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SatCon Technology 10-Q 2007

Documents found in this filing:

  1. 10-Q
  2. Ex-31.1
  3. Ex-31.2
  4. Ex-32.1
  5. Ex-32.1

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended March 31, 2007

Commission File Number 1-11512


SATCON TECHNOLOGY CORPORATION
(Exact name of registrant as specified in its charter)

Delaware

 

04-2857552

(State or other jurisdiction of
incorporation or organization)

 

(IRS Employer Identification No.)

 

 

 

27 Drydock Avenue

 

 

Boston, Massachusetts

 

02210

(Address of principal executive offices)

 

(Zip Code)

 

(617) 897-2400
(Registrant’s telephone number, including area code)


Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer o

 

Accelerated filer o

 

Non-accelerated filer x

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Common Stock, $0.01 Par Value,
42,796,624 shares outstanding as of May 1, 2007.

 




TABLE OF CONTENTS

PART I. FINANCIAL INFORMATION

 

 

Item 1. Financial Statements (Unaudited)

 

 

Financial Statements of SatCon Technology Corporation

 

 

Consolidated Balance Sheets

 

 

Consolidated Statements of Operations

 

 

Consolidated Statements of Changes in Stockholders’ Equity (Deficit)

 

 

Consolidated Statements of Cash Flows

 

 

Notes to Interim Consolidated Financial Statements

 

 

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

 

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

 

 

Item 4. Controls and Procedures

 

 

PART II. OTHER INFORMATION

 

 

Item 1. Legal Proceedings

 

 

Item 1A. Risk Factors

 

 

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

 

 

Item 3. Defaults Upon Senior Securities

 

 

Item 4. Submission of Matters to a Vote of Security Holders

 

 

Item 5. Other Information

 

 

Item 6. Exhibits

 

 

Signature

 

 

Exhibit Index

 

 

 




PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

SATCON TECHNOLOGY CORPORATION
CONSOLIDATED BALANCE SHEETS

 

 

March 31,
2007

 

December 31,
2006

 

 

 

(Unaudited)

 

 

 

ASSETS

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

4,542,678

 

$

7,190,827

 

Restricted cash and cash equivalents

 

84,000

 

84,000

 

 Accounts receivable, net of allowance of $230,709 and $792,245 at March 31, 2007 and December 31, 2006, respectively

 

6,904,056

 

8,549,923

 

Unbilled contract costs and fees

 

261,984

 

267,247

 

Inventory

 

11,177,290

 

7,945,874

 

Prepaid expenses and other current assets

 

2,067,909

 

756,884

 

Total current assets

 

$

25,037,917

 

$

24,794,755

 

Property and equipment, net

 

2,725,832

 

2,783,900

 

Goodwill, net

 

704,362

 

704,362

 

Intangibles, net

 

1,094,667

 

1,224,488

 

Restricted cash

 

1,000,000

 

1,000,000

 

Other long-term assets

 

71,382

 

69,782

 

Total assets

 

$

30,634,160

 

$

30,577,287

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Current portion of long-term debt

 

$

82,759

 

$

123,219

 

Accounts payable

 

5,692,407

 

4,538,569

 

Accrued payroll and payroll related expenses

 

1,589,303

 

1,449,185

 

Other accrued expenses

 

1,683,101

 

2,405,447

 

Accrued restructuring costs

 

 

1,200,326

 

Current portion of senior secured convertible notes

 

5,500,000

 

5,500,000

 

Current portion of warrant liability

 

401,821

 

436,919

 

Deferred revenue

 

8,152,769

 

5,834,537

 

Total current liabilities

 

$

23,102,160

 

$

21,488,202

 

 Redeemable convertible Series B preferred stock (345 shares issued and outstanding at March 31, 2007 and December 31, 2006, respectively; face value $5,000 per share; liquidation preference $1,725,000)

 

1,725,000

 

1,725,000

 

Long-term Senior secured convertible notes, net of current portion

 

6,083,422

 

7,240,482

 

Long-term warrant liability, net of current portion

 

2,736,569

 

2,483,634

 

Other long-term liabilities

 

106,846

 

108,049

 

Total Liabilities

 

$

33,753,997

 

$

33,045,367

 

 

 

 

 

 

 

Commitments and contingencies (Note H)

 

 

 

 

 

 

 

 

 

 

 

Stockholders’ deficit:

 

 

 

 

 

Common stock; $0.01 par value, 100,000,000 shares authorized; 42,113,810 and 40,105,073 shares issued and outstanding at March 31, 2007 and December 31, 2006, respectively

 

421,138

 

401,051

 

Additional paid-in capital

 

159,061,155

 

156,379,193

 

Accumulated deficit

 

(162,377,220

)

(158,991,838

)

Accumulated other comprehensive loss

 

(224,910

)

(256,486

)

 Total stockholders’ deficit

 

$

(3,119,837

)

$

(2,468,080

)

 Total liabilities and stockholders’ deficit

 

$

30,634,160

 

$

30,577,287

 

 

The accompanying notes are an integral part of these consolidated financial statements.

3




SATCON TECHNOLOGY CORPORATION
CONSOLIDATED STATEMENT OF OPERATIONS

(Unaudited)

 

 

Three Months
Ended

 

 

 

March 31,

 

April 1,

 

 

 

2007

 

2006

 

Revenue:

 

 

 

 

 

Product revenue

 

$

6,532,587

 

$

6,660,557

 

Funded research and development and other revenue

 

1,785,179

 

946,281

 

Total revenue

 

$

8,317,766

 

$

7,606,838

 

Operating costs and expenses:

 

 

 

 

 

Cost of product revenue

 

6,370,472

 

5,845,145

 

Research and development and other revenue expenses:

 

 

 

 

 

Funded research and development and other revenue expenses

 

1,356,799

 

978,007

 

Unfunded research and development expenses

 

677,409

 

560,082

 

Total research and development and other revenue expenses

 

$

2,034,208

 

$

1,538,089

 

Selling, general and administrative expenses

 

2,823,841

 

3,359,374

 

Amortization of intangibles

 

109,821

 

111,671

 

Total operating costs and expenses

 

$

11,338,342

 

$

10,854,279

 

 

 

 

 

 

 

Operating loss

 

$

(3,020,576

)

$

(3,247,441

)

Change in fair value of Notes and Warrants

 

234,945

 

 

Other (loss) income

 

(40,554

)

20,837

 

Interest income

 

85,539

 

95,299

 

Interest expense

 

(644,736

)

(102,548

)

Net loss

 

$

(3,385,382

)

$

(3,233,853

)

 

 

 

 

 

 

Net loss attributable to common stockholders per weighted average share, basic and diluted

 

$

(0.08

)

$

(0.08

)

Weighted average number of common shares, basic and diluted

 

41,394,660

 

38,524,241

 

 

The accompanying notes are an integral part of these consolidated financial statements.

4




SATCON TECHNOLOGY CORPORATION
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY (DEFICIT)

For the three months ended March 31, 2007
(Unaudited)

 

 

 

 

 

 

Additional

 

 

 

Accumulated
Other

 

Total

 

 

 

 

 

Common
Shares

 

Common
Stock

 

Paid-in
Capital

 

Accumulated
Deficit

 

Comprehensive
Loss

 

Stockholders’
Deficit

 

Comprehensive
Loss

 

Balance, December 31, 2006

 

40,105,073

 

$

401,051

 

$

156,379,193

 

$

(158,991,838

)

$

(256,486

)

$

(2,468,080

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net loss

 

 

 

 

 

 

 

(3,385,382

)

 

(3,385,382

)

$

(3,385,382

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Issuance of common stock to
401(k) Plan

 

133,797

 

1,338

 

151,190

 

 

 

152,528

 

 

Issuance of common stock in connection with the exercise of stock options to purchase common stock

 

5,000

 

50

 

3,100

 

 

 

3,150

 

 

Issuance of common stock in connection with the termination of Worcester lease

 

850,000

 

8,500

 

1,113,500

 

 

 

1,122,000

 

 

Issuance of common stock in lieu of cash principal payments on July 19, 2006 Notes

 

827,299

 

8,273

 

1,018,167

 

 

 

1,026,440

 

 

Issuance of common stock in lieu of cash interest on July 19, 2006 Notes

 

192,641

 

1,926

 

250,898

 

 

 

252,824

 

 

Employee stock-based compensation

 

 

 

119,697

 

 

 

119,697

 

 

Adjustment to conversion price of Series B preferred stock, due to anti-dilution provisions

 

 

 

25,410

 

 

 

25,410

 

 

Foreign currency translation adjustment

 

 

 

 

 

31,576

 

31,576

 

31,576

 

Comprehensive loss

 

 

 

 

 

 

 

$

(3,353,806

)

Balance, March 31, 2007

 

42,113,810

 

$

421,138

 

$

159,061,155

 

$

(162,377,220

)

$

(224,910

)

$

(3,119,837

)

 

 

 

The accompanying notes are an integral part of these consolidated financial statements

5




SATCON TECHNOLOGY CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)

 

 

Three Months Ended

 

 

 

March 31, 2007

 

April 1, 2006

 

 

 

 

 

 

 

Cash flows from operating activities:

 

 

 

 

 

Net loss

 

$

(3,385,382

)

$

(3,233,853

)

Adjustments to reconcile net loss to net cash used in operating activities:

 

 

 

 

 

Depreciation and amortization

 

359,511

 

365,333

 

Provision for uncollectible accounts

 

25,413

 

114,398

 

Provision for excess and obsolete inventory

 

80,664

 

 

Non-cash compensation expense, including stock based compensation costs of $119,697 and $234,560 for the three months ended March 31, 2007 and April 1, 2006, respectively

 

252,272

 

389,528

 

Change in fair value of senior secured convertible notes and investor and placement agent warrant liability

 

(234,945

)

 

Non-cash interest expense

 

553,301

 

57,429

 

Changes in operating assets and liabilities:

 

 

 

 

 

Accounts receivable

 

1,620,454

 

(36,701

)

Unbilled contract costs and fees

 

5,263

 

(17,555

)

Prepaid expenses and other current assets

 

(1,229,430

)

(69,579

)

Inventory

 

(3,312,080

)

60,285

 

Other long-term assets

 

(1,600

)

(15,184

)

Accounts payable

 

1,153,838

 

7,523

 

Accrued payroll and payroll related expenses and other expenses

 

(596,775

)

(63,035

)

Accrued restructuring

 

(78,326

)

 

Deferred revenue

 

2,318,232

 

71,470

 

Other liabilities

 

(1,203

)

(1,431

)

Total adjustments

 

914,589

 

862,481

 

Net cash used in operating activities

 

(2,470,793

)

(2,371,372

)

Cash flows from investing activities:

 

 

 

 

 

Purchases of property and equipment

 

(171,622

)

(65,516

)

Net cash used in investing activities

 

(171,622

)

(65,516

)

Cash flows from financing activities:

 

 

 

 

 

Repayment of long-term debt

 

(40,460

)

(38,949

)

Net proceeds from exercise of warrants and options to purchase common stock

 

3,150

 

121,662

 

Net cash provided (used in) by financing activities

 

(37,310

)

82,713

 

Effect of foreign currency exchange rates on cash and cash equivalents

 

31,576

 

(34,951

)

Net decrease in cash and cash equivalents

 

(2,648,149

)

(2,389,126

)

Cash and cash equivalents at beginning of period, including restricted cash and cash equivalents

 

7,274,827

 

9,278,720

 

Cash and cash equivalents at end of period, including restricted cash and cash equivalents

 

$

4,626,678

 

$

6,889,594

 

 

 

 

 

 

 

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION

 

 

 

 

 

Non-Cash Investing and Financing Activities:

 

 

 

 

 

Valuation adjustment for Series B preferred stock and warrants

 

$

25,410

 

$

 

Employee stock-based compensation

 

$

119,697

 

$

234,560

 

Common stock issued related to 401(k) contributions

 

$

152,528

 

$

154,968

 

Common stock issued in lieu of interest on Senior Secured Notes

 

$

252,824

 

$

 

Common stock issued for principal payment on Senior Secured Notes

 

$

1,026,440

 

$

 

Amortization of debt discount associated with the valuation of the Senior Secured Notes

 

$

322,163

 

$

 

Interest and Income Taxes Paid:

 

 

 

 

 

Interest

 

$

1,437

 

$

45,121

 

Income Taxes

 

$

 

$

 

 

The accompanying notes are an integral part of these consolidated financial statements.

6




SATCON TECHNOLOGY CORPORATION
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2007 (“2007”) AND April 1, 2006 (“2006”)

(Unaudited)

Note A. Basis of Presentation

The accompanying unaudited consolidated financial statements include the accounts of SatCon Technology Corporation and its wholly-owned subsidiaries (collectively, the “Company”) as of March 31, 2007 and have been prepared by the Company in accordance with accounting principles generally accepted in the United States of America for interim financial reporting and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X.  Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. All intercompany accounts and transactions have been eliminated. These unaudited consolidated financial statements, which, in the opinion of management, reflect all adjustments (including normal recurring adjustments) necessary for a fair presentation, should be read in conjunction with the financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006. Operating results for the three months ended March 31, 2007 are not necessarily indicative of the results that may be expected for any future interim period or for the entire fiscal year.

Note B. Realization of Assets and Liquidity

The accompanying unaudited consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America, which contemplates continuation of the Company as a going concern. However, the Company has sustained substantial losses from operations in recent years. In addition, the Company has used, rather than provided, cash in its operations.

The Company has incurred significant costs to develop its technologies and products. These costs have exceeded total revenue. As a result, the Company has incurred losses in each of the past ten years. As of March 31, 2007, it had an accumulated deficit of $162.4 million since inception. During the three months ended March 31, 2007, the Company incurred a loss from operations of approximately $3.0 million, while using net cash from operations of approximately $2.5 million.  The Company’s restricted cash balances at March 31, 2007 and December 31, 2006 were $1,084,000.

In view of the matters described in the preceding paragraph, recoverability of a major portion of the recorded asset amounts shown in the accompanying consolidated balance sheet is dependent upon the continued operations of the Company. The consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or amounts and classification of liabilities that might be necessary should the Company be unable to continue its existence.

The Company anticipates that its current cash will be sufficient to fund its operations over the next few quarters. This assumes the Company achieves its business plan. The business plan envisions a significant increase in revenue and significant reductions in the cost structure and the cash burn rate from the results experienced in the recent past.  Further, this assumes that the Company will be able to make payments of principal and interest under its senior secured convertible notes (the “Notes”) in shares of common stock and otherwise comply with the terms of the Notes; if, however, the Company is unable to realize its business plan or is unable to pay principal and interest under the Notes in shares of common stock, or otherwise comply with the terms of the Notes, the Company may be forced to raise additional funds by selling stock or taking other actions to conserve its cash position, which could include selling of certain assets and restructuring the Notes to allow for borrowings under another credit facility,  subject to the restrictions contained in the purchase agreement relating to the Notes.

Note C. Significant Accounting Policies and Basis of Presentation

Basis of Consolidation

The consolidated financial statements include the accounts of SatCon Technology Corporation and its wholly-owned subsidiaries (SatCon Applied Technology, SatCon Electronics and SatCon Power Systems). All intercompany accounts and transactions have been eliminated in consolidation.

Revenue Recognition

The Company recognizes revenue from product sales in accordance with Staff Accounting Bulletin (“SAB”) No. 104, Revenue Recognition. Product revenue is recognized when there is persuasive evidence of an arrangement, the fee is fixed or determinable,

7




delivery of the product to the customer has occurred and the Company has determined that collection of the fee is probable. Title to the product passes upon shipment of the product, as the products are typically shipped FOB shipping point, except for certain foreign shipments. If the product requires installation to be performed by the Company, all revenue related to the product is deferred and recognized upon the completion of the installation. If the product requires specific customer acceptance, revenue is deferred until customer acceptance occurs or the acceptance provisions lapse, unless the Company can objectively and reliably demonstrate that the criteria specified in the acceptance provisions are satisfied. When appropriate the Company provides for a warranty reserve at the time the product revenue is recognized.

The Company performs funded research and development and product development for commercial companies and government agencies under both cost reimbursement and fixed-price contracts. Product development revenue is included in product revenue. Cost reimbursement contracts provide for the reimbursement of allowable costs and, in some situations, the payment of a fee. These contracts may contain incentive clauses providing for increases or decreases in the fees depending on how costs compare with a budget. On fixed-price contracts, revenue is generally recognized on the percentage of completion method based upon the proportion of costs incurred to the total estimated costs for the contract. Revenue from reimbursement contracts is recognized as the services are performed. In each type of contract, the Company receives periodic progress payments or payments upon reaching interim milestones. All payments to the Company for work performed on contracts with agencies of the U.S. government are subject to audit and adjustment by the Defense Contract Audit Agency. Adjustments are recognized in the period made. When the current estimates of total contract revenue for commercial product development contracts indicate a loss, a provision for the entire loss on the contract is recorded. As of March 31, 2007 and December 31, 2006, the Company had no accruals for anticipated contract losses on commercial contracts.

Cost of product revenue includes materials, labor and overhead. Costs incurred in connection with funded research and development and other revenue arrangements are included in research and development and other revenue expenses.

Deferred revenue consists of payments received from customers in advance of services performed, product shipped or installation completed.

Cash and Cash Equivalents

Cash and cash equivalents include demand deposits, overnight repurchase agreements with Silicon Valley Bank (the “Bank”) and highly liquid investments with maturities of three months or less when acquired. Cash equivalents are stated at cost, which approximates market value. At March 31, 2007, the Company had approximately $4.0 million invested in a money market account with a national bank. At March 31, 2007 and December 31, 2006, the Company had restricted cash as indicated in the table below. In addition, at March 31, 2007 and December 31, 2006, the Company had overnight repurchase agreements with the Bank of $417,883 and $296,844, respectively.

Restricted Cash

 

March 31, 2007

 

December 31, 2006

 

Senior Secured notes

 

$

1,000,000

 

$

1,000,000

 

Security deposits

 

34,000

 

34,000

 

Certificates of Deposit

 

50,000

 

50,000

 

Total restricted Cash

 

$

1,084,000

 

$

1,084,000

 

 

Under the terms of the Notes, the Company is required, for so long as any Notes are outstanding, to maintain aggregate cash and cash equivalents equal to the greater of (i) $1.0 million or (ii) $3.0 million minus 80% of eligible receivables (as defined therein).  Based on the level of eligible receivables, we are required to maintain aggregate cash and cash equivalents of $1.0 million.  The Company was in compliance with this requirement as of March 31, 2007.

Accounts Receivable

Accounts receivable are reduced by an allowance for amounts that may become uncollectible in the future. The estimated allowance for uncollectible amounts is based primarily on a specific analysis of accounts in the receivable portfolio and historical write-off experience. While management believes the allowance to be adequate, if the financial condition of our customers were to deteriorate, resulting in impairment of their ability to make payments, additional allowances may be required.

Unbilled Contract Costs and Fees and Funded Research and Development Costs in Excess Of Billings

Unbilled contract costs and fees represent revenue recognized in excess of amounts billed due to contractual provisions.

8




Inventory

Inventory is stated at the lower of cost or market and costs are determined based on the first-in, first-out method of accounting and include material, labor and manufacturing overhead costs.  The Company periodically reviews quantities of inventory on hand and compares these amounts to expected usage of each particular product or product line. The Company records, as a charge to cost of sales, any amounts required to reduce the carrying value to net realizable value.

Property and Equipment

Property and equipment are stated at cost. Depreciation and amortization is computed using the straight-line method over the asset’s estimated useful life. The estimated useful lives of property and equipment are as follows:

 

Estimated Lives

Machinery and equipment

 

3-10 years

Furniture and fixtures

 

7-10 years

Computer software

 

3 years

Leasehold improvements

 

Lesser of the remaining life of the lease or the useful life of the improvement

 

When assets are retired or otherwise disposed of, the cost and related depreciation and amortization are eliminated from the accounts and any resulting gain or loss is reflected in other income (loss).

 Goodwill and Intangible Assets

Purchase accounting requires extensive use of accounting estimates and judgments to allocate the purchase price to the fair market value of the assets purchased and liabilities assumed. We have accounted for our acquisitions using the purchase method of accounting. Values were assigned to goodwill and intangible assets based on third-party independent valuations, as well as management’s forecasts and projections that include assumptions related to future revenue and cash flows generated from the acquired assets.

The Company applies the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 142, Goodwill and Other Intangible Assets. This statement affects the Company’s treatment of goodwill and other intangible assets. The statement requires that goodwill existing at the date of adoption be reviewed for possible impairment and that impairment tests be periodically repeated, with impaired assets written down to fair value. Additionally, existing goodwill and intangible assets must be assessed and classified within the statement’s criteria. Intangible assets with finite useful lives will continue to be amortized over those periods.

The Company annually performs a goodwill impairment test as of the beginning of its fourth quarter, as required by SFAS No. 142. The Company determines the fair value of each of the reporting units based on a discounted cash flow income approach. The income approach indicates the fair value of a business enterprise based on the discounted value of the cash flows that the business can be expected to generate in the future. This analysis is largely based upon projections prepared by the Company and data from sources of publicly available information available at the time of preparation. These projections are based on management’s best estimate of future results. In making these projections, the Company considers the markets it is addressing, the competitive environment and its advantages. There will usually be differences between estimated and actual results as events and circumstances frequently do not occur as expected, and those differences may be material. In addition, the Company performs a macro assessment of the overall likelihood that the Company would achieve the projected cash flows and performed sensitivity analysis using historical data as the basis for projected cash flows.

Long-lived Assets

 The Company applies the provisions of SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, which supersedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of, and the accounting and reporting provisions of the Accounting Principles Board (“APB”) Opinion No. 30. SFAS No. 144 addresses financial accounting and reporting for the impairment or disposal of long-lived assets. The statement requires that long-lived assets be reviewed for possible impairment, if certain conditions exist, with impaired assets written down to fair value.

The Company determines the fair value of certain of the long-lived assets based on a discounted cash flow income approach. The income approach indicates the fair value of a long-lived asset based on the discounted value of the cash flows that the long-lived asset can be expected to generate in the future over the life of the long-lived asset. This analysis is based upon projections prepared by the Company. These projections represent management’s best estimate of future results. In making these projections, the Company considers the markets it is addressing, the competitive environment and its advantages. There will usually be differences between estimated and actual results as events and circumstances frequently do not occur as expected, and those differences may be material. In addition, the

9




Company performs a macro assessment of the overall likelihood that we would achieve the projected cash flows and performed sensitivity analysis using historical data as the basis for projected cash flows.

Foreign Currency Translation

The functional currency of the Company’s foreign subsidiary is the local currency. Assets and liabilities of foreign subsidiaries are translated at the rates in effect at the balance sheet date, while stockholders’ equity (deficit) is translated at historical rates. Statements of operations and cash flow amounts are translated at the average rate for the period. Translation adjustments are included as a component of accumulated other comprehensive loss. Foreign currency gains and losses arising from transactions are reflected in the loss from operations and were not significant during the three months ended March 31, 2007 or April 1, 2006.

Use of Estimates

The preparation of financial statements, in conformity with accounting principles generally accepted in the United States of America, requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the period reported. Management believes the most significant estimates include the net realizable value of accounts receivable and inventory, the recoverability of long-lived assets and intangible assets, the accrued contract losses on fixed-price contracts, the recoverability of deferred tax assets and the fair value of equity and financial instruments.  Actual results could differ from these estimates.

Income Taxes

The Company accounts for income taxes in accordance with SFAS No. 109, Accounting for Income Taxes, which is the asset and liability method for accounting and reporting for income taxes. Under SFAS No. 109, deferred tax assets and deferred tax liabilities are recognized based on temporary differences between the financial reporting and income tax basis of assets and liabilities using statutory rates. In addition, SFAS No. 109 requires a valuation allowance against net deferred tax assets if, based upon the available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized.

In June 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109” (“FIN 48”).  FIN 48 requires companies to recognize the tax benefits of uncertain tax positions only where the position is “more likely than not” to be sustained assuming examination by tax authorities.  The amount recognized is the amount that represents the largest amount of tax benefit that is greater than 50% likely of being ultimately realized.  A liability is recognized for any benefit claimed, or expected to be claimed, in a tax return in excess of the benefit recorded in the financial statements, along with any interest and penalties (if applicable) on that excess.  FIN 48 requires a tabular reconciliation of the change in the aggregate unrecognized tax benefits claimed, or expected to be claimed, in tax returns and disclosure relating to the accrued interest and penalties for unrecognized tax benefits.  Discussion is also required for those uncertain tax positions where it is reasonably possible that the estimate of the tax benefit will change significantly in the next twelve months.

The Company adopted the provisions of FIN 48 on January 1, 2007.  The Company did not recognize any decrease in the liability for unrecognized tax benefits as a result of the adoption.

As of December 31, 2006, the Company had federal and state NOL carry forwards and federal and state R&D credit carry forwards, which may be available to offset future federal and state income tax liabilities which expire at various dates starting in 2007 and going through 2026. Utilization of the NOL and R&D credit carry forwards may be subject to a substantial annual limitation due to ownership change limitations that have occurred previously or that could occur in the future provided by Section 382 of the Internal Revenue Code of 1986, as well as similar state and foreign provisions. These ownership changes may limit the amount of NOL and R&D credit carry forwards that can be utilized annually to offset future taxable income and tax, respectively. In general, an ownership change, as defined by Section 382, results from transactions increasing the ownership of certain shareholders or public groups in the stock of a corporation by more than 50 percentage points over a three-year period. Since the Company’s formation, the Company has raised capital through the issuance of capital stock on several occasions (both pre and post initial public offering) which, combined with the purchasing shareholders’ subsequent disposition of those shares, may have resulted in a change of control, as defined by Section 382, or could result in a change of control in the future upon subsequent disposition. The Company has not currently completed a study to assess whether a change of control has occurred or whether there have been multiple changes of control since the Company’s formation due to the significant complexity and cost associated with such study and that there could be additional changes in control in the future. If the Company has experienced a change of control at any time since Company formation, utilization of its NOL or R&D credit carry forwards would be subject to an annual limitation under Section 382 which is determined by first multiplying the value of our stock at the time of the ownership change by the applicable long-term tax-exempt rate, and then could be subject to additional adjustments, as required. Any limitation may result in expiration of a portion of the NOL or R&D credit

10




carry forwards before utilization. Further, until a study is completed and any limitation known, no amounts are being presented as an uncertain tax position under FIN 48. The Company does not expect to have any taxable income for the foreseeable future.

The Company did not recognize any interest and penalties associated with unrecognized tax benefits in the accompanying financial statements.  The Company does not expect any material changes to the unrecognized benefits within 12 months of the reporting date.

Accounting for Stock-based Compensation

The Company has several stock-based employee compensation plans.  On October 1, 2005, the Company adopted SFAS No. 123R (“SFAS 123R”) Accounting for Stock-based Compensation, using the modified prospective method, which results in the provisions of SFAS 123R only being applied to the consolidated financial statements on a going-forward basis (that is, the prior period results have not been restated).  At the time of adoption all outstanding options of the Company had vested.  Under the fair value recognition provisions of SFAS 123R, stock-based compensation cost is measured at the grant date based on the value of the award and is recognized as expense over the service period.  Previously, the Company had followed APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations, which resulted in the accounting for employee stock options at their intrinsic value in the consolidated financial statements.

On March 29, 2005, the SEC issued SAB 107 which expresses the view of the SEC regarding the interaction between SFAS No. 123R and certain SEC rules and regulations concerning the valuation of share-based payment arrangements for public companies. In particular, SAB 107 provides guidance related to share-based payment transactions with non-employees, the transition from nonpublic to public entity status, valuation methods (including assumptions such as expected volatility and expected term), the accounting for certain redeemable financial instrument issues under share-based payment arrangements, the classification of compensation expense, non-GAAP financial measures, first-time adoption of SFAS No. 123R in an interim period, capitalization of compensation costs related to share-based payment arrangements, the accounting for income tax effects of share-based payment arrangements, the accounting for income tax effects of share-based payment arrangements upon adoption of SFAS No. 123R, the modification of employee stock options prior to adoption of SFAS No. 123R, and disclosures in Management’s Discussion and Analysis of Financial Condition and Results of Operations subsequent to adoption of SFAS No. 123R. The Company has accounted for its stock option grants in compliance with SAB 107.

On November 10, 2005, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position SFAS 123R-3 “Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards.”  The Company has elected to adopt the alternative transition method provided in the FASB Staff Position for calculating the tax effects (if any) of stock-based compensation expense pursuant to SFAS 123R.  The alternative transition method includes simplified methods to establish the beginning balance of additional paid-in capital related to the tax effects of employee stock-based compensation, and to determine the subsequent impact to additional paid-in capital and the consolidated statements of operations and cash flows of the tax effects of employee stock-based compensation awards that are outstanding upon adoption of SFAS 123R.

The Company recognized the full impact of its share-based compensation plans in the consolidated financial statements for the three months ended March 31, 2007 and April 1, 2006 under SFAS 123R and did not capitalize any such costs on the consolidated balance sheets, as such costs that qualified for capitalization were not material.  The following table presents share-based compensation expense included in the Company’s consolidated statement of operations:

 

Three Months Ended

 

 

 

March 31, 2007

 

April 1, 2006

 

Cost of product revenue

 

$

12,465

 

$

 

Funded research and development and other revenue expense

 

21,129

 

732

 

Unfunded research and development and other revenue expenses

 

3,794

 

488

 

Selling, general and administrative expenses

 

82,309

 

233,340

 

 

 

 

 

 

 

Share based compensation expense before tax

 

$

119,697

 

$

234,560

 

 

 

 

 

 

 

Income tax benefit

 

 

 

 

 

 

 

 

 

Net compensation expense

 

$

119,697

 

$

234,560

 

 

Compensation expense associated with the granting of stock options to employees is being recognized on a straight-line basis

11




over the service period of the option.  In instances where the actual compensation expense would be greater than that calculated using the straight-line method, the actual compensation expense is recorded in that period.

The Company had previously adopted the provisions of SFAS No. 123, Accounting for Stock-Based Compensation, as amended by SFAS No. 148, Accounting for Stock-Based Compensation — Transition and Disclosure, through disclosure only.  SFAS No. 123, Accounting for Stock-Based Compensation, requires the measurement of the fair value of stock options or warrants granted to employees to be included in the statement of operations or, alternatively, disclosed in the notes to consolidated financial statements. The Company previously accounted for stock based compensation of employees under the intrinsic value method of APB Opinion No. 25, Accounting for Stock Issued to Employees, and had elected the disclosure-only alternative under SFAS No. 123. The Company records the fair value of stock options and warrants granted to non-employees in exchange for services in accordance with Emerging Issues Task Force (“EITF”) No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services, as determined using the Black- Scholes option-pricing model, and amortizes the amount ratably over the period the service is performed in the consolidated statement of operations.

The weighted average grant date fair value of options granted during the three months ended March 31, 2007 and April 1, 2006 were $1.00 and $2.19, respectively, per option.  The fair value of each stock option is estimated on the date of the grant using the Black-Scholes option-pricing model with the following range of assumptions:

 

Three Months Ended

 

Assumptions:

 

March 31, 2007

 

April 1, 2006

 

Expected life

 

6.25 years (1)

 

5.0 years to 6.25 years (1)

 

Expected volatility ranging from

 

87.58% - 89.94% (2)

 

89.8% - 96.5% (2)

 

Dividends

 

none

 

none

 

Risk-free interest rate

 

4.46% to 4.75% (3)

 

4.29% to 4.76% (3)

 

Forfeiture Rate (4)

 

6.25%

 

6.25%

 

 


(1)       The option life was determined using the simplified method for estimating expected option life, which qualify as “plain-vanilla” options.

(2)       The stock volatility for each grant is measured using the weighted average of historical daily price changes of the Company’s common stock over the most recent period equal to the expected option life of the grant, the historical short-term trend of the option and other factors, such as expected changes in volatility arising from planned changes in the Company’s business operations.

(3)       The risk-free interest rate for each grant is equal to the U.S. Treasury yield curve in effect at the time of grant for instruments with a similar expected life.

(4)       The estimated forfeiture rate for each option grant is 6.25%.  At the time SFAS 123R was adopted, all outstanding stock options were vested.  The company periodically reviews the estimated forfeiture rate, in light of actual experience.

In December 2005, the Company granted 50,000 shares of restricted common stock to a senior executive as permitted under the 2005 Stock Incentive Compensation Plan.  This grant vested 12,500 shares per quarter over four quarters.  12,500 of these restricted shares vested during the quarter ended April 1, 2006. Compensation expense for the number of shares issued is recognized over the service period and is recorded in the consolidated statement of operations as a component of selling, general and administrative expense.  For the three month period ended April 1, 2006, compensation expense of $15,235 has been recognized related to this restricted stock award.  This amount is included in the table above that presents share-based compensation expense included in the Company’s consolidated statement of operations. The entire grant was vested as of December 31, 2006.

 Net Loss per Basic and Diluted Common Share

The Company reports net loss per basic and diluted common share in accordance with SFAS No. 128, Earnings Per Share, which establishes standards for computing and presenting earnings per share. Basic earnings per share excludes dilution and is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the Company, except when the effect would be anti-dilutive.

Concentration of Credit Risk

Financial instruments that subject the Company to concentrations of credit risk principally consist of cash equivalents, trade accounts receivable, unbilled contract costs and deposits in bank accounts.   The Company deposits its cash and invests in short-term

12




investments primarily through a national commercial bank. Deposits in excess of amounts insured by the Federal Deposit Insurance Corporation (FDIC) of $100,000 are exposed to loss in the event of nonperformance by the institution. The Company has had cash deposits in excess of the FDIC insurance coverage.

The Company’s trade accounts receivable and unbilled contract costs and fees are primarily from sales to U.S. government agencies and commercial customers. The Company does not require collateral and has not historically experienced significant credit losses related to receivables or unbilled contract costs and fees from individual customers or groups of customers in any particular industry or geographic area.

Significant customers are defined as those customers that account for 10% or more of total net revenue in a fiscal year or 10% or more of accounts receivable and unbilled contract costs and fees at the end of a fiscal year.  For the quarter ended March 31, 2007, two customers, each individually significant, comprised a total of 22% of our revenue.  At March 31, 2007, three customers, each individually significant, had a combined balance equal to 41%, or $2.9 million of our outstanding gross receivables.  As of May 1, 2007, $1.7 million of these receivables had been collected.

Research and Development Costs

The Company expenses research and development costs as incurred. Research and development and other revenue expenses include costs incurred in connection with both funded research and development and other revenue arrangements and unfunded research and development activities.

Comprehensive Income (Loss)

Comprehensive income (loss) includes net loss, change in unrealized gains and losses on marketable securities and foreign currency translation adjustments.

Fair Value of Financial Instruments

The Company’s financial instruments consist of cash equivalents, accounts receivable, unbilled contract costs and fees, warrants to purchase shares of common stock, accounts payable, debt instruments, convertible notes and Series B preferred stock. The estimated fair values of these financial instruments approximate their carrying values at March 31, 2007 and December 31, 2006. The estimated fair values have been determined through information obtained from market sources and management estimates.

Note D. Loss per Share

The following is the reconciliation of the numerators and denominators of the basic and diluted per share computations of net loss:

 

Three Months Ended

 

 

 

March 31,
2007

 

April 1,
2006

 

Net loss

 

$

(3,385,382

)

$

(3,233,853

)

Basic and diluted:

 

 

 

 

 

Common shares outstanding, beginning of period

 

40,105,073

 

38,382,707

 

Weighted average common shares issued during the period

 

1,289,587

 

141,534

 

Weighted average shares outstanding—basic and diluted

 

41,394,660

 

38,524,241

 

 

 

 

 

 

 

Net loss per weighted average share, basic and diluted

 

$

(0.08

)

$

(0.08

)

 

As of March 31, 2007 and April 1, 2006, shares of common stock issuable upon the exercise of options and warrants were excluded from the diluted average common shares outstanding, as their effect would have been antidilutive.  In addition, shares of common stock issuable upon the conversion of redeemable convertible preferred stock were excluded from the diluted weighted average common shares outstanding as their effect would also have been dilutive.   The table below summarizes the option and warrants and convertible preferred stock that were excluded from the calculation above due to their effect being antidilutive:

13




 

 

Three Months Ended

 

 

 

March 31,
2007

 

April 1,
2006

 

Common Stock issuable upon the exercise of:

 

 

 

 

 

Options

 

3,759,245

 

3,708,345

 

Warrants

 

11,097,308

 

4,945,663

 

 

 

 

 

 

 

Total Options and Warrants excluded

 

14,856,553

 

8,654,008

 

 

 

 

 

 

 

Common stock issuable upon the conversion of senior secured convertible notes, at conversion price of $1.65 per share.

 

6,666,667

 

 

Common Stock issuable upon the conversion of redeemable convertible Series B Preferred Stock

 

849,754

 

961,538

 

 

14




Note E. Inventory

Inventory components at the end of each period were as follows:

 

March 31,
2007

 

December 31,
2006

 

Raw material

 

$

3,368,329

 

$

3,042,286

 

Work-in-process

 

5,352,376

 

2,554,871

 

Finished goods

 

2,456,585

 

2,348,717

 

 

 

$

11,177,290

 

$

7,945,874

 

 

Note F. Segment Disclosures

The Company’s organizational structure is based on strategic business units that perform services and offer various products to the principal markets in which the Company’s products are sold. These business units equate to four reportable segments: Applied Technology, Power Systems, US, Power Systems, Canada and Electronics.

SatCon Applied Technology, Inc. performs research and development services in collaboration with third parties. SatCon Power Systems, Canada, ltd. specializes in the engineering and manufacturing of power systems. Satcon Power Systems, US specializes in the engineering and manufacturing of electric motors and hybrid electric automobile systems.  SatCon Electronics, Inc. designs and manufactures electronic products. The Company’s principal operations and markets are located in the United States. In previous years the Company has shown SatCon Power Systems US and Canada as one segment; the table below has been adjusted to show the Power Systems divisions as separate segments.

The accounting policies of each of the segments are the same as those described in the summary of significant accounting policies. The Company evaluates performance based on revenue and profit and loss from operations, including amortization of intangibles. Common costs not directly attributable to a particular segment are included in the corporate segment. These costs include corporate costs such as executive officer compensation, facility costs, legal, audit and tax and other professional fees.

The following is a summary of the Company’s operations by operating segment:

 

Three Months Ended

 

 

 

March 31,

 

April 1,

 

 

 

2007

 

2006

 

Applied Technology:

 

 

 

 

 

Funded research and development and other revenue

 

$

1,785,179

 

$

946,281

 

Loss from operations, including amortization of intangibles of $78,572 for the three months ended March 31, 2007 and $80,421 for the three-month period ended April 1, 2006

 

$

(183,100

)

$

(683,283

)

 

 

 

 

 

 

Power Systems, US

 

 

 

 

 

Product revenue

 

$

735,236

 

$

1,790,541

 

Income (loss) from operations

 

$

(757,352

)

$

(353,012

)

 

 

 

 

 

 

Power Systems, Canada:

 

 

 

 

 

Product revenue

 

$

3,603,672

 

2,302,034

 

Loss from operations

 

$

(1,406,551

)

$

(932,378

)

 

 

 

 

Electronics:

 

 

 

 

 

Product revenue

 

$

2,193,679

 

$

2,567,982

 

Income (loss) from operations, including amortization of intangibles of $31,249 for the three months ended March 31, 2007 and $31,250 for the three month period ended April 1, 2006

 

$

(122,836

)

$

(157,353

)

Corporate:

 

 

 

 

 

Loss from operations

 

$

(550,737

)

$

(1,121,415

)

 

 

 

 

 

 

Consolidated:

 

 

 

 

 

Product revenue

 

$

6,532,587

 

$

6,660,557

 

Funded research and development and other revenue

 

$

1,785,179

 

946,281

 

Total revenue

 

$

8,317,766

 

$

7,606,838

 

 

 

 

 

Operating loss

 

$

(3,020,576

)

$

(3,247,441

)

Change in fair value of Notes and Warrants

 

234,945

 

 

Other (loss) income

 

(40,554

)

20,837

 

Interest income

 

85,539

 

95,299

 

Interest expense

 

(644,736

)

(102,548

)

 

 

 

 

 

 

Net loss

 

$

(3,385,382

)

$

(3,233,853

)

 

15




Common assets not directly attributable to a particular segment are included in the Corporate segment. These assets include cash and cash equivalents, prepaid and other corporate assets.  The following is a summary of the Company’s assets by operating segment:

 

March 31,
2007

 

December 31,
2006

 

Applied Technology:

 

 

 

 

 

Segment assets

 

$

3,946,619

 

$

2,995,181

 

Power Systems, US:

 

 

 

 

 

Segment assets

 

3,567,037

 

4,196,821

 

Power Systems, Canada

 

 

 

 

 

Segment assets

 

11,394,735

 

8,594,046

 

Electronics:

 

 

 

 

 

Segment assets

 

5,867,551

 

5,883,674

 

Corporate:

 

 

 

 

 

Segment assets

 

5,858,218

 

8,907,565

 

Total assets

 

$

30,634,160

 

$

30,577,287

 

 

The Company operates and markets its services and products on a worldwide basis with its principal markets as follows:

 

Three Months Ended

 

 

 

March 31,
2007

 

April 1,
2006

 

Revenue by geographic region based on location of customer:

 

 

 

 

 

United States

 

$

7,800,517

 

$

6,262,505

 

Rest of world

 

517,249

 

1,344,333

 

Total revenue

 

$

8,317,766

 

$

7,606,838

 

 

 

March 31,

 

December 31,

 

 

 

2007

 

2006

 

Long-lived assets (including goodwill and intangible assets) by geographic region based on location of operations:

 

 

 

 

 

United States

 

$

4,027,583

 

$

4,406,166

 

Rest of world

 

497,278

 

306,584

 

Total long-lived assets (including goodwill and intangible assets)

 

$

4,524,861

 

$

4,712,750

 

 

16




Note G. Legal Matters

From time to time, the Company is a party to routine litigation and proceedings in the ordinary course of business.  On May 19, 2006, the Company filed a suit in the U.S. District Court, District of Massachusetts, against one of its customers.  The suit demanded full payment of all outstanding amounts due to the Company from its customer.  The customer filed a counterclaim that the Company believed was without merit.  The suit was settled on March 9, 2007.  The settlement did not have a material effect on the Company’s financial position or operations.

The Company is not aware of any current or pending litigation in which the Company is or may be a party that it believes could materially adversely affect the results of operations or financial condition or net cash flows.

Note H. Commitments and Contingencies

Operating Leases

The Company leases its facilities under various operating leases that expire through October 2011.

Future minimum annual rentals under lease agreements at March 31, 2007 are as follows:

Fiscal Year

 

 

 

2007

 

$

829,959

 

2008

 

$

967,614

 

2009

 

$

825,537

 

2010

 

$

523,797

 

2011

 

$

159,408

 

Thereafter

 

$

 

Total

 

$

3,306,315

 

 

Letters of Credit:

The Company utilizes a standby letter of credit to satisfy a security deposit requirement. Outstanding standby letters of credit as of March 31, 2007 and December 31, 2006 were $34,000.  The Company is required to pledge cash as collateral on these outstanding letters of credit. As of March 31, 2007 and December 31, 2006, the cash pledged as collateral for these letters of credit was $34,000 and is included in restricted cash and cash equivalents on the balance sheet.

Purchase Commitments:

In the ordinary course of business the Company enters into agreements with vendors for the purchase of goods and services through the issuance of purchase orders.  In general the majority of these purchases do not represent commitments of the Company until the goods or services are received.  In the third quarter of fiscal 2003 the Company provided for approximately $0.9 million of outstanding purchase commitments related to its Shaker and UPS product lines.  As of March 31, 2007 and December 31, 2006 the balance outstanding on these purchase commitments was $237,150.  These amounts are included in other accrued expenses in the Company’s consolidated balance sheet.

Employment Agreements:

The Company has employment agreements with certain employees that provide severance payments and accelerated vesting of options upon termination of employment under certain circumstances or a change of control, as defined in the employment agreements. As of March 31, 2007 and December 31, 2006, the Company’s potential obligation to these employees was approximately $300,000.  During the year ended December 31, 2006, the Company terminated the employment of an employee that had an employment agreement that provided for severance payments upon termination.  The Company recorded a charge to operations of approximately $250,000 related to this severance agreement as selling, general and administrative expense in its results of operations for the year ended December 31, 2006.  At March 31, 2007 and December 31, 2006, approximately $0.1 million and $0.2 million was accrued, respectively.

17




Line of Credit:

As a condition precedent to the Note financing (see Note K), the Company was required to repay any amounts outstanding under the credit facility and cancel the agreement with Silicon Valley Bank (the “Bank”).  The Company no longer has a credit facility with the Bank.  Under the Loan Agreement in place as of April 1, 2006, there was $2.0 million outstanding as of April 1, 2006.  Under the terms of the Loan Agreement, the Bank agreed to provide the Company with a credit line of up to $7.0 million.  The Loan Agreement was secured by most of the assets of the Company and advances under the Loan Agreement were limited to 80% of eligible receivables and up to $1.0 million based on the levels of eligible inventory.  Interest on outstanding borrowings accrued at the Bank’s prime rate of interest plus 1.5% per annum.  In addition, the Loan Agreement provided the ability to borrow up to $3,000,000 on a revolver basis paying only interest provided that the Company remained in compliance with all financial covenants, as defined.  In addition, the Company agreed to pay to the Bank a collateral handling fee of $750 per month and agreed to the following additional fees: (i) $25,000 commitment fee; (ii) an unused line fee in the amount of 0.5% per annum; and (iii) an early termination fee of 0.5% of the total credit line if we terminated the Loan Agreement within the first six months.  The Loan Agreement contained certain financial covenants relating to tangible net worth, as defined.

Note I. Restructuring Costs

On September 19, 2006, the Board of Directors approved a plan to close the Company’s Worcester, Massachusetts manufacturing facility by approximately December 31, 2006 in furtherance of the Company’s continuing efforts to streamline operations and reduce its operating costs.

As of December 31, 2006, approximately $1.6 million had been incurred by the Company related to the restructuring.  This charge represents approximately $42,000 related to employee severance, $45,000 related to employee retention payments and $0.2 million in impairment charges related to property, plant and equipment.  In addition, on December 22, 2006, the Company came to an agreement with the landlord of the Worcester facility whereby the Company would issue 850,000 shares of common stock in exchange for allowing the Company to terminate the lease early.  The stock was issued to the landlord on January 3, 2007.  The Company recorded a restructuring charge in the period ended December 31, 2006 in the amount of $1.1 million related to this agreement and approximately $0.2 million related to the revaluation of investor warrants.  The Company paid all remaining amounts related to the restructuring during the quarter ended March 31, 2007 and did not incur any additional costs during the period associated with the restructuring.

The following is a summary of the Company’s accrued restructuring costs at March 31, 2007 and December 31, 2006:

 

March 31, 2007

 

December 31, 2006

 

Severance costs and payroll-related costs

 

$

 

$

78,326

 

Facility costs

 

$

 

$

1,122,000

 

Accrued restructuring costs

 

$

 

$

1,200,326

 

 

Note J. Product Warranties

In its Power Systems Divisions the Company provides a warranty to its customers for most of its products sold.  In general the Company’s warranties are for one year after the sale of the product, and in some instances five years.  The Company reviews its warranty liability quarterly.  Factors taken into consideration when evaluating the Company’s warranty reserve are (i) historical claims for each product, (ii) the development stage of the product, and (iii) other factors.

The following is a summary of the Company’s accrued warranty activity for the following periods:

 

Three Months Ended

 

 

 

March 31,
2007

 

April 1,
2006

 

Balance at beginning of period

 

$

679,747

 

$

556,314

 

Provision

 

105,953

 

83,900

 

Usage

 

(105,535

)

(194,051

)

Balance at end of period

 

$

680,165

 

$

446,163

 

 

18




Note K. Convertible Debt Instruments and Warrant Liabilities

Features of the Convertible Notes and Warrants

On July 19, 2006, the Company entered into a Securities Purchase Agreement (the “Purchase Agreement”) with the purchasers named therein (the “Purchasers”) in connection with the private placement (the “Private Placement”) of:

·                  $12,000,000 aggregate principal amount of senior secured convertible notes (the “Notes”), convertible into shares of the Company’s common stock at a conversion price of $1.65 per share;

·                  Warrant As to purchase up to an aggregate of 3,636,368 shares of the Company’s common stock at a price of $1.815 per share for a period beginning six months from the date of such warrants and ending on the seventh anniversary of the date of such warrants; and

·                  Warrant Bs to purchase up to an aggregate of 3,636,368 shares of the Company’s common stock at a price of $1.68 per share for a period of 90 trading days beginning the later of six months from the date of such warrants and the date the Securities and Exchange Commission (the “SEC”) declares effective a shelf registration statement covering the resale of the common stock underlying the securities issued in the Private Placement (the “Registration Statement”); to the extent the Warrant Bs are exercised, the Purchasers will receive additional warrants, as described below.

In connection with the Private Placement, the Company also entered into a Security Agreement, dated July 19, 2006, with the Purchasers, pursuant to which the Company granted the Purchasers a security interest in all of its right, title and interest in, to and under all of the Company’s personal property and other assets, including its ownership interest in the capital stock of its subsidiaries, as security for the prompt payment in full of all amounts due and owing under the Notes. The following is a summary of the material provisions of the Purchase Agreement, the Notes, the Warrant As and the Warrant Bs.

Securities Purchase Agreement

As noted above, the Purchase Agreement provided for the issuance and sale to the Purchasers of the Notes, the Warrant As and the Warrant Bs for an aggregate purchase price of $12,000,000. Other significant provisions of the Purchase Agreement include:

·                  the requirement that the Company pay off all amounts outstanding under our credit facility with Silicon Valley Bank

·                  for so long as the Notes are outstanding, the obligation that the Company offer to the Purchasers the opportunity to participate in subsequent securities offerings (up to 50% of such offerings), subject to certain exceptions for, among other things, certain underwritten public offerings and strategic alliances;

·                  for so long as the Notes are outstanding, the obligation that the Company not incur any indebtedness that is senior to, or on parity with, the Notes in right of payment, subject to limited exceptions for purchase money indebtedness and capital lease obligations; and

Senior Secured Convertible Notes

The Notes have an aggregate principal amount of $12 million and are convertible into shares of the Company’s common stock at a conversion price of $1.65, subject to adjustment for stock splits, stock dividends, combinations, distributions of assets or evidence of indebtedness, mergers, consolidations, sales of all or substantially all assets, tender offers, exchange offers, reclassifications or compulsory share exchanges.

The Notes bear interest at the higher of (i) 7.0% per annum or (ii) the six-month LIBOR plus 3.5%. Interest is payable quarterly, beginning on October 31, 2006, and may be made in cash or, at the Company’s option if certain equity conditions are satisfied, in shares of the Company’s common stock. If interest is paid in shares of common stock, the price per share will be at a 10% discount to the volume weighted average price for the 20 trading days preceding the payment date.

75% of the original principal amount of the Notes is to be repaid in 18 equal monthly installments ($500,000 per month) beginning on February 28, 2007. Such principal payments may be made in cash or, at the Company’s option if certain equity conditions are satisfied, in shares of our common stock. If principal is paid in shares of common stock, the price per share will be the lesser of (i) the conversion price or (ii) a 10% discount to the volume weighted average price for the 20 trading days preceding the payment date. At any time following the 24-month anniversary of the issuance of the Notes, the holders may elect to require the Company to redeem for cash all or any portion of the outstanding principal on the Notes; provided, however, that on the 60 month

19




anniversary of the issuance of the Notes, the Company will be required to redeem any remaining outstanding principal and unpaid interest. Notwithstanding the foregoing, at any time following the one year anniversary of the effective date of the Registration Statement, the Company may, under certain circumstances, redeem the Notes for cash equal to 120% of the aggregate outstanding principal amount plus any accrued and unpaid interest.

The Notes are convertible at the option of the holders into shares of the Company’s common stock at any time at the conversion price. If at any time following the one year anniversary of the effective date of the Registration Statement, the volume weighted average price per share of common stock for any 20 consecutive trading days exceeds 175% of the conversion price, then, if certain equity conditions are satisfied, the Company may require the holders of the Notes to convert all or any part of the outstanding principal into shares of common stock at the conversion price. The Notes contain certain limitations on optional and mandatory conversion, including that, absent stockholder approval of the transaction, the Company may not issue shares of common stock under the Notes in excess of 19.99% of our outstanding shares on the closing date.

·                  The Notes contain certain covenants and restrictions, including, among others, the following (for so long as any Notes remain outstanding):

·                  the Company must maintain aggregate cash and cash equivalents equal to the greater of (i) $1,000,000 or (ii) $3,000,000 minus 80% of eligible receivables (as defined in the Notes);

·                  if a change of control of the Company occurs, as defined in the Notes, the holders may elect to require the Company to purchase the Notes for 115% of the outstanding principal amount plus any accrued and unpaid interest; and

·                  the Company may not issue any common stock or common stock equivalents at a price per share less than the conversion price.

Events of default under the Notes include, among others, payments defaults, cross-defaults, breaches of any representation, warranty or covenant that is not cured within the proper time periods, failure to perform certain required activities in a timely manner, our common stock is no longer listed on an eligible market, the effectiveness of the Registration Statement lapses beyond a specified period and certain bankruptcy-type events involving us or any significant subsidiary. Upon an event of default, the holders may elect to require us to repurchase all or any portion of the outstanding principal amount of the Notes for a purchase price equal to the greater of (i) 115% of such outstanding principal amount, plus all accrued but unpaid interest or (ii) 115% of the then value of the underlying common stock.

Warrant A’s

The Warrant A’s entitle the holders thereof to purchase up to an aggregate of 3,636,368 shares of the Company’s common stock at a price of $1.815 per share for a period beginning six months from the date of such warrants and ending on the seventh anniversary of the date of such warrants. The exercise price and the number of shares underlying these warrants are subject to adjustment for stock splits, stock dividends, combinations, distributions of assets or evidence of indebtedness, mergers, consolidations, sales of all or substantially all assets, tender offers, exchange offers, reclassifications or compulsory share exchanges.

Warrant B’s

The Warrant B’s entitle the holders thereof to purchase up to an aggregate of 3,636,368 shares of our common stock at a price of $1.68 per share for a period of 90 trading days beginning the later of six months from the date of such warrants and the date the SEC declares effective the Registration Statement.  As noted above, as a result of an amendment, the expiration date of the Warrant B’s is now August 31, 2007. The exercise price and the number of shares underlying these warrants are subject to adjustment for stock splits, stock dividends, combinations, distributions of assets or evidence of indebtedness, mergers, consolidations, sales of all or substantially all assets, tender offers, exchange offers, reclassifications or compulsory share exchanges.

Placement Agent Warrants

First Albany Capital (“FAC”) acted as placement agent in connection with the Private Placement. In addition to a cash transaction fee, FAC or its designees were entitled to receive five-year warrants to purchase 218,182 shares of the Company’s common stock at an exercise price of $1.87 per share. These warrants will be callable after the second anniversary of the closing of the Private Placement if the 20-day volume weighted average price per share of the Company’s common stock exceeds 175% of the exercise price. At the direction of FAC, these warrants were issued to First Albany Companies Inc., the parent of FAC.

20




On December 20, 2006, in connection with the early termination of the lease for the Company’s Worcester facility (see Note I), the Company entered into a First Amendment to Securities Purchase Agreement (the “Amendment”) with certain of the Purchasers who participated in the Company’s Private Placement.

Pursuant to the Amendment:

·                  the definition of “Excluded Stock” set forth in the Purchase Agreement was amended to enable the Company to issue up to 1.1 million shares of the Company’s common stock in connection with the early termination of the lease for the Company’s facility located in Worcester, Massachusetts, without such shares being subject to the Purchasers’ right of participation set forth in the Purchase Agreement and certain prohibitions set forth in the Notes and related warrants; and

·                  the Company agreed to extend the expiration date of the Warrant B’s issued in the Private Placement from May 30, 2007 to August 31, 2007. 

Accounting for the Convertible Debt Instrument and Warrants

The Company has determined that the Notes constitute a hybrid instrument that has the characteristics of a debt host contract containing several embedded derivative features that would require bifurcation and separate accounting as a derivative instrument pursuant to the provisions of SFAS 133, Accounting for Derivative Instruments and Hedging Activities (SFAS 133).   The Company has identified all of the derivatives associated with the July 19, 2006 financing, and concluded that two of the derivatives cannot be reliably measured nor reliably associated with another derivative that can be reliably measured.  As such, the Company has appropriately valued these derivatives as a single hybrid contract together with the Notes.  The contract will be remeasured at each period at the fair value with the changes in fair value recognized in the statement of operations until the Notes are settled.  As permitted under SFAS 155, the Company has irrevocably elected, as of January 1, 2007, to continue to measure the Notes and embedded derivatives in their entirety at fair value with changes in fair value recognized as either gain or loss.  The Company has determined that this election had no impact on the accounting for the Notes.

Upon issuance, the Warrant As and Warrant Bs, along with the Placement Agent Warrants (together the “Warrants”), did not meet the requirements for equity classification set forth in EITF Issue 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in a Company’s Own Stock, because such warrants (a) must be settled in registered shares, (b) are subject to substantial liquidated damages if the Company is unable to maintain the effectiveness of the resale registration of the shares and (c) there is a cash-out election using a Black-Scholes valuation under various circumstances.  Therefore these Warrants are required to be accounted for as freestanding derivative instruments pursuant to the provisions of SFAS 133.  Changes in fair value are recognized as either a gain or loss in the statement of operations under the caption “change in fair value of Notes and warrants”.  In addition, the Warrant B’s are being classified as a current liability on the balance sheet as they are outstanding for less than one year.

Upon issuance of the Notes and Warrants, the Company allocated the proceeds received from the Notes and the Warrants on a relative fair value basis.  As a result of such allocation, the Company determined the initial carrying value of the Notes to be $9.4 million.  The Notes were immediately marked to fair value, resulting in a derivative liability in the amount of $16.3 million.  As of December 31, 2006, the Notes have been marked to fair value resulting in a derivative liability of $12.7 million.  As of March 31, 2007, the Notes have been marked to fair value resulting in a derivative liability of $11.6 million.  The net charge Change in Fair Value of Notes and Warrants for the three months ended March 31, 2007 was $0.5 million.

Upon issuance, the Company allocated $2.7 million of the initial proceeds to the Warrants and immediately marked them to fair value resulting in a derivative liability of $4.9 million and a charge to other expense of $2.2 million.  As of December 31, 2006, the Warrants have been marked to fair value resulting in a derivative liability of $2.9 million.  As of March 31, 2007, the Warrants have been marked to fair value resulting in a derivative liability of $3.1 million.  The credit to Change in Fair Value of Notes and Warrants for the three months ended March 31, 2007 was $0.2 million. The transaction costs were immediately expensed as part of the fair value adjustment.

The debt discount in the amount of $2.6 million (resulting from the allocation of proceeds) is being amortized to interest expense using the effective interest method over the expected term of the Notes.  The Company amortized approximately $0.3 million for the three months ended March 31, 2007, which is a component of interest expense.

21




A Summary of the changes in the fair value of the Notes and the Warrants:

 

Fair Value
 of Notes

 

Fair Value 
of Warrant 
Liabilities

 

Total

 

 

 

 

 

 

 

 

 

Allocation of initial proceeds

 

$

9,351,084

 

$

2,648,916

 

$

12,000,000

 

Transaction costs

 

(1,064,207

)

 

(1,064,207

)

Initial fair value adjustment

 

8,002,518

 

2,204,950

 

10,207,468

 

 at July 19, 2006

 

$

16,289,395

 

$

4,853,866

 

$

21,143,261

 

 

 

 

 

 

 

 

 

Amortization of debt discount

 

239,874

 

 

239,874

 

Restructuring charge fair value adjustment

 

 

193,117

 

193,117

 

Fair value adjustment

 

(3,788,787

)

(2,126,430

)

(5,915,217

)

Balance December 31, 2006

 

$

12,740,482

 

$

2,920,553

 

$

15,661,035

 

 

 

 

 

 

 

 

 

Amortization of debt discount

 

322,162

 

 

322,162

 

Redemptions

 

(1,026,440

)

 

(1,026,440

)

Fair value adjustment

 

(452,782

)

217,837

 

(234,945

)

Balance March 31, 2007

 

$

11,583,422

 

$

3,138,390

 

$

14,721,812

 

 

Under the provisions of the Notes, the Company may elect to make principal and interest payments in shares of its Common Stock.  Through March 31, 2007, the Company made the following types of cash payments and issuances of Common Stock for payment of interest or principal on the Notes:


Date

 


Payment
Type

 


$ value

 


Shares
Delivered

 


Fair
Value(2)

 

Fair Value
Adjustment

 

February 28, 2007

 

Principal Payment

 

$

500,000

 

445,899

 

$

530,620

 

$

30,620

 

May 1, 2007 (1)

 

Principal Payment

 

$

500,000

 

381,400

 

$

495,820

 

$

(4,180

)

 

 

 

 

$

1,000,000

 

827,299

 

$

1,026,440

 

$

26,440

 

 


(1)       On April 30, 2007 the Company delivered an additional 62,961 shares of Common Stock to settle the May 1, 2007 principal payment.  As a result, the Company will record an adjustment to the fair value of the Notes in the amount of $77,442 in its results of operations for its second quarter ending on June 30, 2007.

(2)       The fair value is calculated by taking the Company’s stock price on the date of the payment multiplied by the number of shares issued.  The difference between the fair value and the payment amount is netted in the fair value adjustment for the period in the Company’s results of operations.

In addition, the board of directors elected to make the June 1, 2007 principal payment in shares of Common Stock.  As a result of this decision, the Company was required on April 28, 2007 to make a prepayment of 449,774 shares of common stock based on 90% of the 20-day Volume Weighted Average Price (“VWAP”) through April 28, 2007 divided by the principal payment due.  On or about June 1, 2007, the Company will be required to reconcile this estimate which could result in the issuance of additional shares of Common Stock to settle the actual amount due.

Note L. Redeemable Convertible Series B Preferred Stock

On October 31, 2003, the Company completed a $7.7 million equity transaction involving the issuance of 1,535 shares of its Series B Convertible Preferred Stock, $0.01 par value per share (the “Series B Preferred Stock”), and warrants to purchase up to 1,228,000 shares of the Company’s Common Stock, to accredited investors (the “October 2003 Financing Transaction”).   In connection with the October 2003 Financing Transaction, the Company issued shares of Series B Preferred Stock for $5,000 per share. The Series B Preferred Stock is convertible into a number of shares of Common Stock equal to $5,000 divided by the conversion price of the Series B

22




Preferred Stock, which was initially $2.50.  As of March 31, 2007 and December 31, 2006, 345 shares of Series B Preferred Stock were outstanding. 

As a result of the issuance of 850,000 shares of Common Stock to the Worcester landlord on January 3, 2007, the Company was required to adjust the conversion price of the remaining 345 shares of Series B Preferred Stock outstanding at that time in accordance with the anti-dilution provisions of the Series B Preferred Stock.  These shares of Series B Preferred Stock have a liquidation preference of $5,000 per share and are convertible into a number of shares of Common Stock equal to $5,000 divided by the conversion price of the Series B Preferred Stock, which, as a result of the issuance to the landlord, was adjusted from $2.07 per share to $2.04 per share. As of January 3, 2007, the liquidation preference of the remaining 345 shares of Series B Preferred Stock was $1,725,000, and the shares of Series B Preferred Stock were convertible into 845,588 shares of Common Stock, after adjustment.  The issuance of Common Stock to the landlord resulted in an additional adjustment of $16,912, which was recorded as interest expense for the quarter ended March 31, 2007 (see Note I.  Restructuring Costs).

As a result of the issuance of shares of Common Stock to the landlord, the Company recorded the following non-cash charges as interest expense in its Statement of Operations during the quarter ended March 31, 2007:

Security

 

Conversion/
Exercise Price

 

Adjusted Conversion/
Exercise Price

 

Interest
Expense

 

Redeemable Convertible Series B Preferred Stock

 

$

2.07

 

$

2.04

 

$

16,912

 

 

As a result of the issuance of shares of Common Stock in lieu of the first principal payment on the Notes, due February 28, 2007,  the Company was required to adjust the conversion price of the remaining 345 shares of Series B Preferred Stock outstanding at that time in accordance with the anti-dilution provisions of the Series B Preferred Stock.  These shares of Series B Preferred Stock have a liquidation preference of $5,000 per share and are convertible into a number of shares of Common Stock equal to $5,000 divided by the conversion price of the Series B Preferred Stock, which, as a result of the issuance in lieu of cash for the principal payment due February 28, 2007, was adjusted from $2.04 per share to $2.03 per share. As of, February 28, 2007,  the liquidation preference of the remaining 345 shares of Series B Preferred Stock was $1,725,000, and the shares of Series B Preferred Stock were convertible into 849,754 shares of Common Stock, after adjustment.  The issuance of Common Stock in lieu of cash resulted in an additional adjustment of $8,498, which was recorded as interest expense for the quarter ended March 31, 2007 (see Note K. Convertible Debt Instruments and Warrant Liabilities).

As a result of the issuance of shares of Common Stock in lieu of cash for the principal payment due on February 28, 2007, the Company recorded the following non-cash charges as interest expense in its Statement of Operations during the quarter ended March 31, 2007:


Security

 

Conversion/
Exercise Price

 

Adjusted Conversion/
Exercise Price

 

Interest
Expense

 

Redeemable convertible Series B Preferred Stock

 

$

2.04

 

$

2.03

 

$

8,498

 

 

23




Note M. Stock Option Plans

Stock Option Plans

Under the Company’s 1992, 1994, 1996, 1998, 1999, 2000, 2002 and 2005 Stock Option Plans (collectively, the “Plans”), both qualified and non-qualified stock options may be granted to certain officers, employees, directors and consultants to purchase up to a total of 7,250,000 shares of the Company’s common stock. At March 31, 2007, 1,203,411 of the 7,250,000 shares available for grant under the Plans have been granted.

The Plans are subject to the following provisions:

·                  The aggregate fair market value (determined as of the date the option is granted) of the Company’s common stock that any employee may purchase in any calendar year pursuant to the exercise of qualified options may not exceed $100,000. No person who owns, directly or indirectly, at the time of grant of a qualified option to him or her, more than 10% of the total combined voting power of all classes of stock of the Company shall be eligible to receive any qualified options under the Plans unless the exercise price is at least 110% of the fair market value of the Company’s common stock subject to the option, determined on the date of grant.  Non-qualified options are not subject to this limitation.

·                  Qualified options are issued only to employees of the Company, while non-qualified options may be issued to non-employee directors, consultants and others, as well as to employees of the Company. Options granted under the Plans may not be granted with an exercise price less than 100% of fair value of the Company’s common stock, as determined by the Board of Directors on the grant date.

·                  Options under the Plans must be granted within 10 years from the effective date of the Plan. Qualified options granted under the Plans cannot be exercised more than 10 years from the date of grant, except that qualified options issued to 10% or greater stockholders are limited to five-year terms.

·                  Generally, the options vest and become exercisable ratably over a four-year period.

·                  The Plans contain antidilutive provisions authorizing appropriate adjustments in certain circumstances.

·                  Shares of the Company’s common stock subject to options that expire without being exercised or that are canceled as a result of the cessation of employment are available for future grants.

The following table summarizes activity of the Company’s stock plans since December 31, 2005:

 

Options Outstanding

 

 

 

 

 


Number
of

 

Weighted
Average

 

Weighted
Average
Remaining
Contractual
Term

 


Aggregate
Intrinsic

 

 

 

Shares

 

Exercise Price

 

(years)

 

Value

 

Outstanding at December 31, 2005

 

3,778,095

 

$

3.89

 

7.00

 

 

 

Grants

 

1,000,500

 

$

2.48

 

 

 

 

 

Exercises

 

(229,850

)

$

1.37

 

 

 

 

 

Cancellations

 

(92,000

)

$

2.82

 

 

 

 

 

Outstanding at December 31, 2006

 

4,456,745

 

$

3.73

 

6.71

 

$

130,060

 

Grants

 

9,500

 

$

1.30

 

 

 

 

 

Exercises

 

(5,000

)

$

0.63

 

 

 

 

 

Cancellations

 

(96,750

)

$

2.24

 

 

 

 

 

Outstanding at March 31, 2007

 

4,364,495

 

$

3.76

 

6.51

 

$

174,567

 

 

 

 

 

 

 

 

 

 

 

Exercisable at March 31, 2007

 

3,759,245

 

$

3.96

 

6.08

 

$

167,672

 

 

24




Information relating to stock options outstanding as of March 31, 2007 follows:

 

Options Outstanding

 

Options Exercisable

 

Range of Exercise
Prices

 


Number of
Shares

 

Weighted
Average
Remaining
Contractual
Life
(years)

 

Weighted
Average
Exercise
Price

 


Exercisable
Number of
Shares

 

Exercisable
Weighted
Average
Exercise
Price

 

 

 

 

 

 

 

 

 

 

 

 

 

$0.41   to   $1.39

 

699,450

 

7.87

 

$

1.09

 

593,450

 

$

1.05

 

$1.42   to   $1.76

 

961,500

 

8.07

 

$

1.67

 

936,250

 

$

1.66

 

$1.78   to   $2.05

 

724,633

 

5.23

 

$

2.00

 

703,383

 

$

2.01

 

$2.07   to   $2.95

 

835,250

 

8.98

 

$

2.72

 

382,500

 

$

2.52

 

$3.05   to   $9.00

 

627,412

 

3.55

 

$

5.66

 

627,412

 

$

5.66

 

$9.20   to   $17.563

 

508,750

 

3.14

 

$

13.03

 

508,750

 

$

13.03

 

$17.70   to   $17.75

 

7,500

 

3.61

 

$

17.75

 

7,500

 

$

17.75

 

$0.41   to   $17.75

 

4,364,495

 

6.51

 

$

3.76

 

3,759,245

 

$

3.96

 

 

Options for the purchase of 3,786,745 shares were exercisable at December 31, 2006, with a weighted average exercise price of $3.95.

The Company had no unvested shares of restricted stock outstanding as of December 31, 2006 and March 31, 2007.

As of March 31, 2007, there was approximately $0.8 million of total unrecognized costs related to non-vested share-based compensation arrangements granted under the Plans.  The Company expects to recognize the cost over a weighted average period of approximately 1.1 years.  Options to purchase 5,000 shares were exercised during the three months ended March 31, 2007, and these options had an intrinsic value of approximately $6,093 on their date of exercise. Options to purchase 91,750 shares were exercised during the three month period ended April 1, 2006, and these options had an intrinsic value of $0.2 million on the date of exercise.

During 2000, the Company granted 216,000 non-qualified stock options to employees at an exercise price of $17.56 per share outside of the Plans. As of March 31, 2007 and December 31, 2006, 21,000 of these options were outstanding, which are included in the above table. As of March 31, 2007 and December 31, 2006, an additional 195,000 shares,  included above were available outside of the Plans for future grants.

25




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

Forward-Looking Statement

You should read the following discussion and analysis in conjunction with our consolidated financial statements and notes in Item 1 of this report and with our audited consolidated financial statements and notes included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2006.

In addition to the historical information contained in this report, this report contains or incorporates by reference forward-looking statements within the meaning of section 27A of the Securities Act of 1933 and section 21E of the Securities Exchange Act of 1934.  You can identify these forward-looking statements by our use of the words “believes,” “anticipates,” “plans,” “expects,” “may,” “will,” “intends,” “estimates,” and similar expressions, whether in the negative or in the affirmative.  Such forward-looking statements includes those related to expected revenue growth, our ability to continue to make interest and principal payments on our Notes in shares of our common stock, our ability to achieve our business plan, and our ability to reduce costs in the future.  Although we believe that these forward-looking statements reasonably reflect our plans, intentions and expectations, these forward-looking statements involve risks and uncertainties that could cause actual results to differ materially.  We caution that these statements are qualified by various factors that may affect future results, including the following: business conditions within the distributed power, power quality, aerospace, transportation, industrial, utility, telecommunications, silicon wafer manufacturing, factory automation, aircraft and automotive industries and the world economies as a whole; technology developments and contract research and development for both the government and commercial sectors; the ability of our new products in penetrating the distributed power, power quality, aerospace, transportation, industrial, utility, telecommunications, silicon wafer manufacturing, factory automation, aircraft and automotive markets.  This report should be read in conjunction with our Annual Report on Form 10-K for the fiscal year ended December 31, 2006, including particularly Part I, Item 1A, “Risk Factors.”

Overview (Executive Summary)

We design and manufacture enabling technologies and products for electrical power conversion and control for high-performance, high-efficiency applications in large, growth markets such as alternative energy, hybrid electric vehicles, distributed power generation, power quality, semiconductor fabrication capital equipment, industrial motors and drives, and high reliability defense electronics.

Critical Accounting Policies and Significant Judgments and Estimates

Our discussion and analysis of our financial condition and results of our operations are based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these consolidated financial statements requires management to make significant estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported revenue and expenses during the reporting periods. On an ongoing basis, management evaluates its estimates and judgments, including those related to revenue recognition, receivable reserves, inventory reserves, goodwill and intangible assets, convertible debt instruments and warrant liabilities, contract losses and income taxes. Management bases its estimates on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Our critical accounting policies and estimates were discussed with our Audit Committee.

The significant accounting policies that management believes are most critical to aid in fully understanding and evaluating our reported financial results include the following:

Revenue Recognition

We recognize revenue from product sales in accordance with SEC Staff Accounting Bulletin No. 104, Revenue Recognition. Product revenue is recognized when there is persuasive evidence of an arrangement, the fee is fixed or determinable, delivery of the product to the customer has occurred and we have determined that collection of the fee is probable. Title to the product passes upon shipment of the product, as the products are typically shipped FOB shipping point, except for certain foreign shipments. If the product requires installation to be performed by us, all revenue related to the product is deferred and recognized upon the completion of the installation. If the product requires specific customer acceptance, revenue is deferred until customer acceptance occurs or the acceptance

26




provisions lapse, unless we can objectively and reliably demonstrate that the criteria specified in the acceptance provisions are satisfied. When appropriate, we provide for a warranty reserve at the time the product revenue is recognized.

We perform funded research and development and product development for commercial companies and government agencies under both cost reimbursement and fixed-price contracts. Cost reimbursement contracts provide for the reimbursement of allowable costs and, in some situations, the payment of a fee. These contracts may contain incentive clauses providing for increases or decreases in the fee depending on how costs compare with a budget. On fixed-price contracts, revenue is generally recognized on the percentage of completion method based upon the proportion of costs incurred to the total estimated costs for the contract. Revenue from reimbursement contracts is recognized as services are performed. In each type of contract, we receive periodic progress payments or payment upon reaching interim milestones and retain the rights to the intellectual property developed in government contracts. All payments to us for work performed on contracts with agencies of the U.S. government are subject to audit and adjustment by the Defense Contract Audit Agency. Adjustments are recognized in the period made. The Defense Contract Audit Agency has agreed upon the final indirect cost rates for the fiscal year ended September 30, 2003. When the current estimates of total contract revenue and contract costs for product development contracts indicate a loss, a provision for the entire loss on the contract is recorded. As of March 31, 2007 and December 31, 2006, we had no accruals for anticipated contract losses.

Cost of product revenue includes material, labor and overhead. Costs incurred in connection with funded research and development and other revenue arrangements are included in funded research and development and other revenue expenses.

Deferred revenue consists of payments received from customers in advance of services performed, product shipped or installation completed.

Unbilled contract costs and fees represent revenue recognized in excess of amounts billed due to contractual provisions or deferred costs that have not yet been recognized as revenue or billed to the customer.

Accounts Receivable

Accounts receivable are reduced by an allowance for amounts that may become uncollectible in the future. The estimated allowance for uncollectible amounts is based primarily on a specific analysis of accounts in the receivable portfolio and historical write-off experience. While management believes the allowance to be adequate, if the financial condition of our customers were to deteriorate, resulting in impairment of their ability to make payments, additional allowances may be required.

Inventory

We value our inventory at the lower of actual cost to purchase and/or manufacture the inventory or the current estimated market value of the inventory. We periodically review inventory quantities on hand and record a provision for excess or obsolete inventory based primarily on our estimated forecast of product demand, as well as based on historical usage. Due to the custom and specific nature of certain of our products, demand and usage for products and materials can fluctuate significantly. A significant decrease in demand for our products could result in a short-term increase in the cost of inventory purchases and an increase of excess inventory quantities on hand. In addition, our industry is characterized by rapid technological change, frequent new product development, and rapid product obsolescence that could result in an increase in the amount of obsolete inventory quantities on hand. Therefore, although we make every effort to ensure the accuracy of our forecasts of future product demand, any significant unanticipated changes in demand or technological developments could have a significant impact on the value of our inventory and our reported operating results.

Goodwill and Intangible Assets

Purchase accounting requires extensive use of accounting estimates and judgments to allocate the purchase price to the fair market value of the assets purchased and liabilities assumed. We have accounted for our acquisitions using the purchase method of accounting. Values were assigned to goodwill and intangible assets based on third-party independent valuations, as well as management’s forecasts and projections that include assumptions related to future revenue and cash flows generated from the acquired assets.

We have adopted the provisions of SFAS No. 142, Goodwill and Other Intangible Assets. This statement affects our treatment of goodwill and other intangible assets. The statement requires impairment tests be periodically repeated and on an interim basis, if certain conditions exist, with impaired assets written down to fair value. Additionally, existing goodwill and intangible assets must be assessed and classified within the statement’s criteria. Intangible assets with finite useful lives will continue to be amortized over those periods. Amortization of goodwill and intangible assets with indeterminable lives ceased.

We determine the fair value of each of the reporting units based on a discounted cash flow income approach. The income

27




approach indicates the fair value of a business enterprise based on the discounted value of the cash flows that the business can be expected to generate in the future. This analysis is largely based upon projections prepared by us and data from sources of publicly available information available at the time of preparation. These projections are based on management’s best estimate of future results. In making these projections, we consider the markets we are addressing, the competitive environment and our advantages. There will usually be differences between estimated and actual results as events and circumstances frequently do not occur as expected, and those differences may be material. In addition, we perform a high level assessment of the overall likelihood that we would achieve the projected cash flows and performed sensitivity analysis using historical data as the basis for projected cash flows.

Long-Lived Assets

We have adopted SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, which supersedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of, and the accounting and reporting provisions of APB Opinion No. 30. SFAS No. 144 addresses financial accounting and reporting for the impairment or disposal of long-lived assets. The statement requires that long-lived assets be reviewed for possible impairment, if certain conditions exist, with impaired assets written down to fair value.

We determine the fair value of certain of the long-lived assets based on a discounted cash flow income approach. The income approach indicates the fair value of a long-lived asset based on the discounted value of the cash flows that the long-lived asset can be expected to generate in the future over the life of the long-lived asset. This analysis is based upon projections prepared by us. These projections represent management’s best estimate of future results. In making these projections, we consider the markets we are addressing, the competitive environment and our advantages. There will usually be differences between estimated and actual results as events and circumstances frequently do not occur as expected, and those differences may be material. In addition, we perform a high level assessment of the overall likelihood that we would achieve the projected cash flows and performed sensitivity analysis using historical data as the basis for projected cash flows.

Convertible Debt Instruments and Warrant Liabilities

We account for our senior secured convertible notes (the “Notes”) and associated warrants in accordance with SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities.  Our Notes include features that qualify as embedded derivatives, such as (i) the holders’ conversion option, (ii) our option to settle the Notes at the scheduled dates in cash or shares of our common stock, and (iii) premiums and penalties we would be liable to pay in the event of default.  As permitted under SFAS 155, we have irrevocably elected, as of January 1, 2007, to measure the Notes in their entirety at fair value with changes in fair value recognized as either gain or loss. 

We record interest expense under our Notes based on the greater of (i) 7% or (ii) the six-month LIBOR in effect at the time plus 350 basis points, as well as the amortization of the debt discount, which we compute using the effective interest method.  The debt discount represents the difference between our gross proceeds of $12.0 million and the fair value of the convertible debt upon issuance, after separately valuing the investor warrants, the placement agent warrants and the Notes on a relative fair value basis.  By amortizing the debt discount to interest expense, rather than recognizing it as a change in fair value of the convertible debt instrument and warrants, which is a separate line item in our statement of operations, we believe our interest expense line item more appropriately reflects the cost of the debt associated with our Notes.

We determined the fair values of our Notes, investor warrants and placement agent warrants in consultation with valuation specialists, using valuation models we consider to be appropriate. Our stock price has the most significant influence on the fair value of our Notes and our warrants. An increase in our common stock price would cause the fair values of both the Notes and warrants to increase, because the conversion and exercise prices, respectively, of such instruments are fixed at $1.65 and $1.68 per share, respectively, and result in a charge to our statement of operations. A decrease in our stock price would likewise cause the fair value of the convertible Notes and the warrants to decrease and result in a credit to our statement of operations. If the price of our common stock were to decline significantly, however, the decrease in the fair value of the Notes would be limited by the instrument’s debt characteristics. Under such circumstances, our estimated cost of capital would become another significant variable affecting the fair value of the Notes.

Income Taxes

The preparation of our consolidated financial statements requires us to estimate our income taxes in each of the jurisdictions in which we operate, including those outside the United States, which may be subject to certain risks that ordinarily would not be expected in the United States. The income tax accounting process involves estimating our actual current exposure together with assessing temporary differences resulting from differing treatment of items, such as deferred revenue, for tax and accounting purposes. These differences result in the recognition of deferred tax assets and liabilities. We must then record a valuation allowance to reduce our deferred tax assets to the

28




amount that is more likely than not to be realized.

Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance recorded against deferred tax assets. We have recorded a full valuation allowance against our deferred tax assets of approximately $47.4 million as of December 31, 2006, due to uncertainties related to our ability to utilize these assets. The valuation allowance is based on our estimates of taxable income by jurisdiction in which we operate and the period over which our deferred tax assets will be recoverable. In the event that actual results differ from these estimates or we adjust these estimates in future periods we may need to adjust our valuation allowance which could materially impact our financial position and results of operations.

In June 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109” (“FIN 48”).  FIN 48 requires companies to recognize the tax benefits of uncertain tax positions only where the position is “more likely than not” to be sustained assuming examination by tax authorities.  The amount recognized is the amount that represents the largest amount of tax benefit that is greater than 50% likely of being ultimately realized.  A liability is recognized for any benefit claimed, or expected to be claimed, in a tax return in excess of the benefit recorded in the financial statements, along with any interest and penalties (if applicable) on that excess.  FIN 48 requires a tabular reconciliation of the change in the aggregate unrecognized tax benefits claimed, or expected to be claimed, in tax returns and disclosure relating to the accrued interest and penalties for unrecognized tax benefits.  Discussion is also required for those uncertain tax positions where it is reasonably possible that the estimate of the tax benefit will change significantly in the next twelve months.

We adopted the provisions of FIN 48 on January 1, 2007.  We did not recognize any decrease in the liability for unrecognized tax benefits as a result of the adoption.

As of December 31, 2006, we had federal and state NOL carry forwards and federal and state R&D credit carry forwards, which may be available to offset future federal and state income tax liabilities which expire at various dates starting in 2007 and going through 2026. Utilization of the NOL and R&D credit carry forwards may be subject to a substantial annual limitation due to ownership change limitations that have occurred previously or that could occur in the future provided by Section 382 of the Internal Revenue Code of 1986, as well as similar state and foreign provisions. These ownership changes may limit the amount of NOL and R&D credit carry forwards that can be utilized annually to offset future taxable income and tax, respectively. In general, an ownership change, as defined by Section 382, results from transactions increasing the ownership of certain shareholders or public groups in the stock of a corporation by more than 50 percentage points over a three-year period. Since our formation, we has raised capital through the issuance of capital stock on several occasions (both pre and post initial public offering) which, combined with the purchasing shareholders’ subsequent disposition of those shares, may have resulted in a change of control, as defined by Section 382, or could result in a change of control in the future upon subsequent disposition. We have not currently completed a study to assess whether a change of control has occurred or whether there have been multiple changes of control since our formation due to the significant complexity and cost associated with such study and that there could be additional changes in control in the future. If we have experienced a change of control at any time since our formation, utilization of our NOL or R&D credit carry forwards would be subject to an annual limitation under Section 382 which is determined by first multiplying the value of our stock at the time of the ownership change by the applicable long-term tax-exempt rate, and then could be subject to additional adjustments, as required. Any limitation may result in expiration of a portion of the NOL or R&D credit carry forwards before utilization. Further, until a study is completed and any limitation known, no amounts are being presented as an uncertain tax position under FIN 48. We do not expect to have any taxable income for the foreseeable future.

We did not recognize any interest and penalties associated with unrecognized tax benefits in the accompanying financial statements.  We do not expect any material changes to the unrecognized benefits within 12 months of the reporting date.

Results of Operations

Three Months Ended March 31, 2007 (“2007”) Compared to Three Months Ended April 1, 2006 (“2006”)

Product Revenue.  Total product revenue for 2007 decreased approximately $0.1 million or 1.9 % from $6.7 million in 2006 to $6.6 million in 2007. 

29




 

 

Three Months Ended

 

 

 

(in thousands)

 

Division

 

March 31, 2007

 

April 1, 2006

 

$ Change

 

% Change

 

Power Systems, US

 

$

735

 

$

1,791

 

$

(1,056

)

-59.0

%

Power Systems, Canada

 

3,604

 

2,302

 

1,302

 

56.5

%

Electronics

 

2,194

 

2,568

 

(374

)

-14.6

%

Total product revenue

 

$

6,533

 

$

6,661

 

$

(128

)

-1.9

%

 

The increase of $1.3 million in revenue in 2007 in the Power Systems, Canada division, as compared to 2006, was largely due to an increase in Solar Converter line revenue of approximately $2.2 million which was partially offset by decreases in the following lines of business:

·      Fuel Cell Inverter line revenues decreased approximately $0.4 million,

·      Industrial power supplies decreased approximately $0.3 million, and

·      Frequency convert line revenue decreased approximately $0.1 million

The decrease of $1.1 million in revenue in 2007 in the Power Systems US division, as compared to 2006, was largely due to the following:

·      Motor product line revenues decreased by approximately $0.1 million,

·      MagLev product line revenue decreased approximately $0.6 million, and

·      Test and Measurement product line revenue decreased approximately $0.4 million. 

Revenues in the Electronics division decreased approximately $0.4 million.  The decrease was primarily due to decreased sales of $0.5 million to government customers as compared to 2006 and to a lesser extent increases in sales to commercial non-government customers of $0.1 million.

Funded research and development and other revenue.  Funded research and development and other revenue increased from $0.9 million in 2006 to $1.8 million in 2007.  The increase in revenue is due to an increase in revenue from our commercial customers of $0.7 million and an increase in revenue of $0.2 million on our government contracts.

Cost of product revenue.  Cost of product revenue increased $0.5 million, or 9.0%, from $5.8 million in 2006 to $6.4 million in 2007.

 

Three Months Ended

 

 

 

(in thousands)

 

Division

 

March 31, 2007

 

April 1, 2006

 

$ Change

 

% Change

 

Power Systems, US

 

$

1,025

 

$

1,335

 

$

(310

)

-23.2

%

Power Systems, Canada

 

3,705

 

2,413

 

1,292

 

53.5

%

Electronics

 

1,640

 

2,097

 

(457

)

-21.8

%

Total cost of product revenue

 

$

6,370

 

$

5,845

 

$

525

 

9.0

%

 

The increase was primarily attributable the mix of products sold during the period and higher revenues compared to fiscal 2006 in our Power Systems, Canada division.  This increase was offset, in part, by a decrease in overhead costs during the period in our Power Systems, US division and, in part, by a decrease in the cost of product revenue due to a decrease in revenue and lower material and overhead costs during the period in our Electronics division.

Gross Margin. Gross margins on product revenue decreased from 12% for 2006 to 4% in 2007.  Gross margin by division is broken out below. 

 

Three Months Ended

 

Division

 

March 31, 2007

 

April 1, 2006

 

Power Systems, US

 

-39

%

25

%

Power Systems, Canada

 

-3

%

-5

%

Electronics

 

25

%

18

%

Total gross margin %

 

2

%

12

%

 

30




In our Power Systems, US division, the decrease in gross margin by 64% is a direct result of a decrease in revenue and the absorption of overhead costs. Our Power Systems, Canada division had an increase in gross margin of 2% partially due to a change in the product mix and increased revenues.  The increase in gross margin of 7% in our Electronics division is primarily due to mix of products sold resulting in lower material costs.

Funded research and development and other revenue expenses.  Funded research and development and other revenue expenses increased by approximately $0.4 million, or 39%, from $1.0 million in 2006 to $1.4 million in 2007.   The gross margin on funded research and other revenue increased from (3)% in 2006 to 24% in 2007. This increase is a due to the increase in revenue for 2007 and an increased efficiency in our engineering labor.

Unfunded research and development expenses.  We expended approximately $0.7 million on unfunded research and development in 2007 compared with approximately $0.6 million spent in 2006.  The spending in 2007 and 2006 was related primarily to unfunded engineering in our Electronics and Power Systems, Canada divisions for the development of new products and technologies. 

Selling, general and administrative expenses.  Selling, general and administrative expenses decreased by approximately $0.5 million, or 16%, from $3.3 million in 2006 to $2.8 million in 2007.  Approximately $0.1 million of the decrease is directly attributable to compensation costs related to the issuance of stock options to employees and directors of the Company pursuant to SFAS 123(R) charged to operations during 2006. Approximately $0.4 million of the decrease was associated with reduced corporate costs of $0.6 million offset by higher sales and marketing costs in our Power Systems, Canada division in 2007 of $0.2 million.

Amortization of intangibles.  Amortization of intangibles remained flat at $0.1 million.

Change in fair value of Notes and warrantsThe change in fair value of the Notes and warrants for 2007 was a credit of approximately $0.2 million.

Other Income (expense).  Other expense was approximately $40,000 for 2007 compared to other income of approximately $20,000 for 2006.  Other expense for 2007 consists primarily of consulting services related to the valuation of our convertible note financing transaction as well as other expenses not related to ongoing operations. Other income for 2006 consists primarily of payments received for miscellaneous items sold during the period that had previously been charged off in prior periods.

Interest income.  Interest income remained flat at $0.1 million and is directly attributable to our cash on hand.

Interest expense.  Interest expense increased $0.5 million in 2007 to $0.6 million as compared to $0.1 million in 2006.  Interest expense in fiscal 2007 includes approximately $260,000 of non-cash interest associated with payments on our Notes, approximately $300,000 in amortization of the debt discount on our July 2006 Senior Secured Notes, and approximately $30,000 of non-cash dividends on our Series B Preferred Stock, which was paid in shares of our common stock. In 2006, interest expense was primarily comprised of approximately $40,000 of non-cash dividends on the Series B Preferred Stock and $30,000 of interest expense related to our line of credit.

Liquidity and Capital Resources

As of March 31, 2007, we had approximately $5.6 million of cash, of which approximately $1.1 million was restricted.  In addition, under the terms of the Notes, we are required, for so long as any Notes are outstanding, to maintain aggregate cash and cash equivalents equal to the greater of (i) $1.0 million or (ii) $3.0 million minus 80% of eligible receivables (as defined therein).  Based on the level of eligible receivables, we are required to maintain aggregate cash and cash equivalents of $1.0 million. 

We anticipate that our current cash will be sufficient to fund our operations at least over the next few quarters. This assumes that we will achieve our business plan and that we will be able to pay principal and interest under the Notes in shares of common stock and comply with all other terms of the Notes.  The business plan envisions a significant increase in revenue and significant reductions in the cost structure and the cash burn rate from the results experienced in the recent past.  If, however, we are unable to realize our business plan, or are unable to pay principal and interest under the Notes in shares of common stock or otherwise comply with the terms of the Notes, we may be forced to raise additional funds by selling stock or taking other actions to conserve cash, which could include selling certain assets and restructuring our Notes to allow for borrowings under another credit facility, all of which are subject to the restrictions in the purchase agreement relating to the Notes.

If additional funds are raised in the future through the issuance of equity or convertible debt securities, the percentage ownership of our stockholders will be reduced and our stockholders may experience additional dilution. The terms of additional funding may also

31




limit our operating and financial flexibility. There can be no assurance that additional financing of any kind will be available to us on terms acceptable to us, or at all. Failure to obtain future funding when needed or on acceptable terms would materially, adversely affect our results of operations.

Our financial statements for fiscal year ended December 31, 2006, which are included in our Annual Report on Form 10-K filed with the SEC on April 2, 2007, contain an audit report from Vitale, Caturano and Company, PC. The audit report contains a going concern qualification, which raises substantial doubt with respect to our ability to continue as a going concern. However, our business plan, which envisions a significant improvement in results from the recent past, contemplates sufficient liquidity to fund operations at least through March 31, 2008.  The receipt of a going concern qualification may create a concern among our current and future customers and vendors as to whether we will be able to fulfill our contractual obligations.

We have incurred significant costs to develop our technologies and products. These costs have exceeded total revenue. As a result, we have incurred losses in each of the past five years. As of March 31, 2007, we had an accumulated deficit of $162.4 million.  Since inception, we have financed our operations and met our capital expenditure requirements primarily through the sale of private equity securities and convertible debt, public security offerings, borrowings under our previous line of credit and capital equipment leases.

As of March 31, 2007, our cash and cash equivalents were $5.6 million, including restricted cash and cash equivalents of $1.1 million; this represents a decrease in our cash and cash equivalents of approximately $2.7 million from the $8.3 million on hand at December 31, 2006. Cash used in operating activities for the three months ended March 31, 2007 was $2.5 million as compared to $2.4 million for the three months ended April 1, 2006. Cash used in operating activities during the three months ended March 31, 2007 was primarily attributable to the net loss of approximately $3.4 million offset by non-cash items such as the change in the fair value of our Notes, depreciation and amortization, deferred revenue, non-cash compensation and consulting expense, non-cash interest expense and decreases in working capital. 

Cash used in investing activities during the three months ended March 31, 2007 was $0.2 million as compared to $0.1 million for the three months ended April 1, 2006.  Cash used in investing activities during these periods was a result of capital expenditures during each of the respective periods.

Cash used in financing activities for the three months ended March 31, 2007 was approximately $0.1 million as compared to cash provided by financing activities of $0.1 million for the three months ended April 1, 2006. Net cash used in financing activities during 2007 primarily related to payments on our capital lease obligations. 

Payments Due Under Contractual Obligations

We lease equipment and office space under non-cancelable capital and operating leases. The future minimum rental payments as of March 31, 2007 under the capital and operating leases with non-cancelable terms are included in the table below.  In addition, the table below details the future principal and interest payments on our Notes.

Calendar Years Ending December 31,

 

Capital Leases

 

Operating Leases

 

Long-Term Debt

 

 

 

 

 

 

 

 

 

2007

 

$

82,759

 

$

829,959

 

$

5,782,952

 

2008

 

 

$

967,614

 

$

3,876,579

 

2009

 

 

$

825,537

 

$

361,001

 

2010

 

 

$

523,797

 

$

361,001

 

2011

 

 

$

159,408

 

$

3,202,013

 

Thereafter

 

 

$

 

 

Total

 

$

82,759

 

$

3,306,315

 

$

13,583,546

 

 

Long-term debt consists of scheduled principal and interest payments on our Notes.  Principal is payable in 18 equal installments, which represents 75% of the Notes, with the remaining 25%, at the election of the investor, is either (i) due on the 18th month or (ii) due on the 60th month.  Principal payments, representing 75% of the Notes, commenced on February 28, 2007.  The Notes accrue interest at the greater of (i) 7% or (ii) six month LIBOR plus 350 basis points.  At December 31, 2006, the six month LIBOR was 5.4%.  For purposes of the schedule above, interest for all periods has been calculated using the December 31, 2006 six month LIBOR plus 350 basis points as this rate was greater than 7%.  Principal and interest may be paid, at our option, in cash of shares of our common stock.  Because investors may convert principal into common stock at any time, at their option, the timing of principal and interest payments may accelerate relative to this schedule.  See Note “K” to our unaudited consolidated financial statements filed with this quarterly report for a history of principal and interest payments regarding the Notes.

32




Effects of Inflation

We believe that inflation and changing prices over the past three years have not had a significant impact on our net revenue or on our income from continuing operations.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

The following discussion about our market risks disclosures involves forward-looking statements. Actual results could differ materially from those discussed in the forward-looking statements. We are exposed to market risk related to changes in interest rates and foreign currency exchange rates. We do not use derivative financial instruments for speculative or trading purposes.

Interest Rate Risk

We are exposed to market risk from changes in interest rates primarily through our financing activities. At March 31, 2007, $11.0 million was outstanding on the Notes.  Interest on the Notes accrues at a rate equal to the greater of (i) 7% per annum or (ii) the six month LIBOR plus 350 basis points, currently 8.9%.  Our ability to carry out our business plan or our ability to finance future working capital requirements may be impacted if the cost of carrying debt fluctuates to the point where it becomes a burden on our resources.  We account for the Notes and warrant liability on a fair value basis, and changes in share price and market interest rates will affect our earnings but will not affect our cash flows, assuming that we are able to make interest payments due on the Notes in shares of our common stock.

Foreign Currency Risk

Nearly all of our sales outside the United States are priced in US Dollars. If the US Dollar strengthens versus local currencies, it may result in our products becoming more expensive in foreign markets. In addition, approximately 15-20% of our costs are incurred in foreign currencies, especially the Canadian Dollar. If the US Dollar weakens versus these local currencies, it may result in an increase in our cost structure.

33




Item 4. Controls and Procedures

(a) Evaluation of Disclosure Controls and Procedures.

As required by Rule 13a-15 under the Securities Exchange Act of 1934, as of the end of the period covered by this report, we carried out an evaluation under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures as of March 31, 2007. While we have identified certain internal control deficiencies, which are discussed below, our evaluation indicated that these deficiencies did not impair the effectiveness of our overall disclosure controls and procedures.  Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective as of March 31, 2007 to ensure that information required to be disclosed by us in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms.

Our management and Audit Committee were notified by Vitale, Caturano & Company (“Vitale”) of two significant deficiencies in our internal control over financial reporting that they observed during the audit of the December 31, 2006 financial statements.

The first significant deficiency relates to a need to formalize policies and procedures (including a comprehensive accounting and financial reporting policies and procedures manual, a policy that requires an annual vacation for all employees and periodic rotation of duties, and policies and procedures relating to information technology).  We had begun to formalize policies in this area prior to receiving Vitale’s observations and will continue with these plans.

The second significant deficiency relates to our review and analysis of the carrying value of inventory and improving/retaining applicable documentation at certain of our business segments.  Vitale noted an instance of under capitalized labor and overhead costs at one of our business segments.  During 2007, we plan on continuing efforts to enhance our documentation process and monitoring controls in this area.

(b) Changes in Internal Control Over Financial Reporting.

There was no change in our internal control over financial reporting that occurred during the period covered by this report that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings.

From time to time, we are a party to routine litigation and proceedings in the ordinary course of business.

On May 19, 2006, we filed a suit in the U.S. District Court, District of Massachusetts, against one of our customers.  The suit demands full payment of all outstanding amounts due us from our customer.  The customer filed a counterclaim that we believed was without merit.  The suit was settled on March 9, 2007.

We are not aware of any current or pending litigation to which we are or may be a party that we believe could materially adversely affect our results of operations or financial condition or net cash flows.

34




Item 1A. Risk Factors.

There have been no material changes from the risk factors previously disclosed in Part I, Item 1A, “Risk Factors,” of our Annual Report on Form 10-K for the fiscal year ending December 31, 2006.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds:

Not applicable.

Item 3. Defaults Upon Senior Securities:

Not applicable.

Item 4. Submission of Matters to a Vote of Security Holders:

Not applicable

Item 5. Other Information:

Not applicable.

Item 6. Exhibits:

The exhibits listed in the Exhibit Index immediately preceding the exhibits are filed as part of this Quarterly Report on Form 10-Q.

35




SIGNATURE

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

 

SATCON TECHNOLOGY CORPORATION

Date: May 14, 2007

 

By: