MANAGEMENTS DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion should be read in conjunction with our accompanying unaudited condensed consolidated financial statements and notes thereto
included within this report, and our audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K filed for the fiscal year ended December 31, 2006. In addition to historical information, this Form 10-Q
and following discussion contain statements that are not historical facts and are considered forward-looking within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements contain projections of our
future results of operations or of our financial position or state other forward-looking information. In some cases you can identify these statements by forward-looking words such as anticipate, believe, could,
estimate, expect, intend, may, should, will and would or similar words. We believe that it is important to communicate our future expectations to our investors.
However, there may be events in the future that we are not able to accurately predict or control and that may cause our actual results to differ materially from the expectations we describe in our forward-looking statements. Investors are cautioned
not to rely on forward-looking statements because they involve risks and uncertainties, and actual results may differ materially from those discussed as a result of various factors, including, but not limited to: the risk that the anticipated
synergies of the Cellex Power Products, Inc. and General Hydrogen Corporation acquisitions are not realized; the risk that possible strategic benefits of the investment by Smart Hydrogen do not materialize, that orders will not ship, be installed
and/or convert to revenue; our ability to develop commercially viable on-site energy products; the cost and timing of developing our on-site energy products; market acceptance of our on-site energy products; our ability to manufacture on-site energy
products on a large-scale commercial basis; competitive factors, such as price competition and competition from other traditional and alternative energy companies; the cost and availability of components and parts for our on-site energy products;
the ability to raise and provide the necessary capital to develop, manufacture and market our on-site energy products; our ability to establish relationships with third parties with respect to product development, manufacturing, distribution and
servicing and the supply of key product components; our ability to protect our intellectual property; our ability to lower the cost of our on-site energy products and demonstrate their reliability; the cost of complying with current and future
governmental regulations;
13
the impact of deregulation and restructuring of the electric utility industry on demand for our on-site energy products; fluctuations in the trading price
and volume of our common stock and other risks and uncertainties discussed, but are not limited to, those set forth under the caption Factors Affecting Future Results in our Annual Report on Form 10-K filed for the fiscal year ended
December 31, 2006 as updated by Part II, Item 1A of this Form 10-Q. These forward-looking statements speak only as of the date on which the statements were made and are not guarantees of future performance. Except as may be required by
applicable law, we do not undertake or intend to update any forward-looking statements after the date of this Form 10-Q.
Overview
We design and develop on-site energy systems based on proton exchange
membrane fuel cell technology for commercial and residential energy consumers worldwide. We are focused on fuel cell and fuel processing technologies, from which we are offering or developing multiple products. We are currently offering our
GenCore
®
product for commercial sale. Our GenCore
®
product is a back-up power product for telecommunications, broadband, utility
and industrial uninterruptible power supply, or UPS, applications. We are developing additional products known as GenSys
®
for continuous run power applications, with optional combined heat
and power capability for remote small commercial and remote residential applications. Following the acquisition of Cellex Power Products, Inc. (Cellex) and General Hydrogen Corporation (General Hydrogen) in the second quarter of 2007, the Company is
also pursuing development and commercialization of fuel cell power units known as GenDrive that provide power for electric lift trucks and other mobile industrial equipment for which lead-acid batteries are the incumbent technology. During the
third quarter of 2007, the Company began to manufacture and deliver its GenDrive units to customers from its Latham, NY facility.
We are a development stage enterprise in the early period of field-testing and marketing our
initial commercial products to a limited number of customers, including telecommunications companies, utilities, government entities and our distribution partners. See Product Development and Commercialization. The GenCore
®
is fueled by hydrogen and does not require a fuel processor.
Our sales and marketing strategy is to build a network of leading distributors who have
established relationships, and sub-distributor networks, that can distribute and service our products in targeted geographic and/or market segments. We have distribution agreements in place with 20 distributors including Tyco Electronics Power
Systems, Inc., or Tyco, our largest North American distribution partner and IST Holdings Ltd., or IST, our distribution partner in South Africa. We also form relationships with customers and enter into development and demonstration programs with
telecommunications companies, electric utilities, government agencies and other energy providers. Many of our initial sales of GenSys
®
and GenCore
®
are contract-specific arrangements containing multiple obligations that may include a combination of fuel cell systems, continued service, maintenance and other support. The multiple obligations within our
contractual arrangements are not accounted for separately based on our limited commercial experience and available evidence of fair value. As a result, we defer recognition of product and service revenue and recognize revenue on a straight-line
basis over the contractual terms as the continued service, maintenance and other support obligations expire, which are generally for periods of twelve to thirty months. However, if the warranty or service period is expected to exceed the contractual
warranty/service period, the deferred revenue would be recognized over that expected longer warranty/service period and may not begin until units are installed. See Basis of PresentationProduct and Service Revenue.
As we gain commercial experience, including field experience relative to service and warranty of our initial products, the fair values for the multiple
elements within our future contracts may become determinable and we may, in future periods, recognize product revenue upon delivery or installation of the product, or we may continue to defer recognition, based on application of appropriate guidance
within EITF 00-21, Accounting for Revenue Arrangements with Multiple Deliverables, or changes in the manner in which we structure contractual agreements, including our agreements with distribution partners.
Our cash requirements depend on numerous factors, including completion of our product development activities, our ability to commercialize our fuel cell
systems, market acceptance of our systems and other factors. We expect to pursue the expansion of our operations through internal growth and strategic acquisitions. As of September 30, 2007, we had cash and cash equivalents and
available-for-sale securities totaling $180.4 million and working capital of $180.5 million.
During the nine months ended
September 30, 2007, cash used by operating activities was $35.9 million, consisting primarily of a net loss of $43.1 million offset, in part, by non-cash expenses in the amount of $7.9 million, including $3.8 million for depreciation and
amortization and $4.1 million for stock based compensation. Cash provided by investing activities for the nine months ended September 30, 2007 was $25.9 million, consisting of $75.2 million of net proceeds primarily from the maturing of
available-for-sale securities offset by $2.1 million used to purchase property, plant and equipment, and $47.2 million related to the acquisitions of Cellex Power Products, Inc., or Cellex, and General Hydrogen Corporation.
14
Recent Developments
Acquisitions
On April 3, 2007, the Company completed the acquisition of Cellex. The Company paid $46.1 million, including acquisition
costs, in cash for all of Cellexs outstanding shares. Cellex has been developing PEM fuel cell power units for electric lift trucks and is targeting the estimated $1.5 billion industrial motive battery market. In November 2006, Cellex
successfully completed beta testing of its zero-emission, hydrogen fuel cell power units in pallet trucks at two Ohio-based Wal-Mart distribution centers. Cellex has focused its initial product initiatives on class 3 electric lift trucks, often
referred to as pallet trucks, that are the predominant equipment used to transport goods within large distribution centers. Cellexs product strategy is to develop a full product portfolio addressing all three classes of electric
lift trucks, enabling complete conversion of distribution centers and maximizing customer benefit. Cellexs product delivers value to the customer via increased productivity and reduced fueling time, as well as the elimination of cost,
environmental, and safety issues associated with traditional lead acid batteries.
On May 7, 2007, the Company announced the acquisition of General
Hydrogen Corporation, or General Hydrogen, a leader in the development and commercialization of fuel cell power units that provide motive power for electric lift trucks and other mobile industrial equipment. The Company paid approximately $8.7
million, including acquisition costs, plus the settlement of $3.0 million in senior secured loans previously made by the Company to General Hydrogen, for all of the outstanding capital stock of General Hydrogen. In addition, the shareholders of
General Hydrogen received warrants to purchase up to 571,429 shares of the Companys Common Stock. The warrants become exercisable when the Companys Common Stock trades at a volume weighted average price of $7.00 or more for 10
consecutive trading days. The warrants carry an exercise price of $.01 per share and expire four years from the date of issuance.
Coinciding with the
acquisition of General Hydrogen, Plug Power entered into a two-year agreement with Ballard Power Systems Inc. for the purchase of fuel cell stacks for Plug Powers commercial needs with respect to electric lift truck applications, replacing the
previous agreement between General Hydrogen and Ballard. The General Hydrogen and Cellex products were designed around the Ballard stack and have generated tens of thousands of operating hours to validate reliability and performance. Under the new
agreement, Plug Power and Ballard will work together to develop reliable, low-cost solutions that are expected to significantly improve the outlook for fuel cell commercialization of material handling applications.
Product Development and Commercialization
We are focused on fuel cell technology from which we believe we can offer multiple products. We are
currently advancing two product lines toward commercialization, which we continue to enhance and broaden:
GenCore
®
Direct-Current Back-up Power for Telecommunication, Broadband, Utility and UPS ApplicationsOur GenCore
®
products are fueled by hydrogen and do not require a fuel processor. See Distribution, Marketing and Strategic Relationships for additional information regarding product development and commercialization.
GenDrive Through our recent acquisitions of Cellex and General Hydrogen, we are pursuing development and commercialization of
fuel cell motive power units that provide power for electric lift trucks and other mobile light industrial equipment for which lead-acid batteries are the incumbent technology. Our fuel cell motive power units allow users to increase productivity
and reduce operating costs through a quick hydrogen refueling process that eliminates the need to change batteries repeatedly throughout the day. They also eliminate the environmental and safety issues traditionally associated with lead-acid
batteries.
Additionally, we continue to advance the development of our other technology platforms:
GenSys
®
Remote Continuous Power
for Light Commercial and Residential ApplicationsWe plan to continue to develop GenSys
®
into a platform that is expected to support a number of products, including systems fueled by
liquefied petroleum gas, or LPG, for remote applications and, eventually, both grid independent and grid-connected light commercial and residential applications fueled by LPG or natural gas. In connection with the development of our GenSys
®
platform, we are developing combined heat and power fuel cell systems for light commercial and residential applications that provide supplemental heat as electricity is produced. We began
field-testing of the next generation GenSys
®
, our continuous run product, in the third quarter of 2005. See Distribution, Marketing and Strategic Relationships for additional
information regarding product development and commercialization.
Home Energy StationWe have been developing technology in
support of the automotive fuel cell market under a series of agreements with Honda R&D Co Ltd. of Japan (Honda), a subsidiary of Honda Motor Co., Ltd., under which we have developed, on a joint and exclusive basis, and
tested three phases of prototype fuel cell systems that provide electricity and heat to a home or business, while also providing hydrogen fuel for a fuel cell vehicle (named the Home Energy Station). Since 2003, we have
successfully demonstrated three successive prototype generations of the Home Energy Station at Honda R&D Americas facility in Torrance, California and at Plug Powers facility in Latham,
15
NY. The companies are currently collaborating on the fourth generation prototype Home Energy Station pursuant to the latest agreement signed in early
2006. Across each generation of the Home Energy Station, we have significantly reduced size and weight, as well as improved performance. See Distribution, Marketing and Strategic Relationships for additional information regarding
product development and commercialization.
Distribution, Marketing and Strategic Relationships
We have developed an extended enterprise by forming strategic relationships with well-established companies in key areas including distribution,
marketing, supply, technology development and product development. As part of our sales and marketing strategy, we have built a network of leading distributors who have established relationships and sub-distributor networks that can distribute and
service our products in specific geographic or market segments. We have 20 distribution agreements in place, including agreements with Tyco, our largest North American distribution partner, and IST, our distribution partner in South Africa.
We have continuing strategic partnerships and have established strong supply-chain relationships with several companies some of which are
described in greater detail below.
Telecommunications Consultants India Ltd.
(TCIL)
: In April 2007, the Company announced a non-exclusive agreement with TCIL to market, distribute and service Plug Powers GenCore
®
product line to government entities in
India and specific TCIL projects outside of India. Consistent with the Companys sales and marketing strategy, TCIL will seek opportunities for the GenCore
®
product line to support
existing projects it is developing globally as well as government-owned telecommunications providers in India, where the need for reliable, extended-run backup power is critical. The telecommunications market in India is growing at a rate of four
million subscribers per month due largely to the rapid expansion of wireless networks. The growth of the market, combined with a relatively fragile utility grid, creates strong opportunities for Plug Powers clean, reliable backup and
primary-power fuel cells to support the nations telecommunications infrastructure.
General Electric Company (GE) Entities:
In
March 2006, the Company, GE MicroGen, Inc. (GE MicroGen), a wholly-owned subsidiary of GE, and GE restructured their service and equity relationships by terminating the joint venture GE Fuel Cell Systems (GEFCS) and the
associated distributor and other agreements and entering into a new development collaboration agreement. Under the new agreement, the Company and GE (through its Global Research unit) have agreed to collaborate on programs including, but not limited
to, development of tools, materials and components that can be applied to various types of fuel cell products. The specific programs to be undertaken under the agreement, and the detailed terms and conditions thereof, remain subject to agreement by
both parties. It is anticipated that such programs could also include collaboration on sales and marketing opportunities for the Companys products. Under the terms of the new development collaboration agreement, the Company is obligated to
purchase $1 million of services from GE prior to December 31, 2008. The development collaboration agreement is scheduled to terminate on the earlier of (i) December 31, 2014 or (ii) upon completion of a certain level of program
activity.
Tyco:
In September 2004, we completed an agreement with Tyco to
market, promote and sell our GenCore
®
fuel cell systems for telecommunication backup applications under both the Tyco Electronics and Plug Power brands through its direct sales force. The
Company is party to a nationwide service and installation agreement for GenCore
®
with Tyco Electronics Installation Services Inc.
Honda:
We have an agreement with Honda to exclusively and jointly develop and test the Home Energy Station. We expect our current contract with
Honda to continue throughout 2007 to fund our joint development of the fourth generation Home Energy Station. We also had an agreement with Honda to fund joint research and development of technology that may be utilized in future systems;
we have completed our work under this agreement and are in the process of preparing a final report for Honda.
BASF:
Our joint
development agreement with BASF to develop, on an exclusive basis for certain applications, a high temperature membrane exchange unit, or MEU, for stationary fuel cell systems expired on June 30, 2006. We continue to work with BASF on a
nonexclusive basis under a project funded by the European Commission. We also have an agreement with BASF for the development and supply of advanced catalysts to increase the overall performance and efficiency of our fuel processor. The supply
agreement with BASF specifies the rights and obligations for BASF to supply products to us until 2013.
Vaillant:
We are working
with Vaillant GmbH, a major supplier of residential heating equipment in Europe, as part of a consortium to develop a residential combined heat and power system incorporating the MEU from BASF.
DTE Energy:
We have an exclusive distribution agreement with DTE Energy for the states of Michigan, Ohio, Illinois, and Indiana. Under the
agreement, we can sell directly or negotiate nonexclusive distribution rights to third parties for our
16
GenCore
®
backup power product line. We have agreed to pay a 5% commission for sales of
GenCore
®
based on sales price of units shipped to third parties in the above noted states. The distribution agreement expires on December 31, 2014.
Results of Operations
Comparison of the Three
Months Ended September 30, 2007 and September 30, 2006.
Product
and service revenue.
Product and service revenue increased to $1.2 million for the three months ended September 30, 2007, from $676,000 for the three months ended September 30, 2006, primarily due to units shipped and installed during
2007 and revenue from sales of our GenDrive
product totaling $355,000. We defer recognition of product and service revenue at the time of delivery and recognize revenue as the continued
service, maintenance and other support obligations expire. However, if the warranty or service period is expected to exceed the contractual warranty/service period, the deferred revenue would be recognized over that expected longer warranty/service
period.
Many of our initial sales of GenSys
®
and GenCore
®
products contain multiple obligations that may include a combination of fuel cell systems, continued service, maintenance and other support
obligations. While contract terms generally require payment shortly after delivery or installation (with respect to certain consignment sales) of the fuel cell system and are not contingent on the achievement of specific milestones or other
substantive performance, the multiple obligations within our contractual arrangements are not accounted for separately based on our limited commercial experience and available evidence of fair value of the different components. As a result, we defer
recognition of product and service revenue and recognize revenue on a straight-line basis as the continued service, maintenance and other support obligations expire, which are generally for periods of twelve to thirty months. However, if the
warranty or service period is expected to exceed the contractual warranty/service period the deferred revenue would be recognized over that expected longer warranty/service period.
During the three months ended September 30, 2007, we shipped 25 GenCore
®
systems and began recognizing product and service revenue for this current year activity in the amount of $298,000. We also recognized $547,000 of revenue deferred at December 31, 2006.
This compares to 15 GenCore
®
systems shipped for the three months ended September 30, 2006, during which we recognized $266,000 of product and service revenue against 2006 deliveries
and $410,000 of revenue deferred at December 31, 2005.
During the three months ended September 30, 2007 and 2006, we invoiced
$683,000 and $398,000, respectively, for the shipment (or installation with respect to consignment sales) of fuel cell systems and the release of units that were on consignment and recognized revenue of $1.2 million and $676,000, respectively. Any
differences between the amounts invoiced and the recognized revenue is a result of deferred revenue recognized in accordance with our revenue recognition policy as described above.
Research and development contract revenue.
Research and development contract revenue increased to $3.3 million for the three months ended
September 30, 2007, compared to $1.1 million during the same period last year. The change is the result of spending levels increasing for material purchases and subcontractor activity as the U.S. Department of Energy, the U.S. Department of
Defense, and the New York State Energy Research and Development Authority have begun new programs as well as increased funding from Honda R&D Co., Ltd. of Japan. These increases were partially offset by decreased activity under our contracts
with the National Institute of Standards and Technology. Research and development contract revenue primarily relates to cost reimbursement research and development contracts associated with the development of proton exchange membrane, or PEM, fuel
cell technology. We generally share in the cost of these programs, with our cost-sharing percentages being between 20% and 51% of total project costs. Revenue from time and material contracts is recognized on the basis of hours expended
plus other reimbursable contract costs incurred during the period. We also have fixed fee contracts in 2007. Revenue under these contracts is generally recognized on the basis of the percentage of completion. We expect to continue certain research
and development contract work that is directly related to our current product development efforts.
Cost of product and service revenue.
Cost of product and service revenue increased to $2.0 million for the three months ended September 30, 2007, from $761,000 for the three months ended September 30,
2006. Cost of product and service revenue includes the direct material cost incurred in the manufacture of the products we sell, which costs are generally recognized when units are shipped, as well as the labor and material costs incurred for
product maintenance, replacement parts and service under our contractual obligations, which are recognized as incurred. These costs consist primarily of production materials and fees paid to outside suppliers for subcontracted components and
services. The increase in the cost of product and service revenue primarily resulted from $857,000 related to our GenDrive product sales. Also contributing to the increase was an increase in GenCore
®
shipments and servicing costs of the larger installed base. For the three months ended September 30, 2007 we installed 53 GenCore
®
systems as compared to 28 for the three months ended September 30, 2006.
17
Cost of research and development contract revenue.
Cost of research and development contract
revenue increased to $5.2 million for the three months ended September 30, 2007, from $1.3 million for the three months ended September 30, 2006 as a result of the new contracts for 2007 partially offset by decreased work under existing
agreements as described above. Cost of research and development contract revenue includes costs associated with research and development contracts including compensation and benefits for engineering and related support staff, fees paid to outside
suppliers for subcontracted components and services, fees paid to consultants for services provided, materials and supplies used and other directly allocable general overhead costs allocated to specific research and development contracts.
Noncash research and development expense.
Noncash research and development expense for the three months ended September 30,
2007, increased to $928,000 from $713,000 during the same period last year as a result of increased equity compensation grants during 2007. Noncash research and development expense represents the recognition of the fair value of stock options and
restricted stock awards to employees and others in exchange for services provided over the applicable vesting periods.
Other research
and development expense.
Other research and development expense was $8.4 million for the three months ended September 30, 2007, compared to $10.9 million for the three months ended September 30, 2006. These costs are associated with
our efforts to advance the development of our next generation continuous run product combined with continued research and development activities related to future product initiatives. Other research and development expense includes materials to
build development and prototype units, cash compensation and benefits for the engineering and related staff, expenses for contract engineers, fees paid to outside suppliers for subcontracted components and services, fees paid to consultants for
services provided, materials and supplies consumed, facility related costs such as computer and network services and other general overhead costs. The decrease in other research and development expense primarily resulted from an increase in
resources assigned to revenue-generating research and development contract programs, which more than offset the additional $2.3 million in other research and development expenses incurred by the acquired companies.
Noncash general and administrative expense.
Noncash general and administrative expense for the three months ended September 30, 2007
increased to $484,000 from $320,000 for the three months ended September 30, 2006 as a result of equity compensation grants during 2007. Noncash general and administrative expense represents the recognition of the fair value of stock options
and restricted stock awards to employees and others in exchange for services provided over the applicable vesting periods.
Other
general and administrative expense.
Other general and administrative expense increased to $4.7 million for the three months ended September 30, 2007, from $3.1 million for the three months ended September 30, 2006 primarily as a result
of the general and administrative expenses of the acquired companies plus increased marketing and sales activities. Other general and administrative expense includes cash compensation, benefits and related costs in support of our general corporate
functions, including general management, finance and accounting, human resources, marketing, information technology and legal services.
Amortization of intangible assets.
Amortization of intangible assets was $572,000 for the three months ended September 30, 2007. This expense relates to the amortization of identifiable intangible assets acquired from Cellex and
General Hydrogen during the quarter ended September 30, 2007.
Interest income and net realized gains/(losses) from
available-for-sale securities.
Interest income and net realized gains/(losses) from the sale of available-for-sale securities, consisting primarily of interest earned on our cash, cash equivalents and available-for-sale securities, decreased to
$2.8 million for the three months ended September 30, 2007 from $3.5 million for the three months ended September 30, 2006. The decrease was the result of lower cash and available-for-sale security balances as cash was used for
acquisitions and operating needs. Total net realized gains from the sale of available-for-sale securities was approximately $5,000 and $10,000 for the three months ended September 30, 2007 and 2006, respectively.
Interest expense.
Interest expense increased to $114,000 for the three months ended September 30, 2007 from $56,000 for the three months
ended September 30, 2006. Interest expense for 2007 consists of interest on repayable government assistance obligations related to the acquired companies and in 2006 consisted of interest on our long-term obligations related to the purchase of
real estate and interest paid on capital lease obligations. As of December 31, 2006, all of the Companys previous debt and capital lease obligations were paid in full.
Income taxes.
We did not report a benefit for federal and state income taxes in the consolidated financial statements as the deferred tax asset
generated from our net operating loss has been offset by a full valuation allowance because it is more likely than not that the tax benefits of the net operating loss carryforward will not be realized.
18
Comparison of the Nine Months Ended September 30, 2007 and September 30, 2006.
Product and service revenue.
Product and service revenue was $2.3 million for both the nine months ended September 30, 2007 and 2006,
reflecting the timing of revenue recognition for certain previously shipped systems where revenue became fully recognized prior to the nine months ended September 30, 2007 offset by revenue recognized on units shipped during 2007.
During the nine months ended September 30, 2007, we shipped 128 GenCore
®
systems and began recognizing product and service revenue for this current year activity in the amount of $557,000. We also recognized $1.4 million of revenue deferred at December 31,
2006. This compares to 67 GenCore
®
systems shipped for the nine months ended September 30, 2006, during which we recognized $600,000 of product and service revenue against 2006
deliveries and $1.7 million of revenue deferred at December 31, 2005. Revenue from sales of our GenDrive product was $384,000 for the nine months ended September 30, 2007.
During the nine months ended September 30, 2007 and 2006, we invoiced $2.7 million and $1.8 million, respectively, for the shipment of fuel cell
systems and the release of units that were on consignment. Any differences between the amounts invoiced and the recognized revenue is a result of deferred revenue recognized in accordance with our revenue recognition policy as described above.
Research and development contract revenue.
Research and development contract revenue increased to $8.8 million for the nine months
ended September 30, 2007, compared to $4.5 million during the same period last year. The change is the result of spending levels increasing for material purchases and subcontractor activity as the U.S. Department of Energy, the U.S. Department
of Defense, and the New York State Energy Research and Development Authority have begun new programs as well as increased funding from Honda R&D Co., Ltd. of Japan. These increases were partially offset by decreased activity under our contract
with the National Institute of Standards and Technology. Research and development contract revenue primarily relates to cost reimbursement research and development contracts associated with the development of PEM fuel cell technology. We also have
fixed fee contracts in 2007. We expect to continue certain research and development contract work that is directly related to our current product development efforts.
Cost of product and service revenue.
Cost of product and service revenue increased to $8.0
million for the nine months ended September 30, 2007, from $3.3 million for the nine months ended September 30, 2006. The increase in the cost of product and service revenue primarily resulted from a $2.0 million charge incurred during the
second quarter of 2007 for certain expected service and warranty costs for existing fuel cell units in the field and an increase in shipments and servicing costs of the larger installed base. For the nine months ended September 30, 2007 we
installed 157 GenCore
®
units compared with 73 units for the nine months ended September 30, 2006. Cost of product and
service revenue also increased $907,000 due to our GenDrive product sales.
Cost of research and development contract
revenue.
Cost of research and development contract revenue increased to $12.6 million for the nine months ended September 30, 2007, from $6.2 million for the nine months ended September 30, 2006 primarily as a result of the new
contracts for 2007, partially offset by decreased work under existing agreements as described above.
Noncash research and development
expense.
Noncash research and development expense for the nine months ended September 30, 2007 increased to $2.7 million from $2.1 million during the same period last year as a result of equity compensation grants during 2007. Noncash
research and development expense represents the recognition of the fair value of stock options and restricted stock awards to employees and others in exchange for services provided over the applicable vesting periods.
Other research and development expense.
Other research and development expense was $24.8 million for the nine months ended September 30,
2007, compared to $28.5 million for the nine months ended September 30, 2006. These costs are associated with our efforts to advance the development of our next generation continuous run product combined with continued research and development
activities related to future product initiatives. The decrease in other research and development expense primarily resulted from an increase in resources assigned to revenue-generating research and development contract programs, which more than
offset the additional $3.7 million in other research and development expenses incurred by the acquired companies.
Noncash general and
administrative expense.
Noncash general and administrative expense for the nine months ended September 30, 2007, increased to $1.4 million from $1.1 million for the nine months ended September 30, 2006 as a result of increased equity
compensation grants during 2007. Noncash general and administrative expense represents the recognition of the fair value of stock options and restricted awards to employees and others in exchange for services provided over the applicable vesting
periods.
19
Other general and administrative expense.
Other general and administrative expense increased to
$12.8 million for the nine months ended September 30, 2007, from $7.8 million for the nine months ended September 30, 2006 primarily as a result of the general and administrative expenses of the acquired companies plus increased marketing
and sales activities and costs related to the corporate reorganization announced in February 2007.
Amortization of intangible assets.
Amortization of intangible assets was $1.0 million for the nine months ended September 30, 2007. This expense relates to the amortization of identifiable intangible assets acquired from Cellex and General Hydrogen during the quarter ended
June 30, 2007.
Interest income and net realized gains/(losses) from available-for-sale securities.
Interest income and net
realized gains/(losses) from the sale of available-for-sale securities, consisting primarily of interest earned on our cash, cash equivalents and available-for-sale securities, increased to $9.3 million for the nine months ended September 30,
2007 from $5.4 million for the nine months ended September 30, 2006. The increase was primarily the result of investment returns from higher cash and available-for-sale security balances due to the $217 million of cash proceeds received from
Smart Hydrogen Inc. in the second quarter of 2006. Total net realized gains from the sale of available-for-sale securities was approximately $102,000 and $42,000 for the nine months ended September 30, 2007 and 2006, respectively.
Interest expense.
Interest expense increased to $221,000 for the nine months ended September 30, 2007, from $158,000 for the nine months
ended September 30, 2006. Interest expense for 2007 consists of interest on repayable government assistance obligations related to the acquired companies and for 2006 consisted of interest on our long-term obligation related to the purchase of
real estate and interest paid on capital lease obligations. As of December 31, 2006, all of the Companys previous debt and capital lease obligations were paid in full.
Income taxes.
We did not report a benefit for federal and state income taxes in the consolidated financial statements as the deferred tax asset
generated from our net operating loss has been offset by a full valuation allowance because it is more likely than not that the tax benefits of the net operating loss carryforward will not be realized.
Critical Accounting Policies and Estimates
The
preparation of financial statements in conformity with generally accepted accounting principles and related disclosure requires management to make estimates and assumptions that affect:
|
|
|
the amounts reported for assets and liabilities;
|
|
|
|
the disclosure of contingent assets and liabilities at the date of the financial statements; and
|
|
|
|
the amounts reported for revenues and expenses during the reporting period.
|
Specifically, we must use estimates in determining the economic useful lives of assets, including identifiable intangibles, and various other recorded or
disclosed amounts. Therefore, our financial statements and related disclosure are necessarily affected by these estimates. We evaluate these estimates on an ongoing basis, utilizing historical experience and other methods considered reasonable in
the particular circumstances. Nevertheless, actual results may differ significantly from estimates. To the extent that actual outcomes differ from estimates, or additional facts and circumstances cause management to revise estimates, our financial
position or results of operations as reflected in our financial statements will be affected. Any effects on business, financial position or results of operations resulting from revisions to these estimates are recorded in the period in which the
facts that give rise to the revision become known.
We believe that the following are our most critical accounting policies affected by the
estimates and assumptions the Company must make in the preparation of its financial statements and related disclosure:
Revenue
recognition:
We are a development stage enterprise in the stages of performing field testing and marketing our initial commercial product to a limited number of customers, including telecom, utilities, government entities and our distribution
partners. This product is a limited edition fuel cell system that is intended to offer complementary, quality power while demonstrating the market value of fuel cells as a preferred form of alternative distributed power generation. Subsequent
enhancements to our initial product are expected to expand the market opportunity for fuel cells by lowering the installed cost, decreasing operating and maintenance costs, increasing efficiency, improving reliability, and adding features such as
grid independence and co-generation and UPS applications.
We apply the guidance within Staff Accounting Bulletin No. 104,
Revenue Recognition in Financial Statements (SAB 104) to our initial sales contracts to determine when to properly recognize revenue. Our initial sales of products contain multiple obligations that may include a combination of fuel cell
systems, continued service, maintenance and other support. While contract terms generally require payment shortly after delivery or installation in the case of consignment sales of the fuel cell system and are not contingent on the achievement of
specific milestones or other substantive performance, the
20
multiple obligations within our contractual arrangements are not accounted for separately based on our limited commercial experience and available evidence
of fair value. As a result, we defer recognition of product and service revenue and recognize revenue on a straight-line basis over the contractual service period, which is generally for periods of twelve to thirty months, or over the anticipated
service period if expected to exceed the contractual service period.
As we gain commercial experience, including field experience relative
to service and warranty based on the sales of our initial products, the fair values for the multiple elements within our future contracts may become determinable and we may, in future periods, recognize revenue upon delivery of the product or we may
continue to defer recognition, based on application of appropriate guidance within EITF 00-21, Accounting for Revenue Arrangements with Multiple Deliverables, or changes in the manner in which we structure contractual agreements,
including our agreements with distribution partners.
Valuation of long-lived assets:
We assess the impairment of long-lived assets,
including identifiable intangible assets, and goodwill, if any, whenever events or changes in circumstances indicate that the carrying value may not be recoverable and, for goodwill, at least annually. Factors we consider important which could
trigger an impairment review include, but are not limited to, the following:
|
|
|
significant underperformance relative to expected historical or projected future operating results;
|
|
|
|
significant changes in the manner of our use of the acquired assets or the strategy for our overall business;
|
|
|
|
significant negative industry or economic trends;
|
|
|
|
significant decline in our stock price for a sustained period; and
|
|
|
|
our market capitalization relative to net book value.
|
When we determine that the carrying value of long-lived assets, including identifiable intangible assets, and goodwill may not be recoverable based upon the existence of one or more of the above indicators of impairment, we would measure
any impairment based upon the provisions of Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets and SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived
Assets, as appropriate. Any resulting impairment loss could have a material adverse impact on our financial condition and results of operations.
Accounting for income taxes
: As part of the process of preparing our consolidated financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This
process involves the estimation of our actual current tax exposure together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. Included in this assessment is the determination of the net
operating loss carryforward that has resulted from our cumulative net operating loss since inception. These differences, primarily net operating loss carryforwards, result in a net deferred tax asset. We must assess the likelihood that our deferred
tax assets will be recovered from future taxable income, and to the extent that we believe that recovery is not likely, we must establish a valuation allowance. To the extent we establish a valuation allowance or increase this allowance in a period,
we must include an expense or forego a benefit within income taxes in the consolidated statement of operations.
Under Section 382 of
the Internal Revenue Code (IRC), the use of loss carryforwards may be limited if a change in ownership of a company, as defined by the IRC, occurs. The Company has determined that due to transactions involving the Companys shares by
significant shareholders, a change of ownership has occurred under the provisions of IRC Section 382. As a result of this change of ownership, the usage of a portion, which may be substantial, of the net operating loss amounts, has become
limited. The Company is in the process of determining the impact of this limitation. Once determined, the deferred tax asset related to the net operating loss and an equivalent amount of valuation allowance will be adjusted accordingly.
Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities and any valuation
allowance recorded against our net deferred tax assets. We have recorded a valuation allowance of $211.7 million as of December 31, 2006 due to uncertainties related to our ability to utilize the net deferred tax assets, primarily consisting of
net operating losses and credits which may be carried forward, before they expire. In the event that actual results differ from these estimates or we adjust these estimates in future periods, we may need to adjust the recorded valuation allowance,
which could materially impact our financial position and results of operations. At September 30, 2007 and 2006, our net deferred tax assets have been offset in full by a valuation allowance. As a result, the net provision for income taxes is
zero for the nine month periods ended September 30, 2007 and 2006. The Company adopted the Financial Accounting Standards Board (FASB) Interpretation No. 48, Accounting for Uncertainty in Income Taxes-an interpretation of FASB
Statement No. 109
(FIN 48), which clarifies the accounting for uncertainty in tax positions on January 1, 2007. No adjustment of opening balances was required and the adoption of this Interpretation had no impact on the
Companys consolidated financial statements.
21
Stock Based Compensation
: Our adoption of SFAS No. 123 (revised 2004), Share-Based
Payment, or SFAS 123(R), in the first quarter of 2006 required that we recognize stock-based compensation expense associated with the vesting of share based instruments in the statement of operations. Determining the amount of stock-based
compensation to be recorded requires us to develop estimates to be used in calculating the grant-date fair value of stock options. We calculate the grant-date fair values using the Black-Scholes valuation model. The Black-Scholes model requires us
to make estimates of the following assumptions:
Expected volatilityThe estimated stock price volatility was derived based upon a
blend of implied volatility (i.e. managements expectation of volatility) and the Companys actual historical stock prices over the expected life of the options, which represents the Companys best estimate of expected volatility.
Expected option lifeThe Companys estimate of an expected option life was calculated in accordance with the Staff Accounting
Bulletin No. 107 (SAB 107) simplified method for calculating the expected term assumption. The simplified method is a calculation based on the contractual life of the associated options. The Company will be required to utilize
actual historical data to determine the expected option life beginning in 2008.
Risk-free interest rateWe used the yield on
zero-coupon U.S. Treasury securities for a period that is commensurate with the expected life assumption as the risk-free interest rate.
The amount of
stock-based compensation recognized during a period is based on the value of the portion of the awards that are ultimately expected to vest. SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in
subsequent periods if actual forfeitures differ from those estimates. The term forfeitures is distinct from cancellations or expirations and represents only the unvested portion of the surrendered option. We
reviewed historical forfeiture data and determined the appropriate forfeiture rate based on that data. We will re-evaluate this analysis periodically and adjust the forfeiture rate as necessary. Ultimately, we will recognize the actual expense over
the vesting period only for the shares that vest.
Recent Accounting Pronouncements
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements
(SFAS No. 157). This new standard establishes a
framework for measuring the fair value of assets and liabilities. This framework is intended to provide increased consistency in how fair value determinations are made under various existing accounting standards which permit, or in some cases
require, estimates of fair market value. SFAS No. 157 also expands financial statement disclosure requirements about a companys use of fair value measurements, including the effect of such measures on earnings. This standard is effective
for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company is currently evaluating the provisions of SFAS No. 157.
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities Including an Amendment of
SFAS No. 115
(SFAS No. 159). This new standard permits entities to choose to measure many financial instruments and certain warranty and insurance contracts at fair value on a contract-by-contract basis. This standard is
effective for fiscal years beginning after November 15, 2007. The Company is currently evaluating the provisions of SFAS No. 159.
Liquidity
and Capital Resources
Our cash requirements depend on numerous factors, including completion of our product development activities, our
ability to commercialize our on-site energy products, market acceptance of our systems and other factors. We expect to devote substantial capital resources to continue our development programs directed at commercializing our energy products for
worldwide use, hiring and training our production staff, develop and expand our manufacturing capacity and continue expanding our production and our research and development activities. We expect to pursue the expansion of our operations through
internal growth and strategic acquisitions and expect that such activities will be funded from existing cash, cash equivalents and available-for-sale securities, issuance of additional equity or debt securities or additional borrowings subject to
market and other conditions. The failure to raise the funds necessary to finance our future cash requirements or consummate future acquisitions could adversely affect our ability to pursue our strategy and could negatively affect our operations in
future periods. We anticipate incurring substantial additional losses over at least the next several years and believe that our current cash, cash equivalents and available-for-sale securities balances will provide sufficient liquidity to fund
operations for at least the next twelve months.
22
Several key indicators of liquidity are summarized in the following table:
|
|
|
|
|
|
|
|
|
|
(in thousands)
|
|
Nine months ended
September 30, 2007
|
|
Year ended
December 31, 2006
|
|
Nine months ended
September 30, 2006
|
Unrestricted cash, cash equivalents and available-for-sale securities at end of period
|
|
$
|
180,409
|
|
$
|
269,123
|
|
$
|
278,465
|
Working capital at end of period
|
|
|
180,542
|
|
|
267,002
|
|
|
278,561
|
Net loss
|
|
|
43,086
|
|
|
50,310
|
|
|
37,028
|
Net cash used in operating activities
|
|
|
35,928
|
|
|
46,107
|
|
|
32,787
|
Purchases of property, plant and equipment
|
|
|
2,117
|
|
|
1,275
|
|
|
1,115
|
During the nine months ended September 30, 2007, cash used by operating activities was $35.9
million, consisting primarily of a net loss of $43.1 million offset, in part, by noncash expenses in the amount of $7.9 million, including $3.8 million for depreciation and amortization and $4.1 million for stock-based compensation awards. Cash
provided by investing activities for the nine months ended September 30, 2007 was $25.9 million, consisting of $75.2 million of net proceeds from the sale of available-for-sale securities offset by $2.1 million used to purchase property, plant
and equipment, and $47.2 million related to the acquisitions of Cellex and General Hydrogen.
We have financed our operations through
September 30, 2007 primarily from the sale of equity, which has provided cash in the amount of $635.9 million. Since inception, net cash used in operating activities has been $384.3 million, and cash used in investing activities has been $227.7
million, including our purchase of property, plant and equipment of $36.1 million, our investments in available-for-sale securities in the amount of $162.0 million, and net cash used for acquisitions of $17.8 million.
On April 3, 2007, we purchased all of the outstanding capital stock of Cellex from its equity holders for an aggregate cash purchase price of $46.1
million, including acquisition costs.
On May 4, 2007, the Company acquired General Hydrogen. The Company paid approximately $8.7
million, including acquisition costs, plus the settlement of $3.0 million in senior secured loans previously made by the Company to General Hydrogen, for all of the outstanding capital stock of General Hydrogen. In addition, the shareholders of
General Hydrogen received warrants to purchase up to 571,429 shares of the Companys Common Stock. The warrants become exercisable when the Companys Common Stock trades at a volume weighted average price of $7.00 or more for 10
consecutive trading days. The warrants carry an exercise price of $.01 per share and expire four years from the date of issuance.
From
inception through September 30, 2007, we have incurred losses of $500.5 million and expect to continue to incur losses as we continue our product development and commercialization programs and expand our manufacturing capacity. We expect that
losses will fluctuate from quarter to quarter and that such fluctuations may be substantial as a result of, among other factors, the number of systems we produce, deliver, and install, the cost and sales price of such systems, the related service
requirements necessary to maintain those systems and potential design changes required as a result of field testing.