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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

For the quarterly period ended September 30, 2003

For the transition period from                  to         

Commission file number 0-10120

FAFCO, Inc.

435 Otterson Drive, Chico, California 95928
(Address, including zip code, of Registrant’s principal executive offices)

(530) 332-2100
(Company’s telephone number, including area code)

Indicate by check mark whether the Company (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 Company was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes   [X]   No [   ]

Indicate by check mark whether the registrant is on accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes   [   ]   No [X]

At September 30, 2003, 3,891,529 shares of the Company’s Common Stock, $.125 par value were issued and outstanding.

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Pt I — FINANCIAL INFORMATION

Item 1 — Financial Statements

FAFCO, Inc.
CONDENSED CONSOLIDATED BALANCE SHEET

     The accompanying notes are an integral part of this statement.

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Part I — FINANCIAL INFORMATION — (continued)

FAFCO, Inc.
CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS
(unaudited)

The accompanying notes are an integral part of this statement.

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Part I — FINANCIAL INFORMATION (continued)

FAFCO, Inc.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)

Non-Cash Financing Activity

In January 2002, the Company recorded $28,800, the deemed fair value of the warrants, to purchase common shares with the issuance of the subordinated notes. See Note 4.

The accompanying notes are an integral part of this statement.

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Part I — FINANCIAL INFORMATION (continued)

FAFCO, Inc.
NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

1. The accompanying financial statements of FAFCO, Inc. (the “Company”) have been prepared in accordance with accounting principals generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. However, in the opinion of the Company’s management, all adjustments necessary for a fair statement of results for the periods presented have been included. The results for the period ended September 30, 2003 are not necessarily indicative of results to be expected for the entire year. These financial statements, notes, and analyses should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2002.

The Company applies the intrinsic value method or variable accounting treatment to our stock awards, depending on the nature of the award. The following table summarizes relevant information as if the fair value recognition provisions of SFAS No. 123, “Accounting for Stock Based Compensation,” had been applied to all stock-based awards (in thousands, except per share data):

2. Basic and diluted net income (loss) per share is calculated using the weighted average number of common and common equivalent shares outstanding during the periods presented. [See Note 5]

3. Inventories are valued at the lower of cost, determined on a first in, first out (FIFO) basis, or market, and consist of the following.

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Part I — FINANCIAL INFORMATION – (continued)

4. The Company has a line of credit agreement with Butte Community Bank, which allows the Company to borrow the lesser of $1,000,000 or an amount determined by a formula applied to accounts receivable. Unused borrowing capacity was $1,000,000 at September 30, 2003. Amounts borrowed bear interest at prime rate plus 1.5% (5.5% at September 30, 2003) per annum and are secured by substantially all the assets of the Company. This line of credit expires on August 10, 2004.

In addition to the line of credit, the Company has a 60-month term loan in the amount of $500,000 bearing interest at prime plus 1.5% (5.5% at September 30, 2003). At September 30, 2003, the Company had an outstanding balance of $277,800 on this loan facility.

The Company had a 36-month term loan in the amount of $445,000, bearing interest at prime plus 1.5 %. This loan was paid off in May 2003.

The Company has a $3,400,00 mortgage loan with a maturity date of June 10, 2030. Principal is amortized over a 29 1/2 year term from January 10, 2001. The initial interest rate on this mortgage loan was 9.05%. In November 2002, the interest rate was renegotiated and adjusted to 8%. In March 2003, the interest rate was again renegotiated downward and is currently fixed at 6.75%. The interest rate will be changed on April 10th of each fifth year to the then current prime rate plus .35%. The balance on this mortgage at September 30, 2003, was $3,315,500.

In January 2002, the Company issued $500,000 in principal amount of subordinated notes, accompanied by warrants to purchase up to 200,000 shares of the common stock of the Company. The warrants have an exercise price of $0.125 per share. The Company recorded $28,800 as a discount and additional paid in capital for the deemed fair value of the warrants. The discount is being amortized over the term of the notes. The three-year notes bear interest, payable quarterly, at an initial annual rate of 10%, increasing to 12% for all periods after the first anniversary of the date of the notes. The notes are subordinated to bank borrowings and other secured indebtedness for money borrowed. The Company may at its option call the notes for redemption at any time with ten (10) days notice. Holders of the notes are entitled to certain rights with respect to registration of the common stock issuable upon exercise of the warrants. The Chairman and Chief Executive Officer of the Company and his spouse purchased notes with a principal amount of $150,000 in this offering, and received warrants to purchase 30,000 shares of common stock.

5. Net Income Per Share

Basic earnings per share were calculated as follows:

     Basic earnings (loss) per share are calculated by dividing net income by the weighted average number of shares issued and outstanding.

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Part I — FINANCIAL INFORMATION (continued)

Diluted earnings (loss) per share are calculated by dividing net income by the weighted average number of shares issued and outstanding.

Diluted earnings (loss) per share were calculated as follows:

At September 30, 2003, options and warrants for the purchase of 125,500 shares of common stock at prices ranging from $0.50 to $0.55 were antidilutive and therefore not included in the computation of diluted earnings per share. At September 30, 2002, options and warrants for the purchase of 145,500 shares of common stock at prices ranging from $0.50 to $0.56 were antidilutive and therefore not included in the computations of diluted earnings per share.

6. Business Segment and Concentration of Credit Risk

Business Segment. The Company operates in one business segment, the development, production and marketing of polymer heat exchangers for the solar and thermal energy storage markets worldwide.

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Part I — FINANCIAL INFORMATION – (continued)

Geographic information for revenues and long-lived assets are as follows:

Long-lived assets:

For the nine months ended September 30, 2003, the Company had one major customer who accounted for 10% or more of sales totaling $1,091,500. For the quarter ended September 30, 2003, the Company had one major customer who accounted for 10% or more of sales totaling $289,800.

For the nine months ended September 30, 2002, the Company had one major customer who accounted for 10% or more of sales, totaling $1,910,500. For the quarter ended September 30, 2002, the Company had one major customer who accounted for 10% or more of sales totaling $897,400.

Concentration of Credit Risk: Most of the Company’s business activity is with customers located in California, Florida and foreign countries. As of September 30, 2003, unsecured trade accounts receivable for customers in California, Florida, and foreign countries were $282,400, $1,371,600, and $350,800.

7. Property, Plant and Equipment

Property, plant and equipment consist of the following:

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Part I — FINANCIAL INFORMATION – (continued)

Item 2

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

This Management’s Discussion and Analysis of Financial Condition and Results of Operations contains 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. The forward-looking statements involve risks and uncertainties, including, among other things, the uncertainties associated with forecasting future revenues, costs and expenses. Our actual results may differ materially from the results discussed in the forward-looking statements. You are cautioned not to place undue reliance on the forward-looking statements, which speak only as of the date of this report. Factors that might cause such a difference include, but are not limited to, those discussed below and under “Factors Affecting Future Results”. We assume no obligation to update such forward-looking statements or to update the reasons why actual results could differ materially from those anticipated in such forward-looking statements.

You should read the following discussion in conjunction with the interim condensed consolidated financial statements and notes included elsewhere in this report and in other reports and documents filed from time to time with the Securities and Exchange Commission.

Results of Operations

Net sales for the quarter ended September 30 decreased by 23.3 % to $2,679,100 in 2003 from $3,495,200 in 2002 and decreased by 9.5% to $10,650,700 in the first nine months of 2003 from $11,768,000 in the corresponding period in 2002.

Net sales of the Company’s pool products were 4.0% lower in the first nine months of 2003 than in the corresponding period in 2002 due mainly to decreased sales of its Above Ground Pool heating systems. The Company attributes this decrease to poor weather conditions in the primary Above Ground Pool market. IceStor sales were 25.6% lower in the first nine months of 2003 than in the corresponding period in 2002 primarily due to decreased orders from the Company’s major customer in Japan.

Cost of goods sold decreased to $1,706,600 (63.7% of net sales) in the quarter ended September 30, 2003 from $2,197,800 (62.9% of net sales) in the corresponding period in 2002. This 22.3% decrease in absolute dollars was due primarily to decreased sales. For the first nine months of 2003 cost of goods sold decreased to $6,146,500 (57.7% of net sales) from $6,951,600 (59.1% of net sales). This 11.6% decrease in absolute dollars was due to decreased sales during the 2^nd and 3^rd quarters combined with increased production efficiencies implemented during the 1^st quarter.

Marketing and selling expenses increased slightly in absolute dollars for the third quarter to $605,400 (22.6% of net sales) in 2003 from $577,500 (16.5% of net sales) in the third quarter of 2002. The increase as a percent of sales was primarily due to the decrease in sales for the quarter. Marketing and selling expenses increased to $2,078,500 (19.5% of net sales) for the first nine months of 2003 compared with $1,950,800 (16.6% of net sales) for the corresponding period in 2002. This 6.5% increase was due primarily to costs associated with market research projects and sales incentive programs, along with increased lead generation and personnel-related costs pertaining to the Company’s retail office in Tampa, Florida.

General and administrative expenses increased to $507,400 (18.9% of net sales) in the third quarter of 2003 compared with $443,900 (12.7% of net sales) in the third quarter of 2002, and to $1,759,100 (16.5% of net sales) for the first nine months of 2003 compared with $1,369,500 (11.6% of net sales) in 2002. This 28.4% increase in absolute dollars was due primarily to a $188,500 adjustment to the bad debt reserve due to business difficulties experienced by a single large customer, and to costs associated with a proposed reverse stock split. Additional contributing costs relate to a variety of business expenses such as credit card processing fees and small equipment purchases along with personnel-related costs pertaining to the Company’s retail office in Tampa, Florida.

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Part I — FINANCIAL INFORMATION – (continued)

Research and development expenses decreased to $65,900 (2.5% of net sales) in the third quarter of 2003 from $80,600 (2.3% of net sales) in 2002 and decreased to $214,700 (2.0% of net sales) for the first nine months of 2003 compared with $244,900 (2.1% of net sales) for the corresponding period in 2002. This 12.3% decline in absolute dollars was due to a reduction in personnel resulting from a restructuring of the department.

Net interest expenses decreased to $73,600 (2.7% of net sales) in the third quarter of 2003 compared with $111,400 (3.2% of net sales) in the third quarter of 2002 and to $230,600 (2.2% of net sales) in the first nine months of 2003 compared with $344,700 (2.9% of net sales) in the corresponding period in 2002. These decreases were primarily the result of a reduction in the interest rate on the Company’s mortgage on it’s facility in Chico, California, along with decreased borrowings against the Company’s line of credit and the pay-off of a term loan facility.

Liquidity and Capital Resources

The Company’s cash position increased to $586,400 at September 30, 2003 from $100,400 at December 31, 2002. This increase was due to cash provided by operations offset in part by purchases of fixed assets and pay down of accounts and notes payable.

At September 30, 2003, the Company’s net accounts receivable had decreased to $1,712,100 from $1,974,200 at December 31, 2002 due to decreased sales along with an increase to the bad debt reserve. This increase to the reserve was due to an adjustment resulting from business difficulties experienced by a single large customer and is not expected to have a significant effect on the Company’s liquidity.

At September 30, 2003, the Company’s accounts payable and other accrued expenses had decreased to $1,063,700 from $1,292,300 at December 31, 2002. This was due primarily to decreased inventory purchases resulting from a planned seasonal reduction of the Company’s inventories.

At September 30, 2003, the Company’s inventories had decreased to $1,104,400 from $1,331,900 at December 31, 2002 due to a planned seasonal reduction of the Company’s inventories.

At September 30, 2003, the Company’s accrued compensation and benefits had decreased to $295,400 from $338,400 at December 31, 2002, due primarily to decreased payroll-related accruals offset in part by a build-up in the vacation accrual.

At September 30, 2003, the Company’s current ratio was 2.17:1.00 compared to 1.81:1.00 at December 21, 2002. The Company had working capital of $2,127,300 at September 30, 2003 compared with $1,746,200 at December 31, 2002. Total assets exceeded total liabilities by $3,992,400 at September 30, 2003 compared with $3,828,100 at December 31, 2002.

The Company believes that its cash flow from operations, together with bank borrowing and availability under its bank revolving line of credit, will be sufficient to support operations during the next twelve months. The foregoing statement of how long the Company’s capital resources are expected to last is a forward-looking statement involving risks and uncertainties, including the amount of the variability of demand for the Company’s products and uncertainty regarding the ability of the Company to control its operating expenses. If sales decline from current levels, additional debt or equity financing may be required. There can be no assurance that such additional financing, if required, would be available on favorable terms or at all or that such financing would not significantly dilute the ownership interests and rights of existing shareholders.

The Company has a line of credit, of which $0 was outstanding, and $1,000,000 remained available at September 30, 2003. This line of credit expires on August 10, 2004.

The Company also has a 60-month term loan in the amount of $500,000 bearing interest at prime plus 1.5%. At September 30, 2003, the Company had an outstanding balance of $277,800 on this loan.

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Part I — FINANCIAL INFORMATION – (continued)

The Company has a $3,400,000 mortgage loan with a maturity date of June 10, 2030. Principal is amortized over a 29 1/2 year term from January 10, 2001. The initial interest rate on this mortgage loan was 9.05%. In November 2002, the interest rate was renegotiated and adjusted to 8%. In March 2003, the interest rate was again renegotiated downward and is currently fixed at 6.75%. The interest rate will be changed on April 10^th of each fifth year to the then current prime rate plus .35%. The balance on this mortgage at September 30, 2003, was $3,315,500.

The Company had a 36-month term loan facility in the amount of $445,000, bearing interest at prime plus 1.5 %. This loan was paid off in May 2003.

The Company has outstanding promissory notes with an aggregate principle amount of $500,000 (“the Notes”). The principle amount of the Notes is due and payable in January 2005. Interest is payable quarterly at an initial rate of 10% per annum, increasing to 12% starting January 2003.

At September 30, 2003, the Company owed an aggregate of $3,593,300 under various bank credit facilities and $500,000 of subordinated notes. Payments due under these credit facilities are as follows:

The bank may accelerate payment of the amount owed if the Company fails to meet financial and other covenants set forth in the loan agreements. The Company is currently in compliance with, or has obtained waivers for compliance with the loan covenants.

The Company must maintain various loan covenants including a maximum debt to net worth ratio; minimum current, quick, and cash flow ratios; minimum net worth and working capital. Failure to meet these covenants could result in the Company’s loans being called or restricted by its bank.

Factors Affecting Future Results

U.S. Economic Conditions: A protracted U.S. recession could adversely impact new housing and commercial construction in our largest market, which in turn could cause us to miss our revenue goals.

Asian Economic Conditions: Sales in Japan and other Asian countries account for virtually all our international sales, and contribute a significant portion of our overall revenues. In the event that these economies experience declining growth or contraction, our sales in these areas could be adversely impacted.

Growth of U.S. Thermal Energy Storage (TES) Market: The Company’s ability to increase sales of its thermal energy storage products is dependent on growth in the overall market because opportunities for market share growth are limited. An extended recession in the general economy, a general decline in

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Part I — FINANCIAL INFORMATION – (continued)

construction of commercial properties or a decline in energy prices could all adversely affect demand for thermal energy storage systems.

Destabilizing Incidents: Additional destabilizing events such as terrorist attacks or overseas conflicts, if they occur, could disrupt our supply chain, increase our materials costs, reduce demand for our products, and otherwise negatively impact our operating results.

Materials Prices: Raw materials including polyolefin resins account for a major portion of the Company’s cost of sales. Any increase in these prices because of supply shortages or otherwise would reduce its operating margins and adversely impact its profitability.

Export sales: Products sold outside the United States are subject to certain controls and restrictions, including tariffs and import duties and are subject to certain risks, including changing regulatory requirements of foreign jurisdictions and transportation delays and interruptions. However, the Company has not experienced any material difficulties in the past relating to such limitations.

Item 3 — Quantitative and Qualitative Disclosures About Market Risk

Interest Rate Risk: The Company typically maintains only minimal investments in interest bearing securities and accounts. As of September 30, 2003, the Company’s cash and cash equivalents and other interest bearing assets were $586,400. Accordingly, a change in market interest rates would not have significant impact on the value of the Company’s assets or on interest income.

The Company is subject to fluctuating interest rates for variable rate bank borrowings. These fluctuations may impact, adversely or otherwise, results of operations or cash flows.

As of September 30, 2003, the Company has a mortgage in the amount of $3,315,500 with a maturity date of June 10, 2030. The interest rate at September 30, 2003 was 6.75%. The current interest rate is fixed through April 10, 2008; the interest rate will be changed on April 10th of each fifth year to the then current prime rate plus .35%.

Foreign Exchange Risk: The Company operates primarily in the United States, and all domestic sales to date have been made in U.S. dollars. Although significant portions of the Company’s revenues are contributed by overseas sales, these sales are always denominated in U.S. dollars. Accordingly, there has not been any material exposure to foreign currency rate fluctuations.

Equity Market Risk: FAFCO did not hold any equity securities of other companies as of September 30, 2003. Accordingly, it has not had any material exposure to equity market fluctuations.

Item 4 — Controls and Procedures

(a) Evaluation of disclosure controls and procedures.

The Company’s chief executive officer and chief financial officer, after evaluating the Company’s “disclosure controls and procedures” (as defined in Securities Exchange Act of 1934 (the “Exchange Act”) Rules 13a-14c and 15-d as of a date (the “Evaluation Date”) within 90 days before the filing date of this Quarterly Report on Form 10Q have concluded that as of the Evaluation Date, the Company’s disclosure controls and procedures are effective to ensure that information it is required to disclose in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.

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Part I — FINANCIAL INFORMATION – (continued)

(b) Changes in internal controls.

Subsequent to the Evaluation Date, there were no significant changes in the Company’s internal controls or in other factors that could significantly affect its disclosure controls and procedures, nor were there any significant deficiencies or material weaknesses identified in its internal controls. As a result, no corrective actions were required or undertaken.

Part II — OTHER INFORMATION

Item 2 — Changes in Securities and Use of Proceeds

In July, 2003 the Company’s Board of Directors approved, and on October 29, 2003 proxy material was sent to shareholders regarding, a proposed reverse stock split whereby each 1000 shares of the Company’s common stock held by the shareholder would be converted to one post-split share of common stock. Shareholders owning less than 1000 shares of common stock would receive $0.70 per share for each share of pre-split common stock owned as of the effective date of the reverse stock split. If the stock split is approved by shareholders on November 21, 2003, the effective date of the reverse stock split is expected to be November 24, 2003.

Upon consummation of the proposed stock split, the Company expects to have fewer than 300 shareholders thus allowing it to deregister its shares under the Securities Exchange Act of 1934 and cease being a reporting company with the Securities and Exchange Commission.

Item 5 — Other Information

Subsequent to the end of the quarter being reported on herein, the Company terminated one of its largest distributors of the Company’s swimming pool heating systems located in San Diego, CA.

Although this may have a negative short-term effect on sales, the Company expects to have alternative distribution set up in the San Diego territory by the end of the year. The Company does not expect there to be any significant effect on inventory, accounts receivable or bad debt as a result of this termination.

Item 6 — Exhibits and Reports on Form 8-K

a.

Exhibits

b.

Reports on Form 8-K

No reports on Form 8-K were filed during the quarter ended September 30, 2003.

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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.

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EXHIBIT INDEX

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