows: $232,000 in 2007,$169,000 in 2008, $157,000 in 2009,$160,000 in 2010 and $95,000 in 2011,totaling $813,000. Rental expense incurredfor operating leases for 2006, 2005 and 2004was approximately $309,000, $305,000 and$290,000, respectively.

Purchase CommitmentsOn June 6, 1997, the Company entered intoan Amended and Restated ExclusiveSupply Agreement (“Exclusive SupplyAgreement”) with Cree, Inc. (“Cree”). TheExclusive Supply Agreement had an initialterm of ten years that was extended in 2005to July 2015. In connection with theExclusive Supply Agreement, the Companyhas committed to purchase a minimum of50% (by dollar volume) of its requirementsfor SiC crystals from Cree. If the Company’sorders require Cree to expand beyondspecified production levels, the Companymust commit to purchase certain minimumquantities. In December 2006, theCompany agreed with Cree on a frameworkfor purchases for 2007. For each quarterduring calendar year 2007, the Companyhas committed to purchase approximately$3,200,000 of usable material. Althoughthe amount of usable material to bepurchased by the Company is expected toremain constant each quarter, theCompany's cost per quarter for the usablematerial may be less than $3,200,000depending upon the quality of the usablematerial provided by Cree during thatquarter.

During 2006, 2005, and 2004, the Companymade purchases from Cree ofapproximately $14.6 million, $11.5 million,and $6.0 million, respectively, for SiCmaterials.

In February 2005, we entered into anExclusive Supply Agreement with NorstelAB (formerly Jesperator AB) for the supplyof SiC crystals for use in the manufacturingof moissanite jewels. In March 2007, wesigned an amended agreement withNorstel AB that extended the term toDecember 31, 2009. Under the terms of theamended contract, our remainingminimum commitment under theagreement is $7.8 million, of whichapproximately $465,000 will be expensed asresearch and development. In addition, wehave advanced $400,000 towards thepurchase of certain equipment. Thisadvance is scheduled to be repaid startingJanuary 2007 through a 20% reduction onthe invoice for subsequent purchases of SiCcrystals. Effective October 1, 2007, we willreceive a 35% reduction on the invoice forsubsequent purchases of SiC crystals untilthe advance is repaid. The minimumpurchase commitment during 2007 is$1,600,000, of which approximately$275,000 will be expensed as research anddevelopment. The agreement provides uswith an option to extend the term of theagreement for a four-year period.

In November 2005 the Company enteredinto an Exclusive Supply Agreement with

Intrinsic Semiconductor, Inc. for the supplyof SiC for use in the manufacturing ofmoissanite jewels. The initial term of thecontract was for two years and includedminimum purchase commitments of usablematerials of approximately $2.2 million,subject to Intrinsic Semiconductor, Inc.meeting minimum quality standards. Theagreement gave the Company the exclusiveright to purchase silicon carbide fromIntrinsic Semiconductor, Inc. for thepurpose of fabricating, distributing orselling faceted jewels. On June 26, 2006,Cree announced that it has signed adefinitive agreement to acquire IntrinsicSemiconductor, Inc. In October 2006, ouragreement with Intrinsic was terminated.

ContingenciesThe Company is currently conducting testdistribution via one day trunk shows with anationally recognized fine jeweler. Insupport of the test distribution at thisjeweler, the Company agreed with itsmanufacturer to purchase all unsold itemsafter the test period if the stores do notcontinue with a moissanite program. Evenin such an event, the Company will onlypurchase the jewelry if the manufacturer isunable to sell the jewelry through otherretail outlets after a set period of time. Thejewels involved in this test distribution areon consignment to the manufacturer. If allof the jewelry is not sold, it is estimated thatthe maximum amount for which theCompany would be obligated isapproximately $260,000 for the gold andlabor portion of the jewelry.



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12. SELECTED QUARTERLYDATA (UNAUDITED)

STOCK PERFORMANCE GRAPHThe following line graph and table illustratethe five-year cumulative total shareholderreturn of the Company's Common Stockand the cumulative total return over thesame period of (i) the NASDAQ MarketIndex - US and (ii) a peer group composedof Movado Group, Inc. and Lazare KaplanInternational Inc. The graph assumes aninitial investment of $100 and thereinvestment of all dividends.

The Company’s peer group primarilyconsists of gemstone, watch or jewelrymanufacturers that sell their products toretail jewelers, shopping channels andcatalogs. While these companies have beenselected on the basis of the similaritiesbetween their businesses and the businessof the Company, the Company, unlike themembers of the peer group, manufacturesand sells a patented lab-created jewel thatis not currently available from othersources. The Company therefore believesthat comparisons between the Companyand the peer group may not accurately andreliably reflect the relative performance ofthe Company.

Quarters Ended

March 31 June 30 September 30 December 31

Year Ended December 31, 2006

Net sales $ 8,016,833 $ 8,513,270 $ 12,101,651 $ 12,080,331

Gross profit 5,907,090 6,386,830 8,334,415 9,288,526

Net income 1,524,247 1,095,796 2,226,431 1,258,861

Basic net income per share (1) 0.08 0.06 0.12 0.07

Diluted net income per share (1) 0.08 0.06 0.12 0.07

Year Ended December 31, 2005

Net sales $ 11,218,765 $ 9,305,774 $ 11,347,066 $ 11,672,485

Gross profit 6,952,006 6,079,890 7,657,810 8,390,974

Net income 2,011,948 740,181 2,238,280 884,258

Basic net income per share (1) 0.11 0.04 0.12 0.05

Diluted net income per share (1) 0.11 0.04 0.12 0.05

(1) The sum of the quarterly numbers do not equal the amount reported on the Statement of Operations due to rounding.

Share and per share data for all periods presented reflect the effect of the 5% stock dividend distributed on July 15, 2005,and the one share for every four shares owned stock split, effected in the form of a 25% stock dividend distributed onJanuary 30, 2006.

12/31/2001 12/31/2002 12/31/2003 12/31/2004 12/31/2005 12/31/2006

CHARLES & COLVARD, LTD. 100.00 344.87 264.74 682.05 1359.64 673.16

PEER GROUP INDEX 100.00 94.96 140.34 188.02 181.54 287.01

NASDAQ MARKET INDEX-US 100.00 68.47 102.72 111.54 113.07 123.84

Cumulative Total ReturnAmong Charles & Colvard, Ltd.,

NASDAQ Market Index-US and Peer Group Index

CORPORATE INFORMATION

Cautionary Note:

Certain statements in this Annual Report are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of theSecurities Exchange Act of 1934, as amended. Statements expressing expectations regarding our future and projections relating to products, sales, revenues and earnings aretypical 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, statementsabout 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,”“potential,”“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 statementsincluded 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 Company’s ability to manage growth effectively, dependence on Cree, Inc. as the current supplierof the substantial majority of the raw material, ability to develop a material second source of supply, dependence on a limited number of jewelry manufacturing customers,dependence on continued growth and consumer acceptance of the Company’s products, in addition to the other risks and uncertainties described in more detail in our mostrecent annual report on Form 10-K filed with the Securities and Exchange Commission. Forward-looking statements speak only as of the date they are made. We undertakeno 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 that discuss other factors relevant toour business.

DirectorsRobert S.ThomasChairman & Chief Executive OfficerCharles & Colvard, Ltd.

Lisa A. GavalesSenior Vice PresidentMarketingBloomingdale’s

Laura C. KendallCFOTanner Companies LLC

Lynn L. LaneRetired Sr.Vice President & TreasurerReynolds American, Inc.formerly, R.J. Reynolds Tobacco Holdings, Inc.

Frederick A. Russ, Ph.D.Senior Vice ProvostUniversity of Cincinnati

Geraldine L. SedlarOwner, Sedlar & MinersRetirement Consulting Firm

George A.Thornton, IIIReal Estate Developer

Executive OfficersRobert S.ThomasChairman & Chief Executive Officer

Dennis M. ReedPresident & Chief Marketing Officer

James R. BraunVice President of Finance,Chief Financial Officer, Secretary & Treasurer

Steven L. AbateVice President of Manufacturing

Carl A. MielkeSenior Vice President of Sales

Corporate HeadquartersCharles & Colvard, Ltd.300 Perimeter Park Drive, Suite AMorrisville, NC 27560

Independent RegisteredPublic Accounting FirmDeloitte & Touche LLP150 Fayetteville Street Mall, Suite 1800Raleigh, NC 27601

Transfer Agent & RegistrarAmerican Stock Transfer & Trust Company10150 Mallard Creek Drive, Suite 307Charlotte, NC 25262

Stock ListingNASDAQ Global Select MarketSymbol: CTHR

Shareholder InquiriesThe Company’s Annual Report on Form 10-K,as filed with the Securities and ExchangeCommission, may be obtained without chargeupon written request to:

Integrated Corporate Relations (ICR)450 Post RoadWestport, CT 06880Tel: 203.682.8200Fax: 203.682.8201www.icrinc.com

Annual Meeting ofShareholdersMonday, May 21, 2007, 10:00 a.m.Sheraton Imperial Hotel4700 Emperor BoulevardDurham, NC 27703

Market InformationThe Company’s Common Stock trades on theNASDAQ Global Select Market under the symbol“CTHR”. The following table presents, for the periodsindicated, the high and low sales prices of theCompany’s Common Stock, as reported by theNASDAQ Global Select Market. As of February 28,2007 there were 220 shareholders of record of theCommon Stock.

Sales Price Per Share2006 High LowFirst Quarter $ 18.90 $ 10.25Second Quarter 11.99 9.03Third Quarter 13.15 9.27Fourth Quarter 12.40 7.61

2005 High LowFirst Quarter $ 10.82 $ 6.67Second Quarter 20.92 9.83Third Quarter 23.43 13.62Fourth Quarter 26.29 15.80

On May 23, 2005, we declared a $0.038 per share cashdividend and a 5% stock dividend, both distributed onJuly 15, 2005. Pursuant to these dividends, total cash of$699,309 and 859,457 shares of our common stockwere distributed to shareholders. The stock dividendprovided shareholders one share for every 20 sharesowned and cash in lieu of fractional shares. OnDecember 21, 2005, we declared a one share for everyfour shares owned stock split, effected in the form of a25% stock dividend, distributed on January 30, 2006.Pursuant to this dividend, total cash of $24,280 (in lieuof fractional shares) and 3,658,999 shares of ourcommon stock were distributed to shareholders. Thestock dividend provided shareholders one share forevery four shares owned and cash in lieu of fractionalshares. On April 18, 2006, we declared a $0.08 pershare cash dividend distributed on June 15, 2006.Pursuant to this dividend, total cash of $1,456,080 wasdistributed to shareholders.

We will regularly review and consider the best policiesand practices for the Company, including the dividendpolicy. The payment of future dividends will bedependant on the facts and circumstances at the timeof that review.

CHARLES & COLVARD, LTD.

300 Perimeter Park Drive, Suite AMorrisville, NC 27560

Telephone: 1.919.468.0399 / Fax: 1.919.468.0486

www.moissanite.com or www.charlesandcolvard.comCharles & Colvard is traded under the NASDAQ symbol CTHR.

© 2007 Charles & Colvard, Ltd. All Rights Reserved.

Documents

Charles & Colvard, Ltd. 2006 Annual Reportmedia.corporate-ir.net/media_files/IROL/95/95566/ar/ar_2006.pdf · Charles & Colvard, Ltd. 2 Letter to Shareholders 5 Selected Financial