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Table of Contents
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
 
(Mark One)
x
 
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended September 30, 2002
 
or
 
¨
 
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from                         to                         .
 
Commission File No. 000-31953
 
 
CATALYTICA ENERGY SYSTEMS, INC.
(Exact name of Registrant as specified in its charter)
 
Delaware
  
77-0410420
(State or other jurisdiction of
Incorporation or organization)
  
(IRS Employer
Identification Number)
 
430 Ferguson Drive
Mountain View, California 94043
(Address of principal executive offices)
 
(650) 960-3000
(Registrant’s telephone number, including area code)
 
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x  No ¨
 
Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes  ¨  No  x
 
As of November 12, 2002, there were outstanding 17,560,684 shares of the Registrant’s common stock, par value $0.001, which is the only class of common stock of the Registrant registered under Section 12(g) of the Securities Act of 1933.

Table of Contents
 
CATALYTICA ENERGY SYSTEMS, INC.
 
FORM 10-Q
 
TABLE OF CONTENTS
 
September 30, 2002
 
           
Page No.
PART I.
   
FINANCIAL INFORMATION
       
             
Item 1.
   
Financial Statements
       
             
         
3
             
         
4
             
         
5
             
         
6
             
Item 2.
        
10
             
Item 3.
        
21
             
Item 4.
        
21
             
PART II.
   
OTHER INFORMATION
       
             
Item 6.
        
22
             
         
23
             
         
24

2

Table of Contents
PART I—FINANCIAL INFORMATION
 
ITEM 1.    FINANCIAL STATEMENTS
 
CATALYTICA ENERGY SYSTEMS, INC. (a company in the development stage)
CONSOLIDATED STATEMENTS OF OPERATIONS
for the three and nine-month periods ended September 30, 2002 and 2001
and for the period from January 1, 1988 (inception) through September 30, 2002
(In thousands, except per share amounts)
(Unaudited)
 
    
Three Months Ended September 30,
     
Nine Months Ended September 30,
       
Cumulative Amounts from January 1, 1988 (inception) through September 30, 2002
  
    
2002
     
2001
     
2002
     
2001
       
Revenue:
                                               
Research and development contracts
   
$
1,497
 
   
$
1,177
 
   
$
3,269
 
   
$
4,835
 
     
$
57,309
 
Costs and expenses:
                                               
Research and development
   
 
3,489
 
   
 
3,804
 
   
 
10,548
 
   
 
11,412
 
     
 
94,335
 
Selling, general and administrative
   
 
2,184
 
   
 
661
 
   
 
8,134
 
   
 
4,342
 
     
 
31,225
 
Legal settlements
   
 
—  
 
   
 
3,000
 
   
 
—  
 
   
 
3,000
 
     
 
4,500
 
Spin-off and related transaction costs
   
 
—  
 
   
 
—  
 
   
 
—  
 
   
 
—  
 
     
 
5,304
 
Costs associated with discontinued product line
   
 
—  
 
   
 
—  
 
   
 
—  
 
   
 
—  
 
     
 
9,299
 
    
  
  
  
    
Total costs and expenses
   
 
5,673
 
   
 
7,465
 
   
 
18,682
 
   
 
18,754
 
     
 
144,663
 
    
  
  
  
    
Operating loss
   
 
(4,176
)
   
 
(6,288
)
   
 
(15,413
)
   
 
(13,919
)
     
 
(87,354
)
Interest income, net
   
 
280
 
   
 
671
 
   
 
980
 
   
 
2,041
 
     
 
5,850
 
Loss on equity investments
   
 
—  
 
   
 
(243
)
   
 
—  
 
   
 
(578
)
     
 
(10,258
)
Impairment charge to implied goodwill of an equity investment
   
 
—  
 
   
 
—  
 
   
 
—  
 
   
 
—  
 
     
 
(2,145
)
    
  
  
  
    
Net loss
   
$
(3,896
)
   
$
(5,860
)
   
$
(14,433
)
   
$
(12,456
)
     
$
(93,907
)
    
  
  
  
    
Basic and diluted net loss per share
   
$
(0.22
)
   
$
(0.37
)
   
$
(0.82
)
   
$
(0.90
)
           
    
  
  
  
          
Weighted average shares used in computing basic and diluted net loss per share
   
 
17,548
 
   
 
15,854
 
   
 
17,518
 
   
 
13,856
 
           
    
  
  
  
          
 
See accompanying notes.

3

Table of Contents
CATALYTICA ENERGY SYSTEMS, INC. (a company in the development stage)
CONSOLIDATED BALANCE SHEETS
(In thousands)
 
    
September 30, 2002
     
December 31, 2001
  
    
(Unaudited)
         
ASSETS
                  
Current assets:
                  
Cash and cash equivalents
   
$
60,203
 
   
$
70,064
 
Short-term investments
   
 
10,197
 
   
 
17,583
 
Accounts receivable, net
   
 
1,110
 
   
 
1,324
 
Inventory
   
 
430
 
   
 
178
 
Prepaid expenses and other assets
   
 
422
 
   
 
536
 
    
  
Total current assets
   
 
72,362
 
   
 
89,685
 
    
  
Property and equipment:
                  
Land
   
 
611
 
   
 
—  
 
Building, leasehold improvements and equipment
   
 
18,710
 
   
 
14,682
 
Less accumulated depreciation and amortization
   
 
(11,536
)
   
 
(9,905
)
    
  
    
 
7,785
 
   
 
4,777
 
    
  
Long term deposits
   
 
371
 
   
 
300
 
Notes receivable from related parties, net
   
 
301
 
   
 
378
 
    
  
Total assets
   
$
80,819
 
   
$
95,140
 
    
  
LIABILITIES AND STOCKHOLDERS’ EQUITY
                  
Current liabilities:
                  
Accounts payable
   
$
629
 
   
$
829
 
Accrued payroll and benefits
   
 
2,236
 
   
 
2,432
 
Accrued legal settlements
   
 
750
 
   
 
3,000
 
Accrued liabilities and other
   
 
1,227
 
   
 
2,034
 
Current portion of long-term debt and capital lease obligations
   
 
196
 
   
 
60
 
    
  
Total current liabilities
   
 
5,038
 
   
 
8,355
 
Long-term debt and capital lease obligations
   
 
3,077
 
   
 
63
 
    
  
Total liabilities
   
 
8,115
 
   
 
8,418
 
    
  
Stockholders’ equity:
                  
Common stock
   
 
18
 
   
 
17
 
Additional paid-in capital
   
 
166,761
 
   
 
166,439
 
Deferred compensation
   
 
(168
)
   
 
(260
)
Deficit accumulated during the development stage
   
 
(93,907
)
   
 
(79,474
)
    
  
Total stockholders’ equity
   
 
72,704
 
   
 
86,722
 
    
  
Total liabilities and stockholders’ equity
   
$
80,819
 
   
$
95,140
 
    
  
 
See accompanying notes.

4

Table of Contents
CATALYTICA ENERGY SYSTEMS, INC. (a company in the development stage)
CONSOLIDATED STATEMENTS OF CASH FLOWS
for the nine-month periods ended September 30, 2002 and 2001
and for the period from January 1, 1988 (inception) through September 30, 2002
(In thousands)
(Unaudited)
 
    
Nine Months Ended September 30,
       
Cumulative Amounts from January 1, 1988 (inception) through September 30, 2002
  
    
2002
     
2001
       
Cash flows from operating activities:
                             
Net loss
   
$
(14,433
)
   
$
(12,456
)
     
$
(93,907
)
Adjustments to reconcile net loss to net cash used in operating activities:
                             
Depreciation and amortization
   
 
2,159
 
   
 
1,318
 
     
 
4,649
 
Notes payable issued for contract modification
   
 
200
 
   
 
—  
 
     
 
200
 
Forgiveness of notes receivable from related parties
   
 
—  
 
   
 
100
 
     
 
723
 
Provision for uncollectable accounts
   
 
—  
 
   
 
(200
)
     
 
500
 
Loss on equity investments
   
 
—  
 
   
 
577
 
     
 
10,258
 
Stock based compensation
   
 
104
 
   
 
184
 
     
 
936
 
Impairment charge to implied goodwill of an equity investment
   
 
—  
 
   
 
—  
 
     
 
1,645
 
Changes in:
                             
Accounts and notes receivable
   
 
204
 
   
 
879
 
     
 
(1,501
)
Inventory
   
 
(252
)
   
 
(193
)
     
 
(556
)
Prepaid expenses and other assets
   
 
(15
)
   
 
106
 
     
 
(345
)
Accounts payable
   
 
(125
)
   
 
(822
)
     
 
704
 
Accrued liabilities and other
   
 
(2,782
)
   
 
(1,557
)
     
 
2,210
 
    
  
    
Net cash used in operating activities
   
 
(14,940
)
   
 
(12,064
)
     
 
(74,484
)
    
  
    
Cash flows from investing activities:
                             
Purchases of investments
   
 
(13,586
)
   
 
(3,000
)
     
 
(135,611
)
Maturities of investments
   
 
20,855
 
   
 
7,500
 
     
 
126,410
 
Deposits on facilities
   
 
—  
 
   
 
(300
)
     
 
(400
)
Contributions in equity investments
   
 
—  
 
   
 
(1,894
)
     
 
(11,445
)
Loans to equity investments
   
 
(500
)
   
 
—  
 
     
 
(500
)
Additions to property, plant and equipment, net
   
 
(4,951
)
   
 
(945
)
     
 
(10,005
)
    
  
    
Net cash provided by (used in) investing activities
   
 
1,818
 
   
 
1,361
 
     
 
(31,551
)
    
  
    
Cash flows from financing activities:
                             
Proceeds from issuance of long-term debt, net of repayments
   
 
2,996
 
   
 
—  
 
     
 
2,996
 
Net payments on capital lease obligations
   
 
(46
)
   
 
—  
 
     
 
193
 
Net issuance of notes receivable to employees and related parties
   
 
—  
 
   
 
(28
)
     
 
(1,451
)
Advances from Catalytica, Inc.
   
 
—  
 
   
 
—  
 
     
 
41,934
 
Payments to Catalytica, Inc.
   
 
—  
 
   
 
(719
)
     
 
(16,441
)
Proceeds from issuance of common stock to employees through stock plans
   
 
311
 
   
 
816
 
     
 
1,293
 
Proceeds from issuance of common stock in connection with spin-off from Catalytica, Inc.
   
 
—  
 
   
 
—  
 
     
 
50,000
 
Proceeds from issuance of common and Series A preferred stock at inception
   
 
—  
 
   
 
—  
 
     
 
10,150
 
Proceeds from issuance of Series B preferred stock and option
   
 
—  
 
   
 
—  
 
     
 
29,922
 
Proceeds from follow-on offering, net
   
 
—  
 
   
 
47,746
 
     
 
47,642
 
    
  
    
Net cash provided by financing activities
   
 
3,261
 
   
 
47,815
 
     
 
166,238
 
    
  
    
Net increase (decrease) in cash and cash equivalents
   
 
(9,861
)
   
 
37,112
 
     
 
60,203
 
Cash and cash equivalents at beginning of period
   
 
70,064
 
   
 
54,222
 
     
 
—  
 
    
  
    
Cash and cash equivalents at end of period
   
$
60,203
 
   
$
91,334
 
     
$
60,203
 
    
  
    
Additional disclosure of cash flow information:
                             
Forgiveness of notes receivable from employees
   
$
45
 
   
$
43
 
     
$
434
 
    
  
    
Deferred compensation for issuance and revaluation of stock options to non-employees
   
$
10
 
   
$
64
 
     
$
599
 
    
  
    
Assets invested in NovoDynamics, Inc.
   
$
—  
 
   
$
—  
 
     
$
567
 
    
  
    
 
See accompanying notes.

5

Table of Contents
 
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
1.    Basis of presentation
 
Catalytica Energy Systems, Inc. (“Catalytica Energy,” “the Company” or “we”) operated as an element of Catalytica, Inc.’s research and development activities from inception through the date of its incorporation as a separate division. In 1995, Catalytica Energy (formerly Catalytica Combustion Systems, Inc.) was incorporated and became a subsidiary of Catalytica, Inc. In December 2000, Catalytica Energy was combined with Catalytica Advanced Technologies, Inc., was spun off from Catalytica, Inc. and initiated operations as a stand-alone public entity. Catalytica Energy designs, develops and manufactures advanced products for cleaner energy production. Catalytica Energy is in the development stage.
 
The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles for interim financial information generally accepted in the United States 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 generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and nine-month periods ended September 30, 2002 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2002. Certain amounts for prior periods have been reclassified to conform to the current presentation. For further information, refer to the financial statements and footnotes thereto included in the Catalytica Energy Systems, Inc. Annual Report on Form 10-K for the year ended December 31, 2001.
 
Catalytica Energy operates as one business segment. Consequently, segment disclosure as of and for the three and nine-month periods ended September 30, 2002 and 2001 is not provided.
 
2.    Impact of recently issued accounting standards
 
In August 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”), which was effective for fiscal periods beginning after December 15, 2001 and superseded SFAS 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of.” SFAS 144 provided a single model for accounting and reporting for the impairment and disposal of long-lived assets. The statement also set new criteria for the classification of assets held-for-sale and changed the reporting of discontinued operations. The Company adopted this statement during the first quarter of fiscal 2002. Adoption of this statement did not have a material effect on our financial position or results of operations.
 
3.    Loss per share
 
Basic and diluted loss per share is presented in accordance with Statement of Financial Accounting Standards No. 128, “Earnings Per Share.” As the Company’s potentially dilutive securities (stock options and warrants) were anti-dilutive for the three and nine-month periods ended September 30, 2002 and 2001, they have been excluded from the computation of weighted-average shares outstanding used in computing diluted net loss per share. Total options and warrants outstanding as of September 30, 2002 and 2001 were 2,282,000 and 1,848,000, respectively.
 
(in thousands, except per share amounts)
   
Three months ended September 30,
     
Nine months ended September 30,
  
    
 2002 
     
 2001 
     
 2002 
     
 2001 
  
Numerator for basic and diluted net loss per share—net loss
   
$
(3,896
)
   
$
(5,860
)
   
$
(14,433
)
   
$
(12,456
)
    
  
  
  
Denominator for basic and diluted net loss per share—weighted average shares outstanding
   
 
17,548
 
   
 
15,854
 
   
 
17,518
 
   
 
13,856
 
    
  
  
  
Basic and diluted net loss per share
   
$
(0.22
)
   
$
(0.37
)
   
$
(0.82
)
   
$
(0.90
)
    
  
  
  
 

6

Table of Contents
4.    Long-term debt and capital lease obligations
 
In March 2002, Catalytica Energy received a term loan of $3,010,000 from the Arizona State Compensation Fund. Proceeds of this loan were applied to the purchase of a 43,000 square foot manufacturing and administrative facility in Gilbert, Arizona. This five-year term loan bears interest at a fixed annual rate of 7.4% and matures in April 2007. Payments of principal and interest totaling $21,000 are due monthly with a final principal payment of $2,844,000 due at maturity. This loan is secured by a deed of trust in the acquired real property.
 
Pursuant to an April 2002 settlement agreement with Woodward Governor Company (see Notes 6 and 8), Catalytica Energy recorded two notes payable of $100,000 each at March 31, 2002. These notes are non-interest bearing and are due in full in January 2003 and January 2004.
 
Catalytica Energy leases furniture and computer equipment under various capital lease agreements which expire in the fourth quarter of 2003 and the first quarter of 2004. The total balance outstanding under these capital lease agreements at September 30, 2002 was $77,000.
 
5.    NovoDynamics, Inc.
 
In March 2001, Catalytica Energy entered into agreements to invest $2,258,000 in NovoDynamics, Inc. (“NovoDynamics”), a company engaged in the development of data mining, informatics discovery and high throughput synthesis and testing technologies. This amount consisted of an advance of $1,800,000 in cash, forgiveness of an advance of $200,000 made to a company affiliated with NovoDynamics (NonLinear Dynamics, Inc.), and contribution of $258,000 in assets of a wholly owned subsidiary of Catalytica Energy (Catalytica NovoTec, Inc.). In accordance with these agreements, Catalytica Energy completed this investment in NovoDynamics in April 2001. During 2001, Catalytica Energy owned shares of Series A voting preferred stock representing approximately 38% of NovoDynamics’ outstanding equity. Catalytica Energy recorded its investment at cost and, during the period from March 2001 through December 2001, recorded its pro-rata share of losses under the equity method of accounting. During the three and nine-month periods ended September 30, 2001, Catalytica Energy recorded losses totaling $243,000 and $484,000, respectively, related to its equity investment in NovoDynamics.
 
Additionally, in March 2001, Catalytica Energy agreed to loan NovoDynamics up to $1,500,000 if certain milestones were met. On December 31, 2001, Catalytica Energy committed to loan $500,000 of the $1,500,000 to NovoDynamics, which was funded in January 2002. As of December 31, 2001, Catalytica Energy had recorded a note payable for the $500,000 and a receivable of $500,000 on its balance sheet. Because repayment of the note was not certain at the time it was made, an allowance of $500,000 was recorded against the loan and this amount was charged as impairment to implied goodwill of an equity investment on December 31, 2001.
 
On December 31, 2001, Catalytica Energy determined that an impairment in the carrying value of its equity investment in NovoDynamics had occurred which was other than temporary based on NovoDynamics’ financial history and projected future losses. At that time, Catalytica Energy determined that the estimated fair value of its investment in NovoDynamics was zero and wrote off its net investment amount of $1,645,000 as impairment to implied goodwill of an equity investment. At that time, the Company discontinued applying the equity method of accounting because its net investment was zero. Therefore, no loss related to the equity investment in NovoDynamics was recorded during the three and nine-month periods ended September 30, 2002. At September 30, 2002, Catalytica Energy owned approximately 32% of NovoDynamics’ outstanding equity as a result of NovoDynamics issuing approximately $723,000 worth of Series B preferred stock subsequent to Catalytica Energy’s original investment.

7

Table of Contents
 
6.    GENXON Power Systems, LLC
 
GENXON Power Systems, LLC (“GENXON”) was formed in October 1996 as a 50/50 joint venture between Catalytica Energy and Woodward Governor Company (“WGC”) to develop the potential market for upgrading out-of-warranty turbines with new systems to improve emissions and operating performance. In December 2001, Catalytica Energy purchased WGC’s equity interest in GENXON for $10,000, making it the sole equity owner of GENXON. As part of the purchase agreement between Catalytica Energy and WGC, Catalytica Energy obtained a commitment from WGC to pay 50% of the first $3,000,000 and 30% of any amount above $3,000,000 of any settlement or judgment in the then pending City of Glendale, California lawsuit against Catalytica Energy, Catalytica, Inc. and GENXON, except for damages specified to have been awarded due to fraud or misrepresentation by Catalytica, Inc., Catalytica Combustion Systems, Inc. or Catalytica Energy (see Note 8). Also in December 2001, Catalytica Energy entered into an agreement with WGC which assigned a patent held by WGC to Catalytica Energy in exchange for royalty and license arrangements between WGC and Catalytica Energy.
 
The Company recorded its investment in GENXON under the equity method of accounting from inception through November 2001. During the nine months ended September 30, 2001, Catalytica Energy recorded losses totaling $94,000 related to its equity investment in GENXON as a result of funding a capital contribution in an equal amount during the period. The financial statements of Catalytica Energy and GENXON were consolidated in December 2001 and, therefore, no loss was recorded during the three and nine-month periods ended September 30, 2002.
 
7.    Shareholder Rights Plan
 
On January 29, 2002, the Board of Directors of Catalytica Energy adopted a Shareholder Rights Plan. Pursuant to the Shareholder Rights Plan, the Company distributed Preferred Stock Purchase Rights as a dividend at the rate of one Right for each share of the Company’s common stock held by stockholders of record as of February 20, 2002 (the “Record Date”). The Board of Directors also authorized the issuance of Rights for each share of common stock issued after the Record Date, until the occurrence of certain specified events. Each Right entitles the registered holder to purchase from the Company one one-thousandth of a share of Series A Preferred stock at an exercise price of $45, subject to adjustment. The Rights are not exercisable until the earlier of (i) ten business days (or such later date as may be determined by the Board of Directors) following an announcement that a person or group has acquired beneficial ownership of 15% of the Company’s common stock or (ii) ten days (or such later date as may be determined by the Board of Directors) following the announcement of a tender offer which would result in a person or group obtaining beneficial ownership of 15% or more of the Company’s outstanding common stock, subject to certain exceptions. The Company is entitled to redeem the Rights, for $0.001 per Right, at the discretion of the Board of Directors, until certain specified times. The Company may also require the exchange of Rights, under certain additional circumstances. The Company also has the ability to amend the Rights, subject to certain limitations.
 
8.    Contingencies
 
On August 14, 2000, the City of Glendale, California filed a complaint against Catalytica Energy, Catalytica, Inc. and GENXON, asserting claims for breach of contract, breach of the covenants of good faith and fair dealing, fraud and negligent misrepresentation arising out of defendants’ termination of the September 16, 1996 Technical Services Agreement between the City of Glendale and Catalytica, Inc. Defendants filed a cross-complaint on June 1, 2001 for a declaratory judgment.
 
On March 22, 2002, the parties entered into a settlement agreement with respect to this litigation. Under the terms of the settlement agreement, Catalytica Energy paid the City of Glendale $3,000,000 in April 2002, and all parties dismissed and released all claims arising out of the Technical Services Agreement and/or relating to the claims asserted in the City of Glendale’s complaint and the cross-complaint. Based on an agreement between WGC and Catalytica Energy entered into effective December 2001 (the “GENXON Membership Transfer and Settlement Agreement”), Catalytica Energy believed that WGC would reimburse 50% of the settlement amount, or $1,500,000. Accordingly, the Company accrued a net reserve of $1,500,000 as of December 31, 2001 to account for the net settlement payment, of which $250,000 was expensed in 2001. In March 2002, WGC disputed the amount owed to Catalytica Energy as reimbursement of the settlement payment to the City of Glendale. In April 2002, Catalytica

8

Table of Contents
Energy and WGC entered into a settlement and release of claims (the “Settlement Agreement”) with respect to the GENXON Membership Transfer and Settlement Agreement the parties had entered into in December 2001.
 
In accordance with the Settlement Agreement, WGC paid the Company $1,500,000 in April 2002 as reimbursement of half of Catalytica Energy’s settlement payment to the City of Glendale. In return, Catalytica Energy agreed to the amendment of certain provisions of the Control Patent Assignment and Cross License Agreement (“Patent Assignment Agreement”) entered into between Catalytica Energy and WGC on December 19, 2001 and also agreed to pay certain amounts to WGC as described below. The amendments to the Patent Assignment Agreement increased the royalties owed by Catalytica Energy to WGC by $250,000 and required $50,000 of these royalties to be guaranteed and paid in advance. In accordance with the Settlement Agreement, Catalytica Energy paid WGC $250,000 in April 2002, which consisted of a $50,000 prepayment of royalties under the Patent Assignment Agreement as well as a nonrefundable prepayment of $200,000 of control technology license fees for Catalytica Energy’s first four $50,000 sublicenses of WGC control technology. Catalytica Energy owes WGC an additional $200,000 of guaranteed royalties, evidenced by two non-interest bearing $100,000 promissory notes. These notes are due and payable in January 2003 and January 2004 if such amounts have not previously been paid in accordance with the terms of the Patent Assignment Agreement.
 
During the nine months ended September 30, 2002, Catalytica Energy recorded a general and administrative expense of $450,000 for the royalties and license fees payable to WGC pursuant to the Settlement Agreement.

9

Table of Contents
 
ITEM 2.    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
Overview
 
This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Words such as “anticipates,” “expects,” “intends,” “plans,” “believes,” “seeks,” “estimates” and similar expressions identify such forward-looking statements. These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those indicated in the forward-looking statements. Factors that could cause actual results to differ include those set forth in the following discussion, and, in particular, the risks discussed below under the subheading “Risks That Could Affect Our Financial Condition and Results of Operations” and in other documents we file with the Securities and Exchange Commission. Unless required by law, we undertake no obligation to update publicly any forward-looking statements.
 
Catalytica Energy Systems, Inc. (“Catalytica Energy,” “the Company” or “we”) designs, develops and manufactures advanced products for cleaner energy production. We are marketing our first commercial product, the Xonon Cool Combustion system (“Xonon”), which prevents the formation of nitrogen oxides (NOx), a significant air pollutant, in stationary gas turbines that are used primarily for electric power generation. Our Xonon system is the only commercially available pollution prevention technology proven to achieve ultra-low emissions during combustion.
 
Our costs to date, excluding approximately $9 million associated with the discontinued product line of Advanced Sensor Devices, an inactive subsidiary of Catalytica Energy, have primarily consisted of expenses to support Xonon development. As we begin to fulfill commercial orders, we will incur cost of goods sold expenses.
 
Primarily all of our revenue to date has consisted of revenue from research and development contracts funded by gas turbine manufacturers, government sources or research institutions, as well as contracted and collaborative research. These contracts provide for partial recovery of our direct and indirect costs. The timing of these reimbursements varies from year to year, and from contract to contract, based on the terms agreed upon by us and the funding party.
 
Most of our research and development contracts are subject to periodic review by the funding partner, which may result in modifications, termination of funding or schedule delays. We cannot ensure that we will continue to receive research and development funding. In return for funding development, collaborative partners may receive certain rights in the commercialization of any resulting technology, including royalty payments on future sales (see “Other Commitments”). We expect to continue to pursue funded research programs. These may not, however, be a continual source of revenue. Due to the nature of our operating history, period comparisons of revenues are not necessarily meaningful and should not be relied upon as indications of future performance.
 
Results of Operations
 
Revenue.    Revenue includes research and development contracts funded by gas turbine manufacturers, government sources or research institutions, the timing of which may vary from period to period based on the terms agreed upon by us and the funding party.
 
    
Three Months Ended
September 30,
            
Nine Months Ended
September 30,
         
    
2002
   
2001
     
% Change
     
2002
   
2001
     
% Change
  
Research and development contracts
   
$
1,497
   
$
1,177
     
27
%
   
$
3,269
   
$
4,835
     
(32
)%
 
Revenue during the nine months ended September 30, 2002 declined from the corresponding period of 2001 primarily as a result of a reduction in funding from a gas turbine manufacturer. During 2002, revenue from this

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program to apply Xonon technology to the manufacturer’s gas turbine engines was reduced as the engine development stage was completed and final preparations began for prototype testing. Two new contracts commenced during the three months ended September 30, 2002: one with a state governmental agency to apply Xonon technology to multi-combustor gas turbine engines and another with a gas turbine engine manufacturer to apply Xonon technology and design a pre-mixer assembly for its gas turbine engines. Total revenue recorded during the three months ended September 30, 2002 on these new contracts was $716,000, which favorably impacted revenue compared with the corresponding period of 2001.
 
We expect that revenue for the full fiscal year ending December 31, 2002 will be less than that during fiscal year 2001 due reduced billings to a gas turbine engine manufacturer.
 
Research and Development Expenses (“R&D”).    R&D includes compensation, benefits and related costs for engineering and manufacturing staff, fees for contract engineers, materials to build prototype units, amounts paid to outside suppliers for subcontracted components and services, supplies used and allocated facilities and information technology costs. We expense all R&D costs as incurred.
 
    
Three Months Ended
September 30,
            
Nine Months Ended
September 30,
         
    
2002
   
2001
     
% Change
     
2002
   
2001
     
% Change
  
R&D
   
$
3,489
   
$
3,804
     
(8
)%
   
$
10,548
   
$
11,412
     
(8
)%
 
R&D in 2002 has declined slightly from 2001. We have reduced spending on consulting, contracted research and temporary labor as more of these functions have been assumed internally.
 
We expect that the slight decrease in R&D will continue for the full fiscal year ending December 31, 2002 when compared with that during fiscal year 2001.
 
Selling, General and Administrative Expenses (“SG&A”).    SG&A includes compensation, benefits and related costs of corporate functions, which include management, business development, marketing, human resources, sales and finance, and un-allocated facilities and information technology costs.
 
    
Three Months Ended
September 30,
            
Nine Months Ended
September 30,
         
    
2002
   
2001
     
% Change
     
2002
   
2001
     
% Change
  
SG&A
   
$
2,184
   
$
661
     
230
%
   
$
8,134
   
$
4,342
     
87
%
 
In September 2001, the Company received refunds of investment banking fees totaling $875,000 incurred in conjunction with the December 2000 spin-off transaction from Catalytica, Inc. These refunds became payable upon the completion of a follow-on public offering in August 2001. The refunds of $875,000 were received during the three months ended September 30, 2001 and were recorded as a reduction of SG&A during the three and nine-month periods ended September 30, 2001. SG&A during the three and nine-month periods ended September 30, 2001 was also reduced by rent participation payments of $237,000 and $559,000, respectively, from sub-tenant contracts which terminated prior to 2002.
 
Included in SG&A during the nine months ended September 30, 2002 is a charge of $450,000 related to an April 2002 settlement agreement with Woodward Governor Company (“WGC”) with respect to the GENXON Membership Transfer and Settlement Agreement the parties had originally entered into in December 2001.
 
Additional items contributing to the increases in SG&A during the three and nine-month periods ended September 30, 2002 compared with the corresponding periods in 2001 include: increases in salaries and benefits of $230,000 and $853,000, respectively, for new positions in marketing, legal, finance and administration; increases of $4,000 and $310,000, respectively, in employee relocation costs to move personnel to our new manufacturing and administrative facility in Gilbert, Arizona; increased depreciation expenfse of $48,000 and $269,000, respectively,

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related to recent capital expenditures including the Gilbert, Arizona manufacturing and administrative facility and other costs associated with the commercialization of Xonon totaling $129,000 and $476,000, respectively.
 
We expect that SG&A for the full fiscal year ending December 31, 2002 will be higher than that during fiscal year 2001 due to the $450,000 settlement agreement with WGC in April 2002, costs related to the commercialization of Xonon, the relocation of certain functions from California to the new manufacturing and administration facility in Arizona and the $875,000 refund of investment banking fees received in September 2001.
 
Legal Settlements.    In September 2001, the Company agreed to a $3,000,000 cash settlement with AGC Manufacturing Services, Inc. and AGC Project Development, Inc. (collectively referred to as “AGC”) in connection with a demand for arbitration filed by AGC with respect to a contract dispute. Terms of the cash settlement require payments by the Company to AGC over a 22-month period commencing in September 2001. During the three months ended September 30, 2001, an expense of $3,000,000 was recorded for the full amount of the settlement. Through September 30, 2002, the Company has paid $2,250,000 of the settlement to AGC and the remaining $750,000 is reflected as an accrued liability.
 
Interest Income, net.    Our interest income primarily consists of interest earned on cash, cash equivalents and short-term investments offset by interest accrued on debt obligations.
 
    
Three Months Ended
September 30,
            
Nine Months Ended
September 30,
         
    
2002
   
2001
     
% Change
     
2002
   
2001
     
% Change
  
Interest income, net
   
$
280
   
$
671
     
(58
)%
   
$
980
   
$
2,041
     
(52
)%
 
Although our average cash balances during the three and nine-month periods ended September 30, 2002 were significantly higher than during the corresponding periods in 2001, interest income decreased due to a significant decline in market interest rates. We expect that interest income during the full fiscal year ending December 31, 2002 will be lower than that during fiscal year 2001.
 
Loss on equity investments.    Combined losses totaling $243,000 and $578,000, respectively, were recorded on our equity investments in NovoDynamics, Inc. (“NovoDynamics”) and GENXON Power Systems, LLC (“GENXON”) during the three and nine-month periods ended September 30, 2001. In December 2001, we recorded an impairment charge to reduce our carrying value in NovoDynamics to zero and discontinued applying the equity method of accounting. Also, in December 2001, the financial statements of Catalytica Energy and GENXON were consolidated when we purchased WGC’s equity interest in GENXON, making us the sole equity owner. Therefore, no loss on equity investments was recorded during the three and nine-month periods ended September 30, 2002. We do not expect to record any loss on equity investments during the fiscal year ending December 31, 2002.
 
Income Taxes.    No benefit from income taxes was recorded on the losses incurred during the three and nine-month periods ended September 30, 2002 and 2001 due to our inability to recognize the benefit from our losses.
 
Critical Accounting Policies and Estimates
 
Our discussion and analysis of financial condition and results of operations are based upon our unaudited interim consolidated financial statements, which have been prepared in accordance with accounting principles for interim financial information generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent liabilities. On an on-going basis, we evaluate our estimates and judgments, including those related to contract terms, equity investments, bad debts, inventories, investments, intangible assets, income taxes, financing operations, restructuring, contingencies and litigation. We base our estimates and judgments on historical experience and on various other factors that we believe to be reasonable under the circumstances, the results of which form the basis of our judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results would differ from these estimates under different assumptions or conditions.

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We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our financial statements. We recognize revenue from our funded research and development contracts as work is performed and billable hours are incurred by us, in accordance with each contract. Since these programs are subject to government audits, we maintain a revenue cost reserve for our government-funded programs in the event any of these funded costs, including overhead, are disallowed. If we underestimate the amount of disallowed funding for a particular program, we will have to reduce our revenue in a subsequent period by the amount by which actual disallowed funding exceeds our estimate. We maintain an allowance for doubtful accounts for estimated losses resulting from the inability of our customers or funding partners to make required payments. If the financial condition of any of our customers or funding partners were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances would be required. We maintain a reserve for notes receivable in the event repayment of a note is uncertain. If the financial condition of any of our debtors were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances or write-offs would be required. Based on the market prices of precious metals, we periodically write down our inventory by an amount equal to the difference between the cost of inventory and its estimated realizable value. If actual market conditions become less favorable, additional inventory write-downs will be required. We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. We record a reserve for contingencies, including litigation settlements, when a liability becomes probable.
 
Liquidity and Capital Resources
 
Prior to our spin-off, Catalytica, Inc. made a $50,000,000 cash investment in us. Additionally, in August 2001, we received net proceeds of $47,642,000 from a public offering of our common stock. At September 30, 2002, we had cash, cash equivalents and short-term investments totaling $70,400,000.
 
Our capital requirements depend on numerous factors, including but not limited to product development and commercialization activities, the timing and level of research and development funding, market acceptance of our products and our rate of sales growth. We expect to devote substantial capital resources to further commercialize our technology, hire and train our production staff, develop and expand our manufacturing capacity, begin production activities and expand our research and development activities. We may enter into acquisitions or strategic arrangements which could require the use of cash or additional equity or debt financing. In addition, a principal repayment of our long-term debt totaling $2,844,000 is due in April 2007. We believe that our available cash, cash equivalents and short-term investments as of September 30, 2002 will provide sufficient capital to fund operations as presently planned for at least the next twelve months.
 
In March 2002, we received a term loan of $3,010,000 from the Arizona State Compensation Fund. Proceeds of this loan were applied to the purchase of a 43,000 square foot manufacturing and administrative facility in Gilbert, Arizona. This five-year term loan bears interest at a fixed annual rate of 7.4% and matures in April 2007. Payments of principal and interest totaling $21,000 are due monthly with a final principal payment of $2,844,000 due at maturity. This loan is secured by a deed of trust in the acquired real property.
 
We have never paid cash dividends on our common stock or any other securities. We anticipate that we will retain any future earnings for use in the expansion and operation of our business and do not anticipate paying cash dividends in the foreseeable future.
 
Other Commitments
 
In December 2000, we agreed to indemnify DSM Catalytica, Inc. (“DSM”), the successor corporation to Catalytica, Inc., for liabilities related to us and Catalytica Advanced Technologies, Inc. incurred prior and subsequent to our spin-off from Catalytica, Inc. Additionally, we agreed to indemnify DSM for any costs associated with the merger which were not reduced from the merger consideration distributed to shareholders of Catalytica, Inc. in connection with the merger.
 
We have entered into research collaboration arrangements that may require us to make future royalty payments. These payments would generally be due once specified milestones, such as the commencement of commercial sales

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of a product incorporating the funded technology, are achieved. Currently we have four such arrangements, with Tanaka Kikinzoku Kogyo (“Tanaka”), Gas Technology Institute (“GTI”) (formally known as Gas Research Institute), the California Energy Commission (“CEC”) and WGC.
 
A significant amount of the development effort related to our catalytic combustion technology was funded by Tanaka under a development agreement which divides commercialization rights to the technology between the parties along product market lines. We have exclusive rights to manufacture and market catalytic combustion systems for gas turbines of greater than 25 mega-watt (“MW”) power output and non-exclusive rights for gas turbines of 25 MW power output or less. Tanaka has reciprocal exclusive rights to manufacture and market catalytic combustors for use in automobiles and non-exclusive rights for gas turbines of 25 MW power output or less. In each case, the manufacturing and marketing party will pay a royalty of 5% of net sales to the other party. Each party is responsible for its own development expenses, and any invention made after May 1, 1995 is the sole property of the party making the invention, while the other party has a right to obtain a royalty-bearing, non-exclusive license to use the invention in its areas of exclusivity. As commercialized, the Xonon system contains significant technology developed by us after May 1, 1995 and no technology developed by Tanaka after this date. Our development agreement with Tanaka expires in 2005, and we have no further royalty obligations to Tanaka after 2005.
 
We entered into a funding arrangement with GTI to fund the next generation Xonon combustor and demonstrate its performance. We will be required to make royalty payments to GTI of $243,000 per year for seven years beginning with the sale, lease or other transfer of the twenty-fifth catalyst module for gas turbines rated greater than 1 MW, up to a maximum of $1,701,000.
 
We entered into a funding arrangement with the CEC under which they agreed to fund a portion of our Xonon engine test and demonstration facility located in Santa Clara, California. Under this agreement, we are required to pay a royalty of 1.5% of the sales price on the sale of each product or right developed under this project for fifteen years upon initiation of the first commercial sale of a Xonon-equipped engine greater than 1MW. We have the right to choose an early buyout option for an amount equal to $2,633,000, without a pre-payment penalty, provided that the payment occurs within two years from the date upon which royalties are first due to the CEC.
 
On December 19, 2001, we entered into a Control Patent Assignment and Cross License Agreement (“Patent Assignment Agreement”) with WGC pursuant to which WGC assigned a patent to us, and we and WGC cross-licensed certain intellectual property to each other. Under the Patent Assignment Agreement, we must pay WGC between $5,000 and $15,000 upon each shipment of a Xonon commercial unit. Additionally, as part of an April 2002 settlement agreement with WGC (the “Settlement Agreement”), we agreed to increase royalties by $2,500 per unit on our shipment of the first 100 gas turbines greater than 10MW. These increased royalties are guaranteed, and we must pay them on 100 units even if we do not ship any units of this size. We prepaid $50,000 of these royalties to WGC in April 2002. We will pay WGC an additional $100,000 in January 2003 and $100,000 in January 2004, if we have not paid such amounts sooner through sales of units in accordance with the Patent Assignment Agreement. These guaranteed payments are in addition to the $5,000 we must pay to WGC under the Patent Assignment Agreement upon each shipment of a Xonon commercial unit in a gas turbine of this size.
 
The Patent Assignment Agreement also provides that each time we sublicense the WGC technology to a gas turbine manufacturer or third party control manufacturer, we will pay WGC a control technology license fee of $50,000, as well as a $3,000 additional license fee for each sale of a Xonon control system sold by such manufacturer. As a part of the Settlement Agreement, we paid $200,000 representing a pre-payment of the control technology license fees for our first four $50,000 sublicenses of the WGC control technology. We are obligated to make the foregoing license payments to WGC through December 31, 2014 or until our cumulative payments and license fees to WGC total $15,250,000, whichever occurs first.
 
WGC must pay us a fee of 1% of the sale price of each WGC control system installed in conjunction with Xonon catalytic modules for new and retrofit turbines. WGC is obligated to make these payments through December 31, 2014 or until we have received total payments of $2,000,000, whichever occurs first.

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Impact of Inflation and Foreign Currency Fluctuation
 
The effects of inflation and changing prices on our operations were not significant during the periods presented. We have operated primarily in the United States and all revenue recognized to date has been in U.S. dollars. Accordingly, we have not had any material exposure to foreign currency rate fluctuations.
 
RISKS THAT COULD AFFECT OUR FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
The following risk factors could materially and adversely affect our future operating results and could cause actual events to differ materially from those predicted in the forward-looking statements we make about our business. You should carefully consider the risks described below before you decide to buy, hold or sell our common stock.
 
We are a development stage company and your basis for evaluating us is limited.
 
Our activity to date has primarily consisted of developing the Xonon technology and designing products for its commercialization. Accordingly, there is only a limited basis upon which you can evaluate our business and prospects. Since we are a development stage company, our revenue will initially be low and may vary significantly from quarter to quarter. You should consider the challenges, expenses and difficulties that we will face as a development stage company seeking to develop, manufacture and sell a new product.
 
We have incurred losses and anticipate continued operating losses.
 
As of September 30, 2002, we had an accumulated deficit of $93,907,000 and had not yet recorded any revenue from commercial sales. We have not achieved profitability and expect to continue to incur net losses for at least the next several years. Even if we do achieve profitability, we may be unable to sustain or increase our profitability in the future.
 
We must successfully complete further development and adaptation work before Xonon-equipped gas turbines can be shipped.
 
Incorporating our technology in each gas turbine model requires adaptation work by us and the manufacturer of the turbine engine, or original equipment manufacturer (“OEM”), such as additional engineering work and, for some turbines, technology development. Except with respect to the Kawasaki 1.4 MW gas turbine, that work has not yet been completed. We may not be successful in adapting Xonon technology to particular gas turbine models, and even if we are successful, the development work may result in delays in commercial shipment. Delays in completing this work could result in the loss of orders, and the emergence of significant technical issues could result in termination by OEMs of certain agreements to adapt Xonon to their gas turbines. Due to the current depressed market conditions and the longer lead times required to apply Xonon technology to engines which generate more than 20 MW of electric power, we do not expect that Xonon modules for these gas turbines will comprise a significant portion of our revenue in the foreseeable future.
 
We are heavily dependent on our relationships with OEMs and their commitment to adopt and market Xonon technology on their gas turbines, and some of our agreements with OEMs may limit our market opportunities.
 
Aside from revenue earned under research and development contracts, substantially all of our revenue for the foreseeable future will be derived from sales of Xonon modules to manufacturers of gas turbines for use in their new and installed turbines. We have ongoing programs with several OEMs which are in various stages of incorporating our Xonon technology into, or evaluating our Xonon technology for incorporation into, their gas turbine product lines. These and future OEMs may decide not to continue the development and commercialization of Xonon combustion systems for their gas turbines.
 
Our agreements with OEMs generally provide the OEM with the right to be the exclusive market channel for distribution of Xonon combustion systems in that OEM’s gas turbines. Our OEM agreements generally provide that either party can terminate the agreement, but not necessarily the exclusivity, if technical issues arise that cannot be

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resolved. A decision by an OEM to discontinue the commercialization of Xonon combustion systems in its product line could significantly limit or foreclose our access to the market for that OEM’s turbines.
 
Moreover, some of our agreements provide the OEM limited exclusivity, which prevents us from entering into agreements with other OEMs regarding the application of Xonon to some of their competing turbines.
 
Our ability to sell Xonon modules for those gas turbines for which Xonon combustion systems become commercially available is heavily dependent upon the OEMs’ marketing and sales strategies for Xonon combustion systems and their worldwide sales and distribution networks and service capabilities. Any decision on their part to limit, constrain or otherwise fail to aggressively market and sell Xonon combustion systems, including limiting their availability or pricing them uncompetitively, could harm our potential earnings by depriving us of full access to their markets.
 
We will incur significant costs in developing our technology with OEMs. If any OEM does not complete development for any reason, we may not be able to recover costs incurred for the development with that OEM.
 
We incur significant costs in developing our technology with OEMs. We recover a portion of these costs through contractual reimbursement from the OEMs. However, we bear the balance of the development costs ourselves. If OEMs do not complete development work for any reason, we will not be able to recover our share of development costs through product sales.
 
Xonon-equipped gas turbines may never attain market acceptance.
 
Xonon-equipped gas turbines represent an emerging market. If Xonon technology does not attain market acceptance, end-users may not want to purchase turbines equipped with Xonon modules. If a significant commercial market fails to develop or develops more slowly than we anticipate, we may be unable to recover the losses incurred to develop our Xonon product and may be unable to achieve profitability. The development of a commercial market for our systems may be impacted by factors that are not within our control, including:
 
 
•
 
The cost competitiveness of the Xonon combustion system;
 
 
•
 
A significant drop in demand for new gas turbines;
 
 
•
 
The future costs of natural gas and other fuels;
 
 
•
 
Changing regulatory requirements;
 
 
•
 
The emergence of alternative technologies and products; and
 
 
•
 
Changes in federal, state or local environmental regulations.
 
Our success depends on the continued demand for gas turbines.
 
A significant portion of the market for Xonon combustion systems will result from the purchase and installation of new Xonon-equipped gas turbines. If the market for gas turbines significantly declines, the demand for Xonon combustion systems will also be reduced. The market for new gas turbines has historically been cyclical in nature and has recently experienced a slowdown due to economic factors. If this pattern continues in the future, then during periods of low demand the portion of our business derived from new turbine sales will decline.
 
Competition from alternative technologies may adversely affect our profitability.
 
The market for emissions reduction technologies is intensely competitive. There are alternative technologies which, when used in combination, reduce gas turbine emissions to levels comparable to or lower than Xonon-

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equipped gas turbines. These technologies include lean pre-mix combustion systems, which are used in conjunction with gas turbine exhaust cleanup systems such as selective catalytic reduction. Lean pre-mix systems are offered by several gas turbine OEMs, each of whom may prefer to use their internally developed emissions reduction technology rather than ours. There are also a number of companies, universities, research institutions and governments engaged in the development of emissions reduction technologies that could compete with the Xonon technology.
 
We may be unable to raise additional capital to complete our product development and commercialization plans.
 
Our capital requirements depend on numerous factors, including but not limited to product development and commercialization activities, the timing and level of research and development funding, market acceptance of our products and our rate of sales growth. We face substantial uncertainties with our business operations and may not be able to achieve the cash flows that we currently predict. We expect to devote substantial capital resources to further commercialize our technology, hire and train our production staff, develop and expand our manufacturing capacity, begin production activities and expand our research and development activities. We may enter into acquisitions or strategic arrangements which could require the use of cash or additional equity or debt financing. In addition, a principal repayment of our long-term debt totaling $2,844,000 is due in April 2007. We believe that our available cash, cash equivalents and short-term investments as of September 30, 2002 will provide sufficient capital to fund operations as presently planned for at least the next twelve months.
 
Despite our current expectations, we may need to raise additional funds to achieve full commercialization of the Xonon combustion systems and other potential products, or to meet other capital requirements, in the event our current plans prove insufficient. Any required funding may not be available when required or, may be available only on terms unsatisfactory to us. Further, if we issue equity securities, the ownership percentage of our stockholders will be reduced, and the holders of new equity securities may have rights senior to those of our existing common stockholders.
 
We have limited experience manufacturing Xonon modules on a commercial basis.
 
To date, we have focused primarily on research and development and have limited experience manufacturing Xonon modules on a commercial basis. We may not be able to develop efficient, low-cost manufacturing capability and processes that will enable us to meet the quality, price, engineering, design and production standards or production volumes required to manufacture Xonon modules on a commercial scale. We may also encounter difficulty purchasing components and materials, particularly those with long lead times. Even if we are successful in developing our manufacturing capability and processes, we do not know whether we will do so in time to meet our product commercialization schedule or to satisfy the requirements of our customers.
 
We are dependent on third party suppliers for the development and supply of key components for our products.
 
We have recently entered into commercial arrangements with suppliers of the key components of our systems. We do not know, however, when or whether we will secure arrangements with suppliers of other required materials and components for our Xonon modules, or whether these arrangements will be on terms that will allow us to achieve our objectives. If we fail to obtain suppliers of all the required materials and components for our systems, our business could be harmed. A supplier’s failure to supply materials or components in a timely manner, its failure to supply materials or components that meet our quality, quantity or cost requirements, or our inability to obtain substitute sources of these materials and components on a timely basis or on terms acceptable to us, could harm our ability to manufacture our Xonon modules. One of our components is provided by a single supplier and is not currently available from any other supplier. Additionally, some of our suppliers use proprietary processes to manufacture components. Although alternative suppliers are available, a switch in suppliers could be costly and take a significant amount of time to accomplish.

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If the initial orders for Xonon-equipped turbines do not ship, we will lose the potential revenue associated with these orders and our reputation could be adversely affected. In addition, we would have lost the opportunity to pursue development for other sales.
 
Although our OEM customers have received initial orders for Xonon-equipped gas turbines, we cannot ensure that these orders will ultimately be shipped. There are many reasons why these orders might not ship, including:
 
 
•
 
A failure by us and the OEM to complete necessary development, design and adaptive work;
 
 
•
 
A decision by the OEM not to include Xonon-based systems in its turbines, or in a particular turbine model, for commercial or other reasons; and
 
 
•
 
Cancellation of the OEM’s turbine order by the end-user due to its inability to obtain permits, or for commercial or other reasons.
 
If the initial announced orders for Xonon-equipped turbines do not ultimately ship, we would lose the potential revenue associated with these orders, and, depending on the stated reasons for and market perceptions of the cancellation, our reputation could be adversely affected. In addition, by concentrating our development efforts on the turbines for which orders were cancelled, we would have lost the opportunity to pursue development for other sales.
 
Xonon combustion systems will be deployed in complex and varied operating environments, and they may have limitations or defects that we find only after full deployment.
 
Gas turbines equipped with Xonon combustion systems are expected to be subjected to a variety of operating conditions and to be deployed in a number of extremely demanding environments. For example, gas turbines will be deployed in a wide range of temperature conditions, in the presence of atmospheric or other contaminants, under a wide range of operating requirements and with varying maintenance practices. As a result, technical limitations may only become apparent in the field after many Xonon-equipped gas turbines have been deployed. These limitations could require correction, and the corrections could be expensive. In addition, the need to develop and implement these corrections could temporarily delay the sale of new Xonon-equipped gas turbines.
 
Any failure of gas turbines incorporating our technology could damage our reputation, reduce our revenues or otherwise harm our business.
 
The Xonon combustion system includes components that are located in a critical section of the gas turbine. A mechanical failure of a Xonon-equipped gas turbine may be attributed to the Xonon combustion system, even if the immediate cause is not clear. If this occurs, the reputation of the Xonon combustion system and its acceptability in the marketplace could be negatively impacted.
 
We may have difficulty managing the expansion of our operations.
 
We expect to undergo growth in the number of our employees, the size of our physical plant and the scope of our operations as demand for our products increases. Continuing expansion of our manufacturing operations will require significant management attention. This expansion is likely to place a significant strain on our management team and other resources. Our business could be harmed if we encounter difficulties in effectively managing the issues presented by such an expansion.
 
If we are unable to attract or retain key personnel, our ability to adapt our technology to gas turbines, to continue to develop our technology, to effectively market our product and to manage our business could be harmed.
 
Our business requires a highly skilled management team and specialized workforce, including scientists, engineers, researchers, and manufacturing and marketing professionals who have developed essential proprietary skills. Our future success will therefore depend on attracting and retaining additional qualified management and technical personnel. We do not know whether we will be successful in hiring or retaining these qualified personnel.

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Our inability to hire qualified personnel on a timely basis, or the departure of key employees, could harm our expansion and commercialization plans.
 
Significant price increases in key materials may reduce our gross margins and profitability.
 
The prices of palladium and platinum, which are used in the production of Xonon modules, can be volatile. For example, during the period from September 2001 to September 2002, the price of palladium ranged from $315 to $466 per troy ounce. During that period, the price of platinum ranged from $415 to $574 per troy ounce. If the long-term costs of these materials were to increase significantly, we would, in addition to recycling materials from returned modules, attempt to reduce material usage or find substitute materials. If these efforts were not successful or if these cost increases could not be passed onto the customers of Xonon modules, then our gross margins and profitability would be reduced.
 
We have not yet developed Xonon systems for dual fuel turbines, which may account for a portion of our market.
 
We believe that a portion of new electric generation projects may require turbines powered by natural gas and an alternative liquid fuel. These turbines are known as “dual fuel.” We do not know what portion of the market dual fuel turbines may represent in the future. Xonon is in the development stage for use in dual fuel turbines, and we have not undertaken the adaptation work for any particular turbine models. The necessary adaptation work for specific turbine models may delay availability, or even be unsuccessful, which could limit our markets and adversely affect our sales.
 
If we are unable to protect our intellectual property, others may duplicate our technology.
 
We rely on a combination of patents, copyrights and trade secret laws and restrictions on disclosure to protect our intellectual property rights. Our ability to compete effectively will depend, in part, on our ability to protect our proprietary technology, systems designs and manufacturing processes. The ability of others to use our intellectual property could allow them to duplicate the benefits of our product and reduce our competitive advantage. We do not know whether any of our pending patent applications will issue or, in the case of patents issued or to be issued, that the claims allowed are or will be sufficiently broad to protect our technology or processes. Even if all our patent applications are issued and are sufficiently broad, they may be challenged or invalidated. We could incur substantial costs in prosecuting or defending patent infringement suits. While we have attempted to safeguard and maintain our proprietary rights, we do not know whether we have been or will be completely successful in doing so.
 
Further, our competitors may independently develop or patent technologies or processes that are substantially equivalent or superior to ours. If we are found to be infringing on third party patents, we may be unable to obtain licenses to use those patents on acceptable terms, or at all. Failure to obtain needed licenses could delay or prevent the development, manufacture and sale of our systems.
 
We rely, in part, on contractual provisions to protect our trade secrets and proprietary knowledge. These agreements may be breached, and we may not have adequate remedies for any breach. Our trade secrets may also be known without breach of such agreements or may be independently developed by competitors.
 
The market price of our common stock is highly volatile and may decline.
 
The market price of our common stock is highly volatile. Factors that could cause fluctuation in our stock price may include, among other things:
 
 
•
 
announcements or cancellations of orders or research and development arrangements;
 
 
•
 
changes in financial estimates by securities analysts;
 
 
•
 
conditions or trends in our industry;

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•
 
changes in the market valuations of other companies in our industry;
 
 
•
 
the effectiveness and commercial viability of products offered by us or our competitors;
 
 
•
 
the results of our research and development;
 
 
•
 
announcements by us or our competitors of technological innovations, new products, significant acquisitions, strategic partnerships, divestitures, joint ventures or other strategic initiatives;
 
 
•
 
changes in environmental regulations;
 
 
•
 
additions or departures of key personnel; and
 
 
•
 
sales of our common stock.
 
Many of these factors are beyond our control. These factors may cause the market price of our common stock to decline regardless of our operating performance. In addition, stock markets have experienced extreme price volatility in recent years. This volatility has had a substantial effect on the market prices of securities issued by many companies for reasons that may be unrelated to the operating performance of the specific companies. These broad market fluctuations may adversely affect the market price of our common stock.
 
Because a small number of stockholders own a significant percentage of our common stock, they may exert significant influence over major corporate decisions, and our other stockholders may not be able to do so.
 
As of September 30, 2002, our executive officers, directors and greater than 5% stockholders controlled approximately 47% of our outstanding common stock. If these parties were to act together, they could significantly influence the election of directors and the approval of actions requiring the approval of a majority of our stockholders. The interests of our management or these investors may not always be aligned with the interests of our other stockholders.
 
Based on shares outstanding as of September 30, 2002, the funds managed by Morgan Stanley Private Equity and their affiliates own 19% of our outstanding common stock. The Morgan Stanley Private Equity funds also have stockholder rights, including rights to appoint directors and registration rights. As a result, Morgan Stanley Private Equity and its affiliates hold a substantial voting position in us and may be able to significantly influence our business.
 
Liabilities we acquired as a result of our spin-off may have a negative effect on our financial results.
 
We incurred additional liabilities as a result of our spin-off from Catalytica, Inc. For example, when the business of Catalytica Advanced Technologies, Inc. (“CAT”) was combined with ours, we became responsible for the liabilities of CAT. Additionally, we have obligations under the separation agreements we entered into with Catalytica, Inc., Synotex and DSM. For example, we agreed to indemnify DSM Catalytica, Inc., the successor corporation to Catalytica, Inc., for liabilities arising out of our business, the business of CAT and other liabilities of DSM Catalytica, Inc. not associated with the pharmaceuticals business it purchased from Catalytica, Inc.
 
We are also responsible for specified potential liabilities arising out of the distribution of our common stock by Catalytica, Inc. The nature and amount of these potential liabilities cannot be estimated. If these additional liabilities materialize, our financial results could be harmed.

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ITEM
 
3.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive from our investments without significantly increasing risk. Some of the securities that we invest in have market risk. This means that a change in prevailing interest rates would cause the principal amount of the investment to fluctuate. For example, if we hold a security that was issued with a fixed interest rate at the then-prevailing rate and the prevailing interest rate later rises, the principal amount of our investment will decline. In an effort to minimize this risk, we maintain our portfolio of cash equivalents and short-term investments in a variety of securities, including commercial paper, money market funds, and government and non-government debt securities. The average duration of all of our investments in 2002 and 2001 was less than one year. Due to the short-term nature of these investments, we believe we have no material exposure to interest rate risk arising from our investments. Therefore, no quantitative tabular disclosure is required.
 
ITEM
 
4.    EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES
 
 
(a)
 
Evaluation of disclosure controls and procedures.    Our chief executive officer and our chief financial officer, after evaluating the effectiveness of the Company’s “disclosure controls and procedures” (as defined in the Securities Exchange Act of 1934 Rules 13a-14(c) and 15-d-14(c)) as of a date (the “Evaluation Date”) within 90 days before the filing date of this quarterly report, have concluded that as of the Evaluation Date, our disclosure controls and procedures were adequate and designed to ensure that material information relating to us and our consolidated subsidiaries would be made known to them by others within those entities.
 
 
(b)
 
Changes in internal controls.    There have been no significant changes in our internal controls or in other factors that could significantly affect our disclosure controls and procedures subsequent to the Evaluation Date.

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PART II—OTHER INFORMATION
 
Item 6.    EXHIBITS AND REPORTS ON FORM 8-K
 
(a)    Exhibits
 
99.1
   
Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
99.2
   
Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
(b)    Reports on Form 8-K
 
The Company filed no reports on Form 8-K during the quarter ended September 30, 2002.
 
All information required by other items in Part II is omitted because the items are inapplicable, the answer is negative or substantially the same information has been previously reported by the Registrant.

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CATALYTICA ENERGY SYSTEMS, INC.
 
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
      
CATALYTICA ENERGY SYSTEMS, INC.
(Registrant)
           
By:
  
/S/    DENNIS S. RIEBE        
               
Dennis S. Riebe
Vice President of Finance and
Chief Financial Officer
           
 
Signing on behalf of the Registrant and as principal financial officer
 
 

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CATALYTICA ENERGY SYSTEMS, INC.
 
CERTIFICATIONS
 
I, Ricardo B. Levy, certify that:
 
1.    I have reviewed this quarterly report on Form 10-Q of Catalytica Energy Systems, Inc.;
 
2.    Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;
 
3.    Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;
 
4.    The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
 
(a)    designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within these entities, particularly during the period in which this quarterly report is being prepared;
 
(b)    evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and
 
(c)    presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
 
5.    The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):
 
(a)    all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and
 
(b)    any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant ‘s internal controls; and
 
6.    The registrant’s other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
 
Date:    November 12, 2002
 
By:
  
/s/    RICARDO B. LEVY    
Name:
  
Ricardo B. Levy        
Title:
  
Chief Executive Officer        

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I, Dennis S. Riebe, certify that:
 
1.    I have reviewed this quarterly report on Form 10-Q of Catalytica Energy Systems, Inc.;
 
2.    Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;
 
3.    Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;
 
4.    The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
 
(a)    designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within these entities, particularly during the period in which this quarterly report is being prepared;
 
(b)    evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and
 
(c)    presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
 
5.    The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):
 
(a)    all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and
 
(b)    any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant ‘s internal controls; and
 
6.    The registrant’s other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
 
Date:    November 12, 2002
 
By:
  
/s/    DENNIS S. RIEBE    
Name:
  
Dennis S. Riebe             
Title:
  
Chief Financial Officer        
     

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