PROTON ENERGY SYSTEMS INC - 10-Q Quarterly Report

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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 September 30, 2002

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

For the transition period from to

Commission File Number: 000-31533

PROTON ENERGY SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

Delaware		06-1461988
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification Number)

10 Technology Drive, Wallingford, CT 06492

(Address of registrant’s principal executive office)

(203) 678-2000

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 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 ¨

The number of shares outstanding of the registrant’s common stock, par value $.01 per share, as of November 5, 2002 was 33,406,680.

PROTON ENERGY SYSTEMS, INC.

INDEX to FORM 10-Q

PART I. FINANCIAL INFORMATION

		Page
Item1—Financial Statements
Condensed Consolidated Balance Sheets—September 30, 2002 (unaudited) and December 31, 2001		1

Condensed Consolidated Statements of Operations—Three-Month and Nine-Month Periods ended September 30, 2002 (unaudited) and September 30, 2001 (unaudited)		2

Condensed Consolidated Statements of Cash Flows—Nine-Month Periods ended September 30, 2002 (unaudited) and September 30, 2001 (unaudited)		3

Notes to (unaudited) Condensed Consolidated Financial Statements		4-8

Item 2— Management’s Discussion and Analysis of Financial Condition and Results of Operations		9-21

Item 3— Quantitative and Qualitative Disclosures about Market Risk		22

Item 4— Controls and Procedures		22

PART II. OTHER INFORMATION
Item 1— Legal Proceedings		23

Item 2— Changes in Securities and Use of Proceeds		23

Item 3— Defaults upon Senior Securities		23

Item 4— Submission of Matters to a Vote of Security Holders		23

Item 5— Other Information		24

Item 6— Exhibits and Reports on Form 8-K		24

Signatures		25

Certifications		26-28

Part I—FINANCIAL INFORMATION

ITEM 1. Financial Statements

PROTON ENERGY SYSTEMS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

	September 30, 2002			December 31, 2001
	(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents	$	6,940,229		$	1,836,899
Marketable securities (Note 4)		147,216,416			165,383,001
Accounts receivable		1,393,822			1,011,259
Inventories and deferred costs (Note 5 and 10)		5,113,319			3,143,164
Related party note receivable (Note 11)		—			110,801
Other current assets		2,252,782			2,442,530

Total current assets		162,916,568			173,927,654

Fixed assets, net (Note 6)		16,094,806			7,152,156
Related party note receivable, long term portion (Note 11)		—			133,475
Other assets, net		629,105			654,957

Total assets	$	179,640,479		$	181,868,242


LIABILITIES AND STOCKHOLDERS’ EQUITY

Current liabilities:
Accounts payable	$	552,529		$	718,112
Accrued expenses		1,141,825			565,290
Accrued construction costs		798,075			1,603,640
Accrued compensation		1,362,358			393,802
Accrued service costs (Note 10)		1,217,407			—
Deferred revenue		2,058,835			884,248
Customer advances		49,818			509,973

Total current liabilities		7,180,847			4,675,065


Long term liabilities:
Construction loan (Note 8)		6,208,490			1,166,000

Total liabilities		13,389,337			5,841,065


Commitments and contingencies (Note 10)

Stockholders’ equity:
Preferred stock, undesignated, $.01 par value per share; 5,000,000 shares authorized; no shares issued or outstanding		—			—
Common stock, $.01 par value; 100,000,000 shares authorized; 33,406,680 and 33,228,495 shares issued and outstanding, respectively		334,067			332,285
Additional paid-in capital		241,989,294			242,034,880
Unearned compensation		(831,015	)		(1,447,629	)
Accumulated other comprehensive income (Note 2 and 4)		1,374,174			2,092,949
Accumulated deficit		(76,615,378	)		(66,985,308	)

Total stockholders’ equity		166,251,142			176,027,177

Total liabilities and stockholders’ equity	$	179,640,479		$	181,868,242

The accompanying notes are an integral part of the financial statements.

PROTON ENERGY SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

	Three Months Ended September 30,						Nine Months Ended September 30,
	2002			2001			2002			2001
Contract revenue	$	891,719		$	303,496		$	2,675,891		$	710,448
Product revenue		697,227			60,157			1,167,946			447,384

Total revenues		1,588,946			363,653			3,843,837			1,157,832
Costs and expenses:
Costs of contract revenue		556,811			260,345			1,891,713			689,816
Costs of production		2,302,014			321,612			3,523,203			1,136,540
Research and development		2,269,197			1,810,437			6,840,524			4,289,584
General and administrative		2,172,429			1,768,808			5,949,326			5,164,784

Total costs and expenses		7,300,451			4,161,202			18,204,766			11,280,724

Loss from operations		(5,711,505	)		(3,797,549	)		(14,360,929	)		(10,122,892	)
Interest income, net		1,425,080			2,117,184			4,707,100			7,007,639
Gain on sale of marketable securities		—			113,470			23,759			113,470

Net loss attributable to common stockholders	$	(4,286,425	)	$	(1,566,895	)	$	(9,630,070	)	$	(3,001,783	)

Basic and diluted net loss per share attributable to common stockholders	$	(0.13	)	$	(0.05	)	$	(0.29	)	$	(0.09	)

Shares used in computing basic and diluted net loss per share attributable to common stockholders		33,378,631			33,186,840			33,323,623			33,141,397

The accompanying notes are an integral part of the financial statements

PROTON ENERGY SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

	Nine Months Ended September 30,
	2002			2001
Cash flows from operating activities:
Net loss	$	(9,630,070	)	$	(3,001,783	)

Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization		654,547			360,422
Amortization of premiums on securities		1,034,307			360,206
Non-cash stock-based expense		482,237			546,920
Realized gain on sale of marketable securities		(23,759	)		(113,470	)
Loss on disposal of assets		118,173			—

Changes in operating assets and liabilities:
Accounts receivable		(382,563	)		(81,158	)
Inventories and deferred costs		(1,970,155	)		(1,251,645	)
Other current assets		189,748			187,970
Other assets		6,453			148,298
Accounts payable and accrued expenses		1,785,450			(90,306	)
Deferred revenue and contract advances		720,332			345,564

Net cash used in operating activities		(7,015,300	)		(2,588,982	)


Cash flows from investing activities:
Purchases of fixed assets		(9,708,529	)		(3,601,584	)
Proceeds from sale of fixed assets		12,558			—
Purchases of marketable securities		(68,321,618	)		(161,277,419	)
Proceeds from maturities and sales of marketable securities		84,758,880			176,241,018
Proceeds from repayment of related party note		244,276			—

Net cash provided by investing activities		6,985,567			11,362,015


Cash flows from financing activities:
Borrowings from long term debt		5,042,490			—
Proceeds from sale of common stock, net		51,030			51,755
Proceeds from exercise of stock options		39,543			22,278

Net cash provided by financing activities		5,133,063			74,033

Net increase in cash		5,103,330			8,847,066
Cash and cash equivalents at beginning of period		1,836,899			1,360,127

Cash and cash equivalents at end of period	$	6,940,229		$	10,207,193


Supplemental disclosure of cash paid during the period for:
Interest	$	106,743		$	—
Income taxes		—			—

The accompanying notes are an integral part of the financial statements.

PROTON ENERGY SYSTEMS, INC.

NOTES TO (UNAUDITED) CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. NATURE OF OPERATIONS

Proton Energy Systems, Inc. (the “Company”) was incorporated in Delaware on August 16, 1996 to design, develop and manufacture proton exchange membrane (“PEM”) electrochemical products. The Company employs PEM electrochemical products in hydrogen generation and power generating and storage devices for use in a variety of commercial applications. The Company manufactures products for the domestic and international industrial gas market and operates in a single segment.

2. BASIS OF PRESENTATION

In 2001, the Company established Technology Drive LLC, a Connecticut limited liability company solely owned by the Company. Technology Drive LLC holds title to the building and approximately 44 acres of land in Wallingford, Connecticut, where the Company has substantially completed the construction of its new headquarters, research and development and production facility. The condensed consolidated financial information includes the accounts of the Company and Technology Drive LLC, after elimination of intercompany transactions.

The condensed consolidated financial information as of September 30, 2002 and for the three-month and nine-month periods ended September 30, 2002 and 2001 is unaudited. In the opinion of management, all adjustments, which consist solely of normal recurring adjustments, necessary to present fairly in accordance with generally accepted accounting principles, the financial position, results of operations and cash flows for all periods presented, have been made. The results of operations for the interim periods presented are not necessarily indicative of the results that may be expected for the full year.

Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. These condensed consolidated financial statements should be read in conjunction with the Company’s audited financial statements and notes thereto included in the Company’s Annual Report on Form 10-K filed on March 29, 2002.

Comprehensive Income (Loss)

Comprehensive income (loss) consists of net loss and other gains and losses affecting stockholders’ equity that are not the result of transactions with owners. The following table sets forth the components of comprehensive income:

	September 30,
	2002	2001
	(unaudited)	(unaudited)
Net loss	$ (9,630,070)	$(3,001,783)
Unrealized (losses) gains on marketable securities	(718,775)	2,414,421

Total comprehensive loss	$(10,348,845)	$ (587,362)

Reclassifications

Certain amounts in the 2001 financial statements have been reclassified to conform to the 2002 presentation.

PROTON ENERGY SYSTEMS, INC.

NOTES TO (UNAUDITED) CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

3. RECENT ACCOUNTING GUIDANCE

In September 2002, SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” was issued. This statement provides guidance on the recognition and measurement of liabilities associated with exit or disposal activities and requires that such liabilities be recognized when incurred. This statement is effective for exit or disposal activities initiated on or after January 1, 2003. Adoption of this standard is not expected to impact the timing of recognition of costs associated with future exit and disposal activities.

4. MARKETABLE SECURITIES

The Company classifies its entire investment portfolio as available for sale as defined in SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” As of September 30, 2002, the Company’s investment portfolio consisted of U.S. government and agency securities held by two major banking institutions. The maturities of marketable securities are as follows:

	September 30, 2002	December 31, 2001
	(unaudited)
Less than one year	$104,949,937	$ 88,839,638
One to five years	42,266,479	76,543,363

	$147,216,416	$165,383,001

Securities are carried at fair value with the unrealized gains/losses reported as a separate component of stockholders’ equity. Proceeds from the sale of a security in 2002 totaled $1,028,675. The cost was determined using the specific identification method and the resulting realized gain was $23,759. The unrealized gain from marketable securities was $1,374,174 and $2,092,949 at September 30, 2002 and December 31, 2001, respectively. At September 30, 2002, the Company had five callable agency securities with a fair market value totaling approximately $22.6 million. Additionally, two investments approximating $10.9 million were called at par in 2002. These securities generate a higher relative rate of interest for the Company, in return for the issuer’s right to call, at par value, the security before its maturity date.

5. INVENTORIES AND DEFERRED COSTS

Inventories are stated at the lower of cost or market value. Cost is determined by the first-in, first-out method.

	September 30, 2002		December 31, 2001
	(unaudited)
Raw materials	$	1,868,164	$	1,177,126
Work in process		1,445,960		573,911
Finished goods		1,799,195		1,392,127

	$	5,113,319	$	3,143,164

Deferred costs of $1,126,396 and $716,358 are included in finished goods as of September 30, 2002 and December 31, 2001, respectively. These costs of production have been deferred until the Company recognizes the related product revenue. In addition, costs incurred under our contract with STM of $930,863 and $214,592 are included in work in process as of September 30, 2002 and December 31, 2001, respectively.

PROTON ENERGY SYSTEMS, INC.

NOTES TO (UNAUDITED) CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

6. FIXED ASSETS

	September 30, 2002			December 31, 2001
	(unaudited)
Land	$	2,243,586		$	—
Building		10,205,852			—
Machinery and equipment		2,045,482			1,046,546
Leasehold improvements		368,225			368,225
Office furniture, fixtures and equipment		2,508,336			1,376,101
Construction in process		403,672			5,450,275

		17,775,153			8,241,147
Less: accumulated depreciation		(1,680,347	)		(1,088,991	)

	$	16,094,806		$	7,152,156

In the second quarter of 2002 the Company placed its new facility into service. The building is being depreciated over its useful life which is estimated to be 30 years.

7. LOSS PER SHARE

Net loss per share has been computed by dividing the net loss attributable to common stockholders by the weighted average common shares outstanding. No effect has been given to the exercise of common stock options and stock warrants since the effect would be antidilutive for all reporting periods.

8. DEBT

In 2001, Technology Drive LLC, a limited liability company wholly owned by the Company, entered into a $6,975,000 loan agreement with a major financial institution, in connection with the construction of the Company’s new facility in Wallingford, Connecticut. Under the terms of the loan, the business assets of Technology Drive LLC, including the land and building, are subject to lien. The loan agreement is structured as a one-year construction loan with monthly payments of interest only until December 2002 at which time the loan converts to a seven-year term note. The term note amortizes based upon a fifteen-year schedule with a final lump sum payment due at the maturity date of December 31, 2009. The note is guaranteed by Proton Energy Systems, Inc., the managing member of Technology Drive LLC, and bears interest at the one-month LIBOR plus 2.375% (4.195% at September 30, 2002). The Company is required to comply with certain covenants, including the maintenance of adequate insurance coverage and a liquidity covenant requiring the Company to maintain cash and marketable securities of not less than $20 million. At September 30, 2002, $6,208,490 is outstanding under the note and is classified as long-term debt.

In connection with the loan facility, the Company incurred approximately $206,000 of loan origination costs, which are being amortized over the term of the loan. For the nine months ended September 30, 2002, amortization expense related to these costs totaled $19,399.

9. STOCK OPTION GRANTS

During 1999 and 2000, the Company issued common stock options at less than the fair value of its common stock. The compensation expense for such options is amortized over the vesting periods of the related options. Accordingly, the Company recorded stock-based compensation expense of $159,225 and $179,980 for the three-month periods ended September 30, 2002 and September 30, 2001, respectively, and $513,462 and $534,606 for the nine-month periods September 30, 2002 and September 30, 2001, respectively.

PROTON ENERGY SYSTEMS, INC.

NOTES TO (UNAUDITED) CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

10. COMMITMENTS AND CONTINGENCIES

In November 1999, the Company entered into an agreement with Matheson Tri-Gas, Inc. (“Matheson”), to develop, market and distribute hydrogen generators to be used solely in laboratory applications. This agreement grants Matheson worldwide exclusivity to the commercial sale of this product during the fifteen-year term of the contract as long as the distributor meets minimum purchases, as defined in the agreement. The Company retains the right to modify the contract once annually by providing six months notice. In the nine-month periods ended September 30, 2002 and 2001, the Company recorded losses of $379,033 and $251,000, respectively, under this contract. Any future loss recognition is contingent on the distributor placing additional orders and the Company’s cost per unit exceeding the related sale price per unit.

In 2001, the Company entered into a 10-year agreement with STM Power, Inc. (“STM”) for the exclusive supply of high-pressure hydrogen replenishment systems for Stirling Cycle Engines. Under an initial purchase order relating to this agreement, STM has agreed to provide $395,000 for the product development and delivery of prototype hydrogen replenishment systems. In 2002, the Company received purchase orders totaling approximately $550,000 for additional product development and delivery of 55 high-pressure hydrogen generators.

The Company accounts for the STM contract in accordance with SOP 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts”, and accordingly has recorded costs of $930,000 under the contract in inventory (see Note 5). Additionally, at September 30, 2002 the Company has recorded $748,000 as deferred revenue representing amounts billed under the contract with STM. In 2002 the Company recorded $323,000 of cost overruns associated with this contract. We cannot assure you that the amount accrued for such cost overruns will not exceed this amount.

Also in 2001, the Company entered into an agreement with the Connecticut Clean Energy Fund (“CCEF”). The agreement provides the Company with financial assistance for up to $1.5 million to accelerate commercial deployment of the UNIGEN product. The Company is required to repay CCEF 110% of the amounts advanced by them under the agreement beginning at such time as revenues from UNIGEN products reach $25 million annually. However, prior to the achievement of milestones described in this agreement, these funds are subject to repayment provisions based upon the occurrence of certain events. These events include a failure to maintain a Connecticut presence, the purchase of a controlling interest in the Company by a third party, the sale of substantially all of the Company’s assets, the consolidation or merger of the company with a third party, or the granting of the exclusive license to a third party to manufacture or use the UNIGEN product line. Because of these repayment provisions, the Company records funds received as liabilities until it achieves the contract milestones. At December 31, 2001, $200,000 had been received and was recorded in customer advances. During the first half of 2002 an additional $400,000 had been received. During 2002, the Company achieved the contract milestones and recognized the related $600,000 as an offset against costs and expenses.

In late October 2002, the Company learned that sensor modules in four of its HOGEN 40 series units at customer locations might have been affected by moisture blockage thereby impairing the sensor’s ability to detect the presence of hydrogen in the oxygen gas stream. Further investigation of these units revealed the presence of pinholes in the cell membranes, resulting in hydrogen leakage and cell failure. At this time the Company does not know the number of units that have these problems. To address these problems, the Company has contacted all of its HOGEN 40 series customers to arrange appropriate sensor testing and modifications. Additionally, the Company intends to replace defective cell stacks that are experiencing leakage. The Company is taking the approach that all HOGEN 40 series sensor and cell stack components in the field may need to be replaced. The Company is also working to develop and implement design improvements to extend cell lifetime. The Company has accrued its estimated liability of $1,431,000 for these service costs, which are probable and

PROTON ENERGY SYSTEMS, INC.

NOTES TO (UNAUDITED) CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

can be reasonably estimated. The liability is comprised of $1,217,000 in accrued service costs and $214,000 in costs associated with our units on hand. The liability for such service costs reflects management’s estimate, as of the date of this report, of the ultimate cost of the program. The actual amount of such costs could be less than this accrual but they could also materially exceed the amount accrued.

11. RELATED PARTIES

In 2001, the Company loaned $275,000 to Walter W. Schroeder, the President, Chief Executive Officer, and a director of the Company. The loan had a two-year term and was payable in monthly 7 installments of $10,000 each with a final payment due at maturity. The loan, which accrued interest at the prime rate contained no penalty for early repayment. In July 2002, the loan was paid in full.

In 2001, the Company entered into a contract with STM to develop and deliver hydrogen generators (see Note 10). Richard A. Aube, a member of the Company’s Board of Directors, is also a member of STM’s Board of Directors.

12. SUBSEQUENT EVENT

In October 2002, the Company reduced its workforce by approximately 10% as part of an ongoing effort to increase the efficiency of operations and reduce costs. In connection with the reduction in workforce, the Company expects to recognize a charge in the fourth quarter of 2002 that is not anticipated to exceed $135,000.

ITEM 2— Management’s Discussion and Analysis Of Financial Condition and Results of Operations

The following discussion should be read in conjunction with the Condensed Consolidated Financial Statements and Notes thereto appearing elsewhere in this Form 10-Q and with our Annual Report on Form 10-K filed for the fiscal year ended December 31, 2001. This Form 10-Q contains forward-looking statements that involve substantial risks and uncertainties. You can identify these statements by forward-looking words such as “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,” “plan,” “potential,” “should,” “will,” and “would” or similar words. You should read statements that contain these words carefully because they discuss our future expectations and contain projections of our future results of operation or of our financial position or state other forward-looking information. However, there may be events in the future that we are unable to predict accurately or control. The factors in the section captioned “Critical Accounting Policies” contained in our Annual Report on Form 10-K filed for the fiscal year ended December 31, 2001, and below in this Form 10-Q under the “Legal Proceedings” and “Certain Factors That May Affect Future Results” captions, provide examples of risks, uncertainties and events that may cause our actual results to differ materially from the expectations we describe in our forward-looking statements.

Overview

We were founded in 1996 to design, develop and manufacture PEM electrochemical products for commercial applications. Our proprietary PEM technology is incorporated in two families of products: hydrogen generators, which we are currently developing, manufacturing and delivering to customers, and regenerative fuel cell systems, which we are currently developing. Our hydrogen generator product family consists of three distinct models: HOGEN 40 series style generators with 20 and 40 cubic feet per hour hydrogen production capacities, HOGEN 380 style generator with 380 cubic feet per hour hydrogen production capacities, and hydrogen generators for use in laboratory applications currently marketed by Matheson Tri-Gas, Inc. under the Chyrsalis brand name. We expect to further design, develop and refine our family of hydrogen generation products to expand and deliver different output capacities to better serve customer application requirements. Since our inception, we have funded our operations through private financings that raised approximately $61.6 million, including $50.1 million raised in a private financing in April 2000, and an initial public offering in October 2000 which raised net proceeds of approximately $125.8 million.

We began delivering late-stage development models of our hydrogen generators to customers in 1999; revenue on such transactions has generally been deferred until the expiration of the product warranty period. In the fourth quarter of 2001, we determined that we had adequate product warranty information and experience to begin recognizing product revenue related to sales of HOGEN 40 series units upon shipment. As a result, we recognized previously deferred HOGEN 40 series revenue of $754,000 in the fourth quarter of 2001. The Company will continue to defer revenue on shipments of its Chrysalis and HOGEN 380 hydrogen products until such units are past the product warranty period or until the Company has adequate warranty history. As of September 30, 2002, we have deferred revenue of approximately $2.1 million primarily related to our HOGEN 380, STM and Chyrsalis hydrogen generators. In the future, we expect to derive the majority of our revenue from the sale of the hydrogen generator and regenerative fuel cell systems products we may develop.

We derive contract revenue from customer-sponsored research and development contracts related to our PEM technology. For our Department of Energy and Naval Research Laboratory contracts, which do not require us to meet specific obligations, we recognize contract revenue utilizing the percentage-of-completion method, which is based on the relationship of costs incurred to total estimated contract costs. For those research and development contracts which require us to meet specified obligations or those contracts where total contract costs are not reasonably estimated, amounts advanced to us pursuant to the contracts are recognized as contract liabilities until such obligations are met. Once the obligations are met, the amounts are recognized as contract revenue. The STM contract is accounted for under the latter method. Under these contracts, we have delivered hydrogen generators and demonstration regenerative fuel cell systems.

We have generated cumulative losses since our inception, and as of September 30, 2002, our accumulated deficit was $76.6 million, of which $50.7 million is attributable to deemed preferred dividends and accretion and $25.9 million is attributable to net losses since inception. We expect to continue to make significant investments in new product design and development for the foreseeable future. We expect to incur operating losses in 2002 and for the next several years and cannot predict when we will become profitable, if ever.

Recent Developments

In 2002, we substantially completed the construction of our new facility in Wallingford, CT and the relocation of our corporate offices. By the end of the first quarter 2003, we expect to complete the consolidation of our operations to the new 100,000 square foot facility.

In late October 2002, we learned that sensor modules in four of our HOGEN 40 series units at customer locations may have been affected by moisture blockage thereby impairing the sensor’s ability to detect the presence of hydrogen in the oxygen gas stream. Further investigation of these units revealed the presence of pinholes in the cell membranes, resulting in hydrogen leakage and cell failure. At this time we do not know the number of units that have these problems. To address these problems, we have contacted all of our HOGEN 40 series customers to arrange appropriate sensor testing and modifications. Additionally, we intend to replace defective cell stacks that are experiencing leakage. We our taking the approach that all HOGEN 40 series sensor and cell stack components in the field may need to be replaced. We have accrued its estimated liability of $1,431,000 for these service costs, which are probable and can be reasonably estimated. The liability for such service costs reflects our estimate, as of the date of this report, of the ultimate cost of the program. The actual amount of such costs could be less than this accrual but they could also materially exceed the amount accrued.

Critical Accounting Judgments and Estimates

Our discussion and analysis of our financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared by us in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and disclosure of contingent assets and liabilities. Our estimates include those related to revenue recognition, investments, income taxes, depreciable lives of equipment, warranty obligations and contingency accruals. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. For a complete description of our accounting policies, see Note 2 to our condensed consolidated financial statements included in the Company’s Annual Report on Form 10-K filed on March 29, 2002.

Results of Operations

Comparison of the Three Months Ended September 30, 2002 and September 30, 2001

Contract revenue. Contract revenue increased from $303,000 for the three months ended September 30, 2001 to $892,000 for the comparable period in 2002. The increase was due primarily to research and development activity under the Naval Research Laboratory (“NRL”) contract entered into in the fourth quarter of 2001. In the future, we expect contract revenue from government-sponsored research and development contracts to decrease as a percentage of total revenues as we begin to recognize increasing levels of revenue from product sales.

Product revenue. Product revenue increased from $60,000 for the third quarter of 2001 to $697,000 for the third quarter of 2002. The increase in 2002 relates principally to HOGEN 40 series product revenue. In the third quarter of 2001, HOGEN 40 series product revenue was recognized upon the expiration of the product warranty, which typically occurred twelve months from shipment. In the third quarter of 2002, revenue has been recognized upon shipment. Included in product revenue for the three months ended September 30, 2002 is

HOGEN 40 series product revenue of $620,000, Chrysalis product revenue of $68,000, and spare part sales and other revenue of $9,000.

Costs of contract revenue. Costs of contract revenue increased from $260,000 for the third quarter of 2001 to $557,000 for the third quarter of 2002. The increase in 2002 reflects increased costs incurred under the NRL contract.

Costs of production. Costs of production increased from $322,000 for the third quarter of 2001 to $2.3 million for the third quarter of 2002. The amounts in 2001 and 2002 reflect costs associated with manufacturing, refining and delivering our hydrogen generators as well as warranty costs on units in the field. Included within costs of production for the period is the $1,431,000 reserve established to address performance problems relating to the operation of cell stacks and associated sensors in our HOGEN 40 series units.

Under the Matheson Tri-Gas contract, Matheson has the exclusive right to sell our hydrogen generators if it meets minimum purchase requirements specified in the contract. For periods after December 31, 2001, the contract currently provides that Matheson must purchase 1,000 units per year if it wishes to maintain exclusivity; however, the Company and Matheson are currently in negotiation regarding quantity and price adjustments for 2002. We anticipate that the terms of the contract may be revised. Any future recognition of losses by us under this contract will depend on the number of orders placed by Matheson and the extent to which our cost per unit exceeds the sale price per unit.

To date, under our agreement with Matheson Tri-Gas, Inc., we have recognized costs in excess of our contracted sales price in the amount of $634,935. We have implemented programs aimed at cost reduction which are intended to get this product to profitability, however, we are incurring costs in excess of our sales price under this contract and cannot predict when we will become profitable, if ever.

Research and development expenses. Research and development expenses increased from $1.8 million for the third quarter of 2001 to $2.3 million for the third quarter of 2002. The increase was due to an increase in our research and development activities related to our PEM technology in our regenerative fuel cell systems and our hydrogen generators. These research and development activities primarily related to increased salaries and benefits for our growing research and development staff and materials to support our research and development projects. We expect our research and development expenses to remain level for the next twelve months.

General and administrative expenses. General and administrative expenses increased from $1.8 million for the third quarter of 2001 to $2.2 million for the third quarter of 2002. This change reflects an increase in salaries and benefits, resulting from an increase in employees over the third quarter of 2001.

Interest income, net. Interest income decreased from $2.1 million for the third quarter of 2001 to $1.4 million for the third quarter of 2002. The decrease resulted from decreased cash and marketable securities balances as well as lower average interest rates.

Comparison of the Nine Months Ended September 30, 2002 and September 30, 2001

Contract revenue. Contract revenue increased from $710,000 for the nine months ended September 30, 2001 to $2.7 million for the comparable period in 2002. The increase was due primarily to research and development activity under the NRL contract entered into in the fourth quarter of 2001. In the future, we expect contract revenue from government-sponsored research and development contracts to decrease as a percentage of total revenues as we begin to recognize increasing levels of revenue from product sales.

Product revenue. Product revenue increased from $447,000 in the first nine months of 2001 to $1.2 million for the comparable period of 2002. The increase in 2002 primarily relates to HOGEN 40 series product revenue. In the first nine months of 2001, HOGEN 40 series product revenue was recognized upon the expiration of the product warranty which typically occurred twelve months from shipment. In the first nine months of 2002,

revenue has been recognized upon shipment. Included in 2002 product revenue is HOGEN 40 series product revenue of $999,000, Chrysalis product revenue of $135,000, and spare part sales and other revenue of $34,000.

Costs of contract revenue. Costs of contract revenue increased from $690,000 for the first nine months of 2001 to $1.9 million for the comparable period of 2002. The increase in 2002 reflects increased costs incurred under the NRL contract. Additionally, cost of contract revenue includes $323,000 of charges in 2002 related to cost overruns associated with our contract with STM. We cannot assure you that the amount to be incurred for such cost overruns will not exceed this amount (see Note 10).

Costs of production. Costs of production increased from $1.1 million for the first nine months of 2001 to $3.5 million for the comparable period of 2002. The amounts in 2001 and 2002 reflect costs associated with manufacturing, refining and delivering our hydrogen generators as well as warranty costs on units in the field. The amount in 2002 also includes costs associated with anticipated sales price reductions as we transition to a new generation of the HOGEN 40 product line. Included within costs of production for the period is a $1,431,000 reserve established to address performance problems relating to the operation of cell stacks and associated sensors in our HOGEN 40 series units. Additionally, costs of production could increase if our warranty experience deteriorates.

Research and development expenses. Research and development expenses increased from $4.3 million for the first nine months of 2001 to $6.8 million for the comparable period of 2002. The increase was due to an increase in our research and development activities related to our PEM technology in our regenerative fuel cell systems and our hydrogen generators. These research and development activities primarily related to increased salaries and benefits for our growing research and development staff and materials to support our research and development projects. We expect our research and development expenses to remain level for the next twelve months.

General and administrative expenses. General and administrative expenses increased from $5.2 million for the first nine months of 2001 to $5.9 million for the comparable period of 2002. This change reflects an increase in salaries and benefits, resulting from an increase in employees over the prior year.

Interest income, net. Interest income decreased from $7.0 million for the first nine months of 2001 to $4.7 million for the comparable period of 2002. The decrease resulted from decreased cash and marketable securities balances as well as lower average interest rates.

Liquidity and Capital Resources

Since our inception in August 1996, we have financed our operations through the series A, A-1, B, B-1 and C convertible preferred stock issuances and our initial public offering that, in total, raised approximately $187.4 million. As of September 30, 2002, we had $154.2 million in cash, cash equivalents and marketable securities.

Cash used in operating activities was $7.0 million for the nine months ended September 30, 2002 and was primarily attributable to our net loss and increases in inventory and deferred costs, offset by increases in accounts payable and accrued expenses and increases in deferred revenue and customer advances. Cash used in operating activities was $2.6 million for the comparable 2001 period and was primarily attributable to our net loss and increases in inventory.

Cash provided by investing activities was $7.0 million for the nine months ended September 30, 2002 and was primarily attributable to proceeds from the maturity of marketable securities offset by purchases of marketable securities and fixed assets. Cash provided by investing activities was $11.4 million for the nine months ended September 30, 2001 and was primarily attributable to maturities of marketable securities offset by purchases of marketable securities and fixed assets.

Cash provided by financing activities was $5.1 million for the nine months ended September 30, 2002 and was primarily attributable to proceeds under our debt agreement. Cash provided by financing activities was $74,000 for the nine months ended September 30, 2001.

We anticipate that our cash, cash equivalents and marketable securities on hand as of September 30, 2002 will be adequate to fund our operations, working capital and capital expenditure requirements for at least the next 12 months. We have purchased approximately 44 acres of land in Wallingford, CT and have substantially completed our new headquarters, research and development and manufacturing facility. We are in the process of fully relocating our operations and expect to spend approximately $1 million over the next 3 months in connection with this facility. To date through September 30, 2002, we have invested approximately $14.2 million for the land, building, furniture, and equipment associated with the facility. Over the next 12 months, we expect to continue to fund the production of our hydrogen generators and to continue our research and development activities on our regenerative fuel cell systems. We cannot assure you that we will not require additional financing to fund our operations or that, if required, any further financing will be available to us on acceptable terms, or at all. If sufficient funds are not available, we may be required to delay, reduce or eliminate some of our research and development or manufacturing programs. The terms of any additional financing may require us to relinquish rights to our technologies or potential products or other assets.

Certain Factors That May Affect Future Results

The following important factors, among others, could cause actual results to differ materially from those indicated by forward-looking statements made in this Quarterly Report on Form 10-Q and presented elsewhere by management from time to time.

Our future success is uncertain because we have a limited operating history.

We face many risks and uncertainties. If we are unsuccessful in addressing these risks and uncertainties, we may be unable to generate revenue and grow our company. We were formed in 1996 to research and develop PEM electrochemical products. We began shipping late-stage development models of our hydrogen generators in 1999 and have not yet manufactured commercial regenerative fuel cell systems. Accordingly, there is only a limited basis upon which you can evaluate our business and prospects and our future success is uncertain. You should consider the challenges, expenses, delays and other difficulties typically involved in the establishment of a new business, including the continued development of our products, development of fully functioning manufacturing operations, refinement of processes and components for our commercial products, recruitment of qualified personnel, and achievement of market acceptance for our products.

We have incurred, and expect to continue to incur, substantial losses, and we may never become profitable.

We have incurred substantial losses since we were founded and we anticipate we will continue to incur substantial losses in the future. As of September 30, 2002, we had an accumulated deficit of approximately $77 million. In 2002, we experienced increased cash burn and increased our headcount. We cannot predict when we will operate profitably, if ever. We expect to continue to incur expenses related to research and development activities, expansion of our manufacturing facilities and general administrative functions. As a result, we anticipate that we will continue to incur losses until we can cost-effectively produce and sell our hydrogen generators and regenerative fuel cell systems in substantial quantities. Even if we do achieve profitability, we may be unable to sustain or increase our profitability in the future.

If we fail to retain our key personnel and attract and retain additional qualified personnel, we may be unable to develop our products and generate revenue.

Our success depends upon the continued service of our executive officers and other key employees such as manufacturing and research and development personnel. The loss of any of our executive officers or key employees, especially Walter W. Schroeder, president and chief executive officer, Dr. Larry M. Sweet, chief

operating officer, Trent M. Molter, senior vice president of technology and new business, Robert J. Friedland, senior vice president of products and manufacturing, and Lawrence C. Moulthrop, Jr., vice president of product development, could impair our ability to pursue our growth strategy and slow our product development processes. We do not have employment agreements with any of our key executives. We may not be able to attract, assimilate or retain additional highly qualified personnel in the future.

We may not be able to generate revenue in the future if we do not complete the development of our regenerative fuel cell systems.

Our regenerative fuel cell systems are still in the development stage. We do not know when or whether we will successfully complete research and development of commercial regenerative fuel cell systems. If we are unable to develop commercial regenerative fuel cell systems, we may not be able to generate future revenue and we may not recover the losses we have incurred in attempting to develop these products. If we experience delays in meeting our development milestones or if our regenerative fuel cell systems exhibit technical defects or cannot meet cost or performance goals, including output, useful life and reliability goals, potential purchasers of our products may decline to purchase them or choose alternative technologies. We may be unable to make the substantial technological advances necessary to produce commercial regenerative fuel cell systems that provide the features and performance specifications required by customers at a competitive price. For example, we must identify improved hydrogen storage technologies and fuel cell module structures. If we are unable to successfully complete these development activities, we may be unable to commercially market our products. In some cases, we are attempting to expedite our development efforts by utilizing third parties for important engineering work. These third parties include vendors of hydrogen storage, purification systems, power supply and control components. If these third parties are unable to successfully complete their development activities on our behalf, we may be unable to commercially market our products.

We will not be able to grow our business if we do not achieve widespread commercial acceptance of our hydrogen generators in the market for delivered hydrogen.

We intend to market our hydrogen generators to small- and medium-volume users of delivered hydrogen. Our business depends on the widespread commercial acceptance of our hydrogen generators and we may be unable to grow our business if our targeted customers do not purchase substantial numbers of our hydrogen generators. Our targeted customers, or the distributors who we intend to use to market to these customers, may not purchase our hydrogen generators at all or in sufficient quantities to support the growth of our business. Our hydrogen generators will require our target customers to make a substantial initial investment, currently ranging from approximately $40,000 to $200,000 per unit for our HOGEN models. Our method of supplying hydrogen by producing it on-site using PEM electrolysis represents a significant departure from conventional means of supplying hydrogen to end users. PEM electrolysis is a new and unproven technology in the markets we are targeting, and we do not know if our targeted customers will accept our product. We are also working to develop and implement design improvements to extend the life of our cell stack components. If we are unable to successfully complete these activities, sales of our hydrogen generators may be reduced. In addition, we have just begun to demonstrate that we can supply hydrogen to our targeted customers at a lower cost than conventionally delivered hydrogen.

The success of our hydrogen generators as a fuel source for PEM fuel cells depends upon the development of a mass market for PEM fuel cells, and we may not be able to generate revenue in the future if this market does not develop.

We also intend to market our hydrogen generators for use as fuel generators for PEM fuel cells in a variety of applications, in particular fuel cell vehicles. If a mass market for PEM fuel cells fails to develop or develops more slowly than we anticipate, we may be unable to generate revenue in the future and recover the losses we will have incurred in the development of our hydrogen generators. PEM fuel cells represent an emerging

commercial market, and we do not know whether end-users will want to use them. The development of a mass market for PEM fuel cells may be affected by many factors outside of our control, including:

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the emergence of newer, more competitive technologies;

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the cost competitiveness of PEM fuel cells compared to existing and new technologies;

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the future cost of hydrogen;

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regulatory requirements;

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consumer perceptions of the safety, reliability and functionality of PEM fuel cells; and

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consumer willingness to try a new product.

In addition, the sole market for vehicular PEM fuel cells is and will continue to be car, bus and other vehicle manufacturers. Automobile manufacturers’ interest in vehicular PEM fuel cells has been driven in large part by environmental laws and regulations concerning vehicle emission requirements that have been enacted in California and some northeastern states. If these laws and regulations are not kept in force or do not become widely adopted, the demand for vehicular PEM fuel cells may be limited. Further, automobile manufacturers may be able to use other technologies to meet their regulatory requirements, such as batteries, low emission internal combustion engines and hybrid internal combustion/battery engines. Even if automobile manufacturers decide to develop vehicles powered by PEM fuel cells, it may be many years before substantial numbers of vehicles powered by PEM fuel cell systems are manufactured. Further, there are several other technologies that may be used to generate hydrogen, such as hydrocarbon reforming, and there remains a strong possibility that our means of generating hydrogen will not be used to supply fuel to fuel cells.

We may be unable to increase our revenue in the future if the use of renewable energy does not increase.

We anticipate that one of the primary uses of our regenerative fuel cell systems will be for storing energy produced by renewable power sources, such as solar, wind and hydroelectric power. If the demand for renewable energy develops more slowly than we anticipate, our ability to sell our regenerative fuel cell systems could be impaired and we may be unable to grow our business. The market for renewable energy is still in an early stage of development and the demand for renewable energy will remain limited until the cost of producing energy from renewable sources is substantially reduced. Power from renewable energy sources currently costs significantly more than power derived from nonrenewable sources, such as coal and oil. The growth of the renewable energy market will be dependent on many factors that are outside of our control, such as the emergence of new, more cost-effective power technologies and products, and domestic and international regulatory requirements.

We expect to incur significant expenses in expanding our manufacturing facilities and production and we may not be successful in these efforts.

We have expanded our manufacturing facilities in anticipation of increased demand for our products. If this demand does not materialize, we will not generate sufficient revenue to offset the costs of maintaining and operating these facilities, which could increase our losses and prevent us from growing our business. We expect to expand our production and may experience delays or problems in our expected expansion that could compromise our ability to increase our sales and grow our business. Factors that could delay or prevent our expected production expansion include:

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the inability to purchase parts or components in adequate quantities or sufficient quality;

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the cost of raw materials;

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the failure to increase our assembly and test operations;

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the failure to hire and train additional manufacturing personnel; and

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the failure to develop and implement manufacturing processes and equipment.

If we fail to successfully manufacture our products in commercial quantities, we may not be able to increase our revenue.

To be financially successful, we will have to manufacture our products in commercial quantities at acceptable costs while also preserving the quality levels achieved in manufacturing these products in limited quantities. This presents a number of technological and engineering challenges for us. We may not be successful in developing product designs and manufacturing processes that permit us to manufacture our hydrogen generators and regenerative fuel cell systems in commercial quantities at commercially acceptable costs while preserving quality. Currently, we sell some of our products for less than it costs us to produce them. In addition, we will incur significant start-up costs and may experience unforeseen delays and expenses in our product design and manufacturing efforts. If the commercialization of our products is delayed, potential purchasers may also decline to purchase them or choose alternative technologies, both of which could impair our ability to generate revenue in the future.

If our suppliers do not supply us with a sufficient amount and quality of components at acceptable prices, we may not be able to manufacture our products commercially.

Although we generally attempt to use standard components for our products, the proton exchange membrane material and hydrogen purification system used in our products are currently available only from limited sources. Also, we may be unable to purchase components of adequate quality or that meet our cost requirements. In addition, to the extent these components are proprietary products of our suppliers, or the processes used by our suppliers to manufacture these components are proprietary, we may be unable to obtain comparable components from alternative suppliers. We may experience delays in production of our products and our business and financial results would suffer if we fail to identify alternate suppliers, or if our supply is interrupted or reduced or there is a significant increase in cost.

In addition, platinum is a key component of our PEM fuel cells. Platinum is a scarce natural resource and we are dependent upon a sufficient supply of this commodity. We may not be able to produce commercial products, or the cost of producing our products may significantly increase, if there are any shortages in the supply of platinum.

We may be unable to sell our products and generate revenue if we fail to establish distribution relationships.

Because we intend to sell some of our products through third-party distributors, the financial benefits to us of commercializing our products will be dependent on the efforts of others. We intend to enter into additional distribution agreements or other collaborative relationships to market and sell our products. If we are unable to enter into additional distribution agreements, or if our third-party distributors do not successfully market and sell our products, we may be unable to generate revenue and grow our business. We may seek to establish relationships with third-party distributors who also indirectly compete with us. For example, we have targeted industrial gas suppliers as potential distributors of our hydrogen generators. Because industrial gas suppliers currently sell hydrogen in delivered form, adoption by their customers of our hydrogen generation products could cause them to experience declining demand for delivered hydrogen. For this reason, industrial gas suppliers may be reluctant to become distributors of our hydrogen generators. In addition, our third-party distributors may require us to provide volume price discounts and other allowances, or customize our products, either of which could reduce the potential profitability of these relationships.

We have historically focused on research and development activities and have limited experience in marketing, selling and servicing our products.

We have primarily focused on the research and development of our hydrogen generators and regenerative fuel cell systems. Consequently, our management team has limited experience directing the commercialization efforts that are essential to our future success. To date, we only have limited experience marketing, selling and

servicing our hydrogen generators, and no experience marketing, selling or servicing our regenerative fuel cell systems. Furthermore, there are very few people anywhere who have significant experience marketing, selling or servicing PEM electrochemical products. We will have to expand our marketing and sales organization as well as our maintenance and support capability. We may not be successful in our efforts to market and service our products, which would compromise our ability to increase our revenue.

Our plans to market, distribute and service our products internationally subject our business to additional risks, which could prevent us from growing our business.

We intend to market, distribute and service our products internationally and we may derive a significant portion of our revenue from international sales. If we fail to successfully sell our products internationally, our ability to increase our future revenue and grow our business would be impaired. We have limited experience developing, and limited experience manufacturing, our products to comply with the commercial and legal requirements of international markets. Our success in those markets will depend on our ability to secure relationships with foreign resellers and our ability to manufacture products that meet foreign regulatory and commercial requirements. In addition, our planned international operations may be subject to a variety of additional risks, including:

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difficulties in collecting international accounts receivable;

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increased costs associated with maintaining international marketing efforts;

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compliance with U.S. Department of Commerce export controls;

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increases in duty rates;

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the introduction of non-tariff trade barriers;

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fluctuations in currency exchange rates;

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political and economic instability; and

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difficulties in enforcing intellectual property rights.

We currently face and will continue to face significant competition, which could cause us to lose sales or render our products uncompetitive or obsolete.

The markets for delivered hydrogen and reliable backup power are highly competitive. There are a number of companies located in the United States, Canada and abroad that deliver hydrogen, sell hydrogen generation equipment or are developing PEM fuel cell technology. Many of these companies have substantially greater resources than we do. Each of these companies has the potential to capture market share in the markets we intend to address, which could cause us to lose sales and prevent us from growing our business. New developments in technology may also delay or prevent the development or sale of some or all of our products or make our products uncompetitive or obsolete. If this were to occur, we would not be able to generate sufficient revenue to offset the cost of developing our hydrogen generators and regenerative fuel cell systems.

Our regenerative fuel cell systems are one of a number of power technology products being developed today to provide high quality, highly reliable backup power to the existing electric transmission system, or grid. These products include advanced batteries, ultracapacitors, microturbines, flywheels, internal combustion generator sets, superconducting magnetic energy storage devices and other fuel cells using alternative hydrogen supply applications. Improvements are also being made to the existing electric grid. Technological advances in power technology products and improvements in the electric grid may reduce the attractiveness of our regenerative fuel cell systems.

As the markets for PEM fuel-cell related products, on-site hydrogen generation and backup power develop, other large industrial companies may enter these fields and compete with us. These large industrial companies may have the research and development, manufacturing, marketing and sales resources necessary to commercialize hydrogen generators and regenerative fuel cell systems more quickly and effectively than we do.

We depend on our intellectual property and our failure to protect it could enable competitors to market products with similar features that may reduce demand for our products.

If we are unable to protect our intellectual property, our competitors could use our intellectual property to market products similar to our products, which could reduce demand for our products. Our success depends substantially upon the internally developed technology that is incorporated in our products. We may be unable to prevent unauthorized parties from attempting to copy or otherwise obtain and use our products or technology. Policing unauthorized use of our technology is difficult, and we may not be able to prevent misappropriation of our technology, particularly in foreign countries where the laws may not protect our intellectual property as fully as those in the United States. Others may circumvent the trade secrets, trademarks and copyrights that we own and any of the U.S. patents or foreign patents owned by us or subsequently issued to us may be invalidated, circumvented, challenged or rendered unenforceable. In addition, we may not be issued any patents as a result of our pending and future patent applications, and any patents we are issued may not have the breadth of claim coverage sought by us.

Most of our intellectual property is not covered by any patent or patent application. We seek to protect this proprietary intellectual property, which includes intellectual property that may not be patented or patentable, in part by confidentiality agreements with our distributors and employees. These agreements afford only limited protection and may not provide us with adequate remedies for any breach or prevent other persons or institutions from asserting rights to intellectual property arising out of these relationships.

We could incur substantial costs defending our intellectual property from infringement by others.

Unauthorized parties may attempt to copy aspects of our products or to obtain and use our proprietary information. Litigation may be necessary to enforce our intellectual property rights, to protect our trade secrets and to determine the validity and scope of the proprietary rights of others. Any litigation could result in substantial costs and diversion of resources with no assurance of success.

We could incur substantial costs defending against claims that our products infringe on the proprietary rights of others.

The patent situation in the field of PEM fuel cell technology is complex. A large number of patents, including overlapping patents, relating to this technology have been granted worldwide. We are aware of patents in the fuel cell architecture field held by potential competitors and other third parties, including Ballard Power Systems, General Motors, Giner, H-Power, Oronzio deNora Impianti Electrochemical, Packard Instrument, Plug Power, Shinko Pantec, Siemens, Toyota, United Technologies and Whatman. Third parties could claim infringement by us with respect to these patents or other patents or proprietary rights, and we cannot assure you that we would prevail in any such proceeding.

In addition, some of our employees are parties to assignment of invention and nondisclosure agreements with their former employers. These agreements generally grant the former employer rights to technology developed by the employee while employed by the former employer and prohibit disclosure of that technology or other employer information to third parties. We cannot assure you that such employers will not assert claims against us or our employees alleging a breach of those agreements or other violations of their proprietary rights or alleging rights to inventions by our employees, or that we would prevail in any such proceeding.

Any infringement claim against us, whether meritorious or not, could:

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be time-consuming;

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result in costly litigation or arbitration and diversion of technical and management personnel; or

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require us to develop non-infringing technology or to enter into royalty or licensing agreements.

We might not be successful in developing non-infringing technologies. Royalty or licensing agreements, if required, may not be available on terms acceptable to us, or at all, and could significantly harm our business and operating results. A successful claim of infringement against us or our failure or inability to license the infringed or similar technology could require us to pay substantial damages and could harm our business because we would not be able to sell the affected product without redeveloping it or incurring significant additional expense. In addition, to the extent we agree to indemnify customers or other third parties against infringement of the intellectual property rights of others, a claim of infringement could require us to incur substantial time, effort and expense to indemnify these customers and third parties and could disrupt or terminate their ability to use, market or sell our products.

We may not be able to control our warranty exposure, which could increase our expenses.

Any significant incurrence of warranty expense could increase our costs. In addition, any warranty disclaimers we use may not effectively limit our liability. We have experienced problems with certain components, specifically hydrogen sensor modules and cell stacks, in some of our products which require component replacement. We cannot be certain that further problems related to these or other components will not occur and require replacement.

We may be exposed to lawsuits and other claims if our products malfunction, which could increase our expenses, harm our reputation and prevent us from growing our business.

Any liability for damages resulting from malfunctions of our products could be substantial and could increase our expenses and prevent us from growing our business. In particular, hydrogen is a flammable gas and can pose safety risks if not handled properly. In one instance it appears hydrogen, in one of our HOGEN40 series generators leaked into the ambient oxygen stream resulting in a flame that burned several components in the system. Further investigation of this unit revealed the presence of pinholes in the cell membranes, resulting in hydrogen leakage and cell failure. Although we have taken steps to improve safety and reliability in our products, we cannot be certain that future similar malfunctions will not occur. In addition, our products may require modifications to operate properly under extreme temperatures. Potential customers will also rely upon our products for critical needs, such as backup power. A malfunction of our products could result in tort or warranty claims. In addition, a well-publicized actual or perceived problem could adversely affect the market’s perception of our products. This could result in a decline in demand for our products, which would reduce our revenue and harm our business.

Future government regulation may impair our ability to market and sell our products.

Our products are potentially subject to federal, local and foreign laws and regulations governing, among other things, emissions to air as well as laws relating to occupational health and safety. We may incur substantial costs or liabilities in complying with governmental regulations. Our potential customers must also comply with numerous laws and regulations, which could affect their interest in our products. We could incur potentially significant expenditures in complying with environmental and health and safety laws, regulations and requirements that may be adopted or imposed in the future.

We anticipate undergoing a period of rapid growth and our failure to manage this growth could harm our business.

We anticipate undergoing a period of rapid growth in the number of our employees and the scope of our operations. We intend to introduce new products, increase our production capacity and develop additional distributor relationships. Rapid expansion would likely place a significant strain on our senior management team and other resources. In addition, we may be required to hire additional senior management personnel. Our ability to manage growth will depend in part on our ability to continue to enhance our operating, financial and management information systems. Our personnel, systems and controls may be unable to support our growth.

We may not be able to obtain sufficient funds to grow our business.

We have regularly needed to raise funds in order to operate our business and believe we may need to raise additional funds to achieve full commercialization of some or all of our products. If we are unable to raise additional funds when needed, our ability to operate and grow our business could be impaired. We do not know whether we will be able to secure additional funding or funding on terms acceptable to us. Our ability to obtain additional funding will be subject to a number of factors, including market conditions, our operating performance and investor sentiment. These factors may make the timing, amount, terms and conditions of additional funding unattractive to us. If we issue additional equity securities, existing stockholders may experience dilution or be subordinated to any rights, preferences or privileges granted to the new equity holders.

Our revenue and operating results may fluctuate significantly as a result of factors outside of our control, which could cause the market price of our common stock to decline.

We expect our revenue and operating results to vary significantly from quarter to quarter. As a result, quarterly comparisons of our financial results are not necessarily meaningful and you should not rely on them as an indication of our future performance. In addition, due to our stage of development, we cannot predict our future revenue or results of operations accurately. As a consequence, our operating results may fall below the expectations of securities analysts and investors, which could cause the price of our common stock to decline. Factors that may affect our operating results include:

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the status of development of our technology, products and manufacturing capabilities;

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the cost of our raw materials and key components;

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warranty and service cost for products in the field;

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the introduction, timing and market acceptance of new products introduced by us or our competitors;

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the development of our strategic relationships and distribution channels;

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general economic conditions, which can affect our customers’ capital investments and the length of our sales cycle;

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the development of vehicular PEM fuel cells and renewable energy markets; and

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government regulation.

We expect to make significant investments in all areas of our business, particularly in research and product development and in expanding our manufacturing capability. Because the investments associated with these activities are relatively fixed in the short-term, we may be unable to adjust our spending quickly enough to offset any unexpected shortfall in our revenue growth. In addition, because we are in the very early stages of selling our products and have a limited number of customers, we expect our order flow to be uneven from period to period.

Our stock price is likely to be highly volatile and may result in substantial losses for investors purchasing shares.

The market price of our common stock is likely to be highly volatile. The stock market in general, and the market for technology-related stocks in particular, has been highly volatile. As a result, investors in our common stock may experience a decrease in the value of their common stock regardless of our operating performance or prospects. Our common stock may not trade at the same levels as other technology-related stocks and technology-related stocks in general may not sustain their current market prices. In addition, an active public market for our securities may not be sustained.

The trading price of our common stock could be subject to wide fluctuations in response to:

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our perceived prospects;

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variations in our operating results and achievement of key business targets;

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changes in securities analysts’ recommendations or earnings estimates;

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differences between our reported results and those expected by investors and securities analysts;

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announcements of new products by us or our competitors;

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market reaction to any acquisition, joint venture or strategic investments announced by us or our competitors; and

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general economic or stock market conditions unrelated to our operating performance.

In the past, securities class action litigation has often been instituted against companies following periods of volatility in their stock price. This type of litigation could result in substantial costs and divert our management’s attention and resources.

Our executive officers, directors and their affiliates hold a large percentage of our stock and their interests may differ from other stockholders.

Our directors, executive officers and individuals or entities affiliated with our directors as a group beneficially own, as of December 31, 2001, approximately 25% of our outstanding common stock. If these stockholders choose to act or vote together, they will have the power to significantly influence the election of our directors, and the approval of any other action requiring the approval of our stockholders, including any amendments to our certificate of incorporation and mergers or sales of substantially all of our assets. In addition, without the consent of these stockholders, we could be prevented from entering into transactions that could be beneficial to us or our other stockholders. Also, third parties could be discouraged from making a tender offer or bid to acquire us at a price per share that is above the then-current market price.

The provisions of our charter documents and Delaware law could inhibit a takeover that stockholders may consider favorable and diminish the voting rights of the holders of our common stock.

There are provisions in our certificate of incorporation and by-laws that make it more difficult for a third party to acquire, or attempt to acquire, control of Proton, even if a change in control was considered favorable by our stockholders. For example, our board of directors has the authority to issue up to 5,000,000 shares of preferred stock. The board of directors can fix the price, rights, preferences, privileges and restrictions of the preferred stock without any further vote or action by our stockholders. The issuance of shares of preferred stock may delay or prevent a change in control transaction. As a result, the market price of our common stock and the voting and other rights of our stockholders may be adversely affected. The issuance of shares of preferred stock may result in the loss of voting control to other stockholders.

Our charter documents contain other provisions that could have an anti-takeover effect, including:

•

only one of the three classes of directors is elected each year;

•

stockholders have limited ability to remove directors;

•

stockholders cannot take actions by written consent;

•

stockholders cannot call a special meeting of stockholders; and

•

stockholders must give advance notice to nominate directors or submit proposals for consideration at stockholder meetings.

In addition, we are subject to the anti-takeover provisions of Section 203 of the Delaware General Corporation Law, which regulates corporate acquisitions. These provisions could discourage potential acquisition proposals and could delay or prevent a change in control transaction. They could also have the effect of discouraging others from making tender offers for our common stock. These provisions may also prevent changes in our management.

ITEM 3. Quantitative and Qualitative Disclosures About Market Risk

We hold marketable securities consisting of U.S. government and agency securities that are held by two major banking institutions. Our marketable securities portfolio of approximately $147.2 million includes five callable agency securities with a fair market value totaling approximately $22.6 million. In 2002, two investments approximating $10.9 million were called at par. These securities generate a higher relative rate of interest for the Company; in return, the embedded call option gives the issuer the right to buy back the security. Interest rate risk is the major price risk facing our investment portfolio. Such exposure can subject us to economic losses due to changes in the level or volatility of interest rates. Generally, as interest rates rise, prices for fixed income instruments will fall. As rates decline the inverse is true. We attempt to mitigate this risk by investing in high quality issues of short duration. We do not expect any material loss from our marketable securities investments and believe that our potential interest rate exposure is not material.

ITEM 4. Controls and Procedures

(a) Evaluation of disclosure controls and procedures. Based on their evaluation of the Company’s disclosure controls and procedures (as defined in Rules 13a-14(c) and 15d-14(c) under the Securities and Exchange Act of 1934) as of a date within 90 days of the filing date of this Quarterly Report on Form 10-Q, the Company’s chief executive officer and principal financial and accounting officer have concluded that the Company’s disclosure controls and procedures are designed to ensure that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and are operating in an effective manner.

(b) Changes in internal controls. There were no significant changes in the Company’s internal controls or in other factors that could significantly affect these controls subsequent to the date of their most recent evaluation.

PART II.

OTHER INFORMATION

ITEM 1. Legal Proceedings

Between July 3, 2001 and August 29, 2001, four purported class action lawsuits were filed in the United States District Court for the Southern District of New York against the Company and several of its officers and directors as well as against the underwriters who handled the September 28, 2000 initial public offering (“IPO”) of common stock. All of the complaints were filed allegedly on behalf of persons who purchased the Company’s common stock from September 28, 2000 through and including December 6, 2000. The complaints are similar, and allege that the Company’s IPO registration statement and final prospectus contained material misrepresentations and/or omissions related, in part, to excessive and undisclosed commissions allegedly received by the underwriters from investors to whom the underwriters allegedly allocated shares of the IPO. On April 19, 2002, a single Consolidated Amended Complaint was filed, reiterating in one pleading the allegations contained in the previously filed separate actions, including the alleged Class Period of September 28, 2000 through and including December 6, 2000. On July 15, 2002 the Company joined in an omnibus motion to dismiss filed by all issuer defendants named in similar actions which challenges the legal sufficiency of the plaintiffs’ claims, including those in the consolidated amended complaint. Plaintiffs have opposed that motion, which has not yet been heard by the Court. In addition, in August 2002, the plaintiffs agreed to dismiss without prejudice all of the individual defendants from the consolidated complaint. An order to that effect was entered by the Court in October 2002.

The Company believes it has meritorious defenses to the claims made in the complaints and intends to contest the lawsuits vigorously. However, there can be no assurance that we will be successful, and an adverse resolution of the lawsuits could have a material adverse effect on our financial position and results of operation in the period in which the lawsuits are resolved. The Company is not presently able to reasonably estimate potential losses, if any, related to the lawsuits. In addition, the costs to us of defending any litigation or other proceeding, even if resolved in our favor, could be substantial.

ITEM 2. Changes in Securities and Use of Proceeds

On October 4, 2000, we closed an initial public offering of our common stock. The effective date of the Securities Act registration statement for which the use of proceeds information is being disclosed was September 28, 2000, and the Commission file number assigned to the registration statement is 333-39748.

After deducting underwriting discounts and commissions and offering expenses, our net proceeds from the offering were approximately $125.8 million. The net proceeds have been allocated for general corporate purposes and capital expenditures, including purchase of equipment for and leasehold improvements to our planned manufacturing facility, and the possible acquisition of businesses, products or technologies that are complementary to our business. As of September 30, 2002, approximately $28.2 million of the net proceeds of the offering had been used to fund operations and purchase fixed assets. The remaining net proceeds are invested in U.S. Government and Agency securities. In October 2001, we loaned $275,000 of the proceeds to Mr. Schroeder, who is president and a director of the Company. In July 2002, the loan was paid in full. No other portion of the proceeds were paid directly or indirectly to any director, officer or general partner of us or our associates, persons owning ten percent or more of any class of our equity securities, or an affiliate of us.

ITEM 3. Default 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 and Reports on Form 8-K

(a) Exhibits

Exhibit

99.1—Certifications

(b) Reports

on Form 8-K

None.

SIGNATURES

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.

Date: November 12, 2002

PROTON ENERGY SYSTEMS, INC. (Registrant)

By:		/S/ WALTER W. SCHROEDER
		Walter W. Schroeder President and Chief Executive Officer



By:		/S/ JOHN A. GLIDDEN
		John A. Glidden Vice President of Finance (Principal Financial and Accounting Officer

CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the quarterly report on Form 10-Q of Proton Energy Systems, Inc. (the “Company”) for the period ended September 30, 2002 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), the undersigned, Walter W. Schroeder, President and Chief Executive Officer of the Company, hereby certifies, pursuant to 18 U.S.C. Section 1350, that:

(1)

the Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

(2)

the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

Dated: November 12, 2002



		/s/ WALTER W. SCHROEDER
		Walter W. Schroeder
		President and Chief Executive Officer

CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the quarterly report on Form 10-Q of Proton Energy Systems, Inc. (the “Company”) for the period ended September 30, 2002 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), the undersigned, John A. Glidden, Vice President of Finance of the Company, hereby certifies, pursuant to 18 U.S.C. Section 1350, that:

(1)

the Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

(2)

the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

Dated: November 12, 2002



		/s/ JOHN A. GLIDDEN
		John A. Glidden
		Vice President of Finance

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