UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended September 30, 2003
| | TRANSITION REPORT PURSUANT SECTION 13 OR 15 (d)
OF SECURITIES EXCHANGE ACT OF 1934
For the Transition Period From ______to_________
Commission File Number 333-13287
EARTHSHELL CORPORATION
(Exact name of registrant as specified in its charter)
Delaware 77-0322379
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
6740 Cortona Drive, Santa Barbara, California 93117
(Address of principal executive office) (Zip Code)
(805) 571-8232
(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 Exchange Act Rule 12b-2). Yes |X| No | |
The number of shares outstanding of the Registrant's Common Stock as
of November 11, 2003 is 13,988,551.
EARTHSHELL CORPORATION
FORM 10-Q
For the Quarter Ended September 30, 2003
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES
Part I. Financial Information
Item 1. Consolidated Financial Statements Page
a) Consolidated Balance Sheets as of September 30, 2003 (unaudited) and
December 31, 2002............................................................... 1
b) Consolidated Statements of Operations for the three and nine months ended
September 30, 2003 and September 30, 2002 (unaudited) and for the period from
November 1, 1992 (inception) through September 30, 2003 (unaudited)............. 2
c) Consolidated Statements of Stockholders' (Deficit) Equity for the period
from November 1, 1992 (inception) to September 30, 2003 (unaudited)............. 3
d) Consolidated Statements of Cash Flows for the nine months ended
September 30, 2003 and September 30, 2002 (unaudited) and for the
period from November 1, 1992 (inception) through September 30, 2003
(unaudited)..................................................................... 5
e) Notes to Consolidated Financial Statements (unaudited).......................... 7
Item 2. Management's Discussion and Analysis of Financial Condition and Results of
Operations........................................................................... 13
Item 3. Quantitative and Qualitative Disclosures About Market Risk........................... 18
Item 4. Controls and Procedures ............................................................. 18
Part II. Other Information
Item 1. Legal Proceedings.................................................................... 18
Item 2. Changes in Securities and Use of Proceeds............................................ 18
Item 3. Defaults Upon Senior Securities...................................................... 18
Item 4. Submission of Matters to a Vote of Security Holders.................................. 18
Item 5. Other Information.................................................................... 18
Item 6 Exhibits and Reports on Form 8-K..................................................... 18
Signature............................................................................................... 19
EARTHSHELL CORPORATION
(A Development Stage Enterprise)
CONSOLIDATED BALANCE SHEETS
September 30, December 31,
2003 2002
------------------- --------------------
(Unaudited)
ASSETS
CURRENT ASSETS
Cash and cash equivalents........................................... $ 1,469,170 $ 111,015
Restricted cash..................................................... 3,500,000 12,500,000
Prepaid expenses and other current assets........................... 412,849 570,802
------------------- --------------------
Total current assets........................................... 5,382,019 13,181,817
PROPERTY AND EQUIPMENT, NET............................................... 4,137,026 4,476,174
INVESTMENT IN JOINT VENTURE............................................... 112,098 366,012
------------------- --------------------
TOTALS.................................................................... $ 9,631,143 $ 18,024,003
=================== ====================
LIABILITIES AND STOCKHOLDERS' DEFICIT
CURRENT LIABILITIES
Accounts payable and accrued expenses............................... $ 4,921,199 $ 7,904,957
Payable to related party............................................ - 578,779
Accrued purchase commitment......................................... 3,500,000 3,500,000
Notes payable to related party...................................... - 1,745,000
Convertible debentures.............................................. - 7,767,953
------------------- --------------------
Total current liabilities...................................... 8,421,199 21,496,689
PAYABLES TO RELATED PARTY................................................. 1,393,302 -
CONVERTIBLE DEBENTURES.................................................... 5,605,268 -
NOTES PAYABLE TO RELATED PARTY............................................ 2,510,496 -
OTHER LONG-TERM LIABILITY................................................. 50,000 -
------------------- --------------------
Total liabilities.............................................. 17,980,265 21,496,689
STOCKHOLDERS' DEFICIT
Preferred stock, $.01 par value, 10,000,000 shares authorized; 9,170,000
Series A shares designated; no shares issued and outstanding as of
September 30, 2003 and December 31, 2002........................... - -
Common stock, $.01 par value, 25,000,000 shares authorized; 13,892,200 and
12,054,637 shares issued and outstanding as of September 30, 2003
and December 31, 2002, respectively................................. 138,922 120,546
Additional paid-in common capital......................................... 300,682,833 292,257,340
Deficit accumulated during the development stage.......................... (309,133,648) (295,833,940)
Accumulated other comprehensive loss...................................... (37,229) (16,632)
------------------- --------------------
Total stockholders' deficit......................................... (8,349,122) (3,472,686)
------------------- --------------------
TOTALS.................................................................... $ 9,631,143 $ 18,024,003
=================== ====================
See Notes to Consolidated Financial Statements.
1
EARTHSHELL CORPORATION
(A Development Stage Enterprise)
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
November 1,
For the For the 1992
Three Months Nine Months (inception)
Ended September 30, Ended September 30, through
--------------------------------- -------------------------------- September 30,
2003 2002 2003 2002 2003
--------------- ---------------- --------------- --------------- -----------------
Operating Expenses:
Related party license fee and research and
development expenses.................... $ 353,907 $ 300,000 $ 1,012,374 $ 1,068,313 $ 70,891,282
Other research and development expenses..... 1,287,516 2,941.860 4,892,009 13,418,082 139,169,664
Related party general and administrative
expenses................................ - - (4,074) (18,333) 2,187,540
Other general and administrative expenses... 1,361,900 2,366,377 4,408,944 6,972,359 66,831,629
Depreciation and amortization............... 95,207 795,065 311,483 2,385,770 22,772,913
Related party patent expenses............... - - - - 8,693,105
--------------- ---------------- --------------- --------------- -----------------
Total operating expenses................ 3,098,530 6,403,302 10,620,736 23,826,191 310,546,133
Other Expenses (Income):
Interest income............................. (16,705) (18,345) (80,956) (61,259) (10,890,589)
Related party interest expense.............. 95,697 - 265,931 - 5,103,261
Other interest expense...................... 292,251 79,447 1,214,988 80,319 3,203,606
Gain on sales of property and equipment..... (122,964) - (185,964) (9,500) (627,377)
Other (income) expense...................... (486,659) - (399,701) - (399,701)
Loss on extinguishment of debentures........ - - 1,697,380 - 1,697,380
Debenture conversion costs.................. 60,647 320,970 166,494 320,970 487,464
--------------- ---------------- --------------- --------------- -----------------
Loss before income taxes.................... 2,920,797 6,785,374 13,298,908 24,156,721 309,120,177
Income taxes................................ - - 800 800 13,471
--------------- ---------------- --------------- --------------- -----------------
Net loss.................................... 2,920,797 6,785,374 13,299,708 24,157,521 309,133,648
Preferred dividends ........................ - - - - 9,926,703
--------------- ---------------- --------------- --------------- -----------------
Net loss available to common
stockholders............................ $ 2,920,797 $6,785,374 $13,299,708 $24,157,521 $ 319,060,351
=============== ================ =============== =============== =================
Basic and diluted loss per common
share................................... $0.21 $0.59 $1.02 $2.19 $38.42
Weighted average number of common
shares outstanding...................... 13,595,973 11,541,668 12,993,999 11,036,143 8,305,315
See Notes to Consolidated Financial Statements.
2
EARTHSHELL CORPORATION
(A Development Stage Enterprise)
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' (DEFICIT) EQUITY
(Unaudited)
Cumulative
Convertible
Preferred Stock Additional
Series A Paid-In Common Stock
-------------------- Preferred ------------------------
Shares Amount Capital Shares Amount
---------- -------- ----------- ----------- -----------
ISSUANCE OF COMMON STOCK AT
INCEPTION................. -- -- -- 6,877,500 $ 3,150
Sale of preferred stock, net. 582,404 $ 267 $24,472,734 -- --
Net loss..................... -- -- -- -- --
---------- -------- ----------- ----------- -----------
BALANCE, DECEMBER 31, 1993... 582,404 267 24,472,734 6,877,500 3,150
Net loss..................... -- -- -- -- --
---------- -------- ----------- ----------- -----------
BALANCE, DECEMBER 31, 1994... 582,404 267 24,472,734 6,877,500 3,150
Contribution to equity....... -- -- -- -- --
Net loss..................... -- -- -- -- --
---------- -------- ----------- ----------- -----------
BALANCE, DECEMBER 31, 1995... 582,404 267 24,472,734 6,877,500 3,150
Contribution to equity....... -- -- -- -- --
Issuance of stock warrants... -- -- -- -- --
Net loss..................... -- -- -- -- --
---------- -------- ----------- ----------- -----------
BALANCE, DECEMBER 31, 1996... 582,404 267 24,472,734 6,877,500 3,150
Compensation related to
stock options, warrants
and stock grants.......... -- -- -- -- --
Net loss..................... -- -- -- -- --
---------- -------- ----------- ----------- -----------
BALANCE, DECEMBER 31, 1997... 582,404 267 24,472,734 6,877,500 3,150
262 to 1 stock split -- 5,557 (5,557) -- 65,625
Conversion of preferred
stock into common stock... (582,404) (5,824) (24,467,177) 582,404 5,824
Issuance of common stock..... -- -- -- 877,193 8,772
Preferred stock dividends.... -- -- -- -- --
Net loss..................... -- -- -- -- --
---------- -------- ----------- ----------- -----------
BALANCE, DECEMBER 31, 1998... -- -- -- 8,337,097 83,371
Net loss..................... -- -- -- -- --
---------- -------- ----------- ----------- -----------
BALANCE, DECEMBER 31, 1999... -- -- -- 8,337,097 83,371
Issuance of common stock..... -- -- -- 371,431 3,714
Net loss..................... -- -- -- -- --
---------- -------- ----------- ----------- -----------
BALANCE, DECEMBER 31, 2000... -- -- -- 8,708,528 87,085
Issuance of common stock..... -- -- -- 1,126,727 11,268
Compensation related to
stock options, warrants
and stock grants.......... -- -- -- 25,000 250
Net loss..................... -- -- -- -- --
---------- -------- ----------- ----------- -----------
BALANCE, DECEMBER 31, 2001... -- -- -- 9,860,255 98,603
Issuance of common stock..... -- -- -- 2,025,686 20,256
Common stock warrants issued
in connection with
convertible debentures.... -- -- -- -- --
Conversion of convertible
debentures to common stock -- -- -- 168,696 1,687
Debentures conversion costs.. -- -- -- -- --
Net loss.....................
Foreign currency translation
adjustment................ -- -- -- -- --
Comprehensive loss........... -- -- -- -- --
---------- -------- ----------- ----------- -----------
BALANCE, DECEMBER 31, 2002... -- -- -- 12,054,637 120,546
Interest paid in common stock -- -- -- 17,162 172
Conversion of convertible
debentures to common stock. -- -- -- 1,216,485 12,165
Issuance of common stock..... -- -- -- 603,916 6,039
Issuance of stock warrants... -- -- -- -- --
Beneficial conversion value
due to change in
debentures conversion
price..................... -- -- -- -- --
Net loss..................... -- -- -- -- --
Foreign currency translation
adjustment................ -- -- -- -- --
Comprehensive loss........... -- -- -- -- --
---------- -------- ----------- ----------- -----------
BALANCE, SEPTEMBER 30, 2003 -- $ -- $ -- 13,892,200 $ 138,922
========== ======== =========== =========== ===========
3
Accum-
Deficit ulated
Additional Accumulated Other
Paid-In during Compre-
Common Development hensive
Capital Stage Loss Totals
------------- ------------ -------- -------------
ISSUANCE OF COMMON STOCK AT
INCEPTION................. $ 6,850 -- -- $ 10,000
Sale of preferred stock, net. -- -- -- 24,473,001
Net loss..................... -- $ (7,782,551) -- (7,782,551)
------------- ------------- --------- -------------
BALANCE, DECEMBER 31, 1993... 6,850 (7,782,551) -- 16,700,450
Net loss..................... -- (16,582,080) -- (16,582,080)
------------- ------------- --------- -------------
BALANCE, DECEMBER 31, 1994... 6,850 (24,364,631) -- 118,370
Contribution to equity....... 1,117,723 -- -- 1,117,723
Net loss..................... -- (13,914,194) -- (13,914,194)
------------- ------------- --------- -------------
BALANCE, DECEMBER 31, 1995... 1,124,573 (38,278,825) -- (12,678,101)
Contribution to equity....... 650,000 -- -- 650,000
Issuance of stock warrants... 246,270 -- -- 246,270
Net loss..................... -- (16,950,137) -- (16,950,137)
------------- ------------- --------- -------------
BALANCE, DECEMBER 31, 1996... 2,020,843 (55,228,962) -- (28,731,968)
Compensation related to
stock options, warrants
and stock grants.......... 3,156,659 -- -- 3,156,659
Net loss..................... -- (18,992,023) -- (18,992,023)
------------- ------------- --------- -------------
BALANCE, DECEMBER 31, 1997... 5,177,502 (74,220,985) -- (44,567,332)
262 to 1 stock split (65,625) -- -- --
Conversion of preferred
stock into common stock... 24,467,177 -- -- --
Issuance of common stock..... 205,979,984 -- -- 205,988,756
Preferred stock dividends.... (9,926,703) -- -- (9,926,703)
Net loss..................... -- (26,620,052) -- (26,620,052)
------------- ------------- --------- -------------
BALANCE, DECEMBER 31, 1998... 225,632,335 (100,841,037) -- 124,874,669
Net loss..................... -- (44,188,443) -- (44,188,443)
------------- ------------- --------- -------------
BALANCE, DECEMBER 31, 1999... 225,632,335 (145,029,480) -- 80,686,226
Issuance of common stock..... 10,518,074 -- -- 10,521,788
Net loss..................... -- (48,911,605) -- (48,911,605)
------------- ------------- --------- -------------
BALANCE, DECEMBER 31, 2000... 236,150,409 (193,941,085) -- 42,296,409
Issuance of common stock..... 30,542,772 -- -- 30,554,040
Compensation related to
stock options, warrants
and stock grants.......... 986,869 -- -- 987,119
Net loss..................... -- (62,301,511) -- (62,301,511)
------------- ------------- --------- -------------
BALANCE, DECEMBER 31, 2001... 267,680,050 (256,242,596) -- 11,536,057
Issuance of common stock..... 21,881,460 -- -- 21,901,716
Common stock warrants issued
in connection with
convertible debentures.... 1,521,046 -- -- 1,521,046
Conversion of convertible
debentures to common stock 998,313 -- -- 1,000,000
Debentures conversion costs.. 176,471 -- -- 176,471
Net loss..................... (39,591,344) (39,591,344)
Foreign currency translation
adjustment................ -- -- $(16,632) (16,632)
------------
Comprehensive loss........... -- -- -- (39,607,976)
-------------- ------------- --------- -------------
BALANCE, DECEMBER 31, 2002... 292,257,340 (295,833,940) (16,632) (3,472,686)
Interest paid in common stock 92,062 -- -- 92,234
Conversion of convertible
debentures to common stock. 5,626,063 -- -- 5,638,228
Issuance of common stock..... 2,043,846 -- -- 2,049,885
Issuance of stock warrants... 303,522 -- -- 303,522
Beneficial conversion value
due to change in
debentures conversion
price..................... 360,000 -- -- 360,000
Net loss..................... -- (13,299,708) -- (13,299,708)
Foreign currency translation
adjustment................ -- -- (20,597) (20,597)
-------------
Comprehensive loss........... -- -- -- (13,320,305)
------------- ------------- --------- -------------
BALANCE, SEPTEMBER 30, 2003 $300,682,833 $(309,133,648) $(37,229) $(8,349,122)
============= ============= ========= =============
See Notes to Consolidated Financial Statements.
4
EARTHSHELL CORPORATION
(A Development Stage Enterprise)
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
November 1,
Nine Months Ended 1992 (inception)
September 30, through
-------------------------------- September 30,
2003 2002 2003
--------------- --------------- ----------------
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss.................................................... $ (13,299,708) $(24,157,521) $ (309,133,648)
Adjustments to reconcile net loss to net cash used in
operating activities:
Depreciation and amortization............................. 311,483 2,385,770 22,772,913
Compensation related to issuance of stock, stock options
and warrants to directors, consultants and officers.... - - 4,848,641
Amortization and accretion of debt issue costs............ 753,428 76,052 1,169,205
Debentures issuance and conversion costs.................. 166,494 320,970 487,464
Gain on change in fair value of warrant obligation........ (399,701) - (399,701)
Loss on extinguishment of debentures...................... 1,697,380 - 1,697,380
Beneficial conversion value due to change in debentures 360,000 - 360,000
conversion price.......................................
(Gain) Loss on sale, disposal, or impairment of property (185,964) 1,842,143 47,027,576
and equipment..........................................
Equity in the losses of joint venture..................... 280,018 45,000 429,444
Accrued purchase commitment............................... - - 3,500,000
Net loss on sale of investments........................... - - 32,496
Accretion of discounts on investments..................... - - (410,084)
Other non-cash expense items ............................. 590 - 590
Changes in operating assets and liabilities:
Prepaid expenses and other current assets................. 157,916 66,480 (412,886)
Accounts payable and accrued expenses..................... (2,955,813) (1,014,011) 4,903,498
Payable to related party.................................. 768,877 - 1,393,302
Other long term liability ................................ 50,000 - 50,000
--------------- --------------- ----------------
Net cash used in operating activities.................. (12,295,000) (20,435,117) (221,683,810)
--------------- --------------- ----------------
CASH FLOWS FROM INVESTING ACTIVITIES
Purchase of investments in U.S. government securities....... - - (52,419,820)
Purchase of restricted time deposit in connection with
purchase commitment.................................... - (9,000,000) (3,500,000)
Proceeds from sales and redemption of investments........... - - 52,797,408
Proceeds from sales of property and equipment............... 214,949 9,500 990,185
Investment in joint venture................................. (26,104) - (541,542)
Purchase of property and equipment.......................... (1,320) (2,662,278) (75,799,435)
--------------- --------------- ----------------
Net cash provided by (used in) investing activities.... 187,525 (11,652,778) (78,473,204)
--------------- --------------- ----------------
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from issuance of common stock...................... - 19,505,758 284,040,180
Common stock issuance costs................................. - 3,030,000 (15,178,641)
Proceeds from issuance of common stock and convertible 8,659,079 10,000,000 8,659,079
debentures..............................................
Proceeds from issuance of convertible debentures............ - - 10,000,000
Purchase of restricted time deposit in connection with
issuance of convertible debentures..................... - - (10,000,000)
Proceeds from release of restricted time deposit upon
conversion of convertible debentures into common stock. 1,800,000 - 2,800,000
Repayment of convertible debentures......................... (5,200,000) - (5,200,000)
Proceeds from release of restricted cash for repayment of
convertible debentures................................. 5,200,000 - 5,200,000
Proceeds from release of restricted cash upon exchange of
convertible debentures................................. 2,000,000 - 2,000,000
Proceeds from issuance of notes payable to related party.... 1,010,000 - 20,105,000
Repayment of notes payable to related party................. - (1,030,000) (15,325,651)
Proceeds from drawings on line of credit with bank.......... - - 14,000,000
Repayment of line of credit with bank....................... - - (14,000,000)
Preferred dividends paid.................................... - - (9,926,703)
Proceeds from issuance of preferred stock................... - - 25,675,000
Preferred stock issuance costs.............................. - - (1,201,999)
--------------- --------------- ----------------
Net cash provided by financing activities.............. 13,469,079 31,505,758 301,646,265
--------------- --------------- ----------------
Effect of exchange rate changes on cash and cash equivalents (3,449) - (20,081)
--------------- --------------- ----------------
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS............ 1,358,155 (582,137) 1,469,170
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD.............. 111,015 828,007 -
--------------- --------------- ----------------
CASH AND CASH EQUIVALENTS, END OF PERIOD.................... $ 1,469,170 $ 245,870 $ 1,469,170
=============== =============== ================
5
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Cash paid for:
Income taxes........................................... $ - $ 800 $ 12,671
Interest............................................... 77,579 - 3,126,877
Common stock warrants issued in connection with convertible 745,562 1,521,046 2,572,776
debentures...............................................
Conversion of convertible debentures into common stock...... 6,975,000 1,000,000 7,975,000
Transfer of property from EKI............................... - - 28,745
Interest paid in Common Stock............................... 92,234 - 92,234
Commission paid in common stock............................. 29,500 - 29,500
Common stock issued to service providers in connection
with the March 2003 financing........................... 484,500 - 484,500
Conversion of preferred stock to common stock............... - - 24,473,001
See Notes to Consolidated Financial Statements.
6
EARTHSHELL CORPORATION
(A Development Stage Enterprise)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
September 30, 2003
- --------------------------------------------------------------------------------
Organized in November 1992 as a Delaware corporation, EarthShell Corporation is
engaged in the commercialization of composite material technology for the
manufacture of foodservice disposable packaging designed with the environment in
mind. EarthShell Packaging(R) is based on patented composite material
technology (collectively, the "EarthShell Technology"), licensed on an
exclusive, worldwide basis from E. Khashoggi Industries LLC and its wholly owned
subsidiaries.
The EarthShell Technology has been developed over many years in consultation
with leading material scientists and environmental experts to reduce the
environmental burdens of foodservice disposable packaging through the careful
selection of raw materials, processes, and suppliers. EarthShell Packaging(R),
including hinged-lid sandwich containers, plates, bowls, and cups, is primarily
made from commonly available natural raw materials such as natural ground
limestone and potato starch. EarthShell believes that EarthShell Packaging(R)
has comparable or superior performance characteristics and can be commercially
produced and sold at prices that are competitive with comparable paper and
plastic foodservice disposable packaging.
Presentation of Financial Information
The foregoing interim financial information is unaudited and has been prepared
from the books and records of EarthShell Corporation. EarthShell Corporation's
consolidated financial statements include the accounts of its wholly-owned
subsidiary, EarthShell GmbH. All significant intercompany balances and
transactions have been eliminated in consolidation. Both EarthShell Corporation
and its subsidiary (collectively "EarthShell" or the "Company") are development
stage enterprises. In the opinion of management, the financial information
reflects all adjustments necessary for a fair presentation of the financial
condition, results of operations and cash flows of the Company in conformity
with generally accepted accounting principles. All such adjustments were of a
normal recurring nature for interim financial reporting. Certain
reclassifications have been made to the 2002 financial statements to conform to
the 2003 presentation.
The accompanying unaudited consolidated financial statements and these notes do
not include certain information and footnote disclosures required by accounting
principles generally accepted in the United States, which were included in the
Company's consolidated financial statements for the year ended December 31,
2002. The information included in this Form 10-Q should be read in conjunction
with Management's Discussion and Analysis of Financial Condition and Results of
Operations and the Company's consolidated financial statements and notes thereto
for the year ended December 31, 2002 included in the Company's Annual Report on
Form 10-K/A.
The accompanying consolidated financial statements have been prepared on a going
concern basis, which contemplates the realization of assets and the satisfaction
of liabilities in the normal course of business. During the period from November
1, 1992 (inception) to September 30, 2003, the Company has incurred a cumulative
net loss of $309,133,648 and has a stockholders' deficit of $8,349,122 at
September 30, 2003. These factors among others may indicate that the Company
will be unable to continue as a going concern for a reasonable period of time.
The consolidated financial statements do not include any adjustments relating to
the recoverability and classification of recorded asset amounts or the amounts
and classification of liabilities that might be necessary should the Company be
unable to continue as a going concern. The Company's continuation as a going
concern is dependent upon its ability to generate sufficient cash flow to meet
its obligations on a timely basis, to obtain additional financing or refinancing
as may be required, and ultimately to attain successful operations.
Basic loss per common share is computed by dividing net loss available to common
stockholders by the weighted-average number of common shares outstanding during
the period. Diluted loss per common share is computed by dividing net loss
available to common stockholders by the weighted-average number of common shares
outstanding plus an assumed increase in common shares outstanding for
potentially dilutive securities, which consist of options and warrants to
acquire common stock and convertible debentures. Potentially dilutive shares are
excluded from the computation in loss periods, as their effect would be
anti-dilutive. The dilutive effect of options and warrants to acquire common
stock is measured using the treasury stock method. The dilutive effect of
convertible debentures is measured using the if-converted method. Basic and
diluted loss per common share is the same for all periods presented because the
impact of potentially dilutive securities is anti-dilutive. As noted in
"Subsequent Events," the Company effected a reverse split of its common stock,
effective as of October 31, 2003. Accordingly, the split has been retroactively
reflected in these financial statements.
Since March 5, 2003 the Company's common stock has traded on the NASDAQ SmallCap
Market under
7
the symbol "ERTH." Due to the October 31, 2003 reverse stock split (see
"Subsequent Events"), the Company's common stock will trade under the symbol
"ERTHD" from October 31, 2003 through November 28, 2003, at which time it will
revert back to "ERTH."
Related Party Transactions
E. Khashoggi Industries LLC and its wholly owned subsidiaries ("EKI") own
approximately 30% of the Company's outstanding shares, and may be deemed to be a
controlling stockholder. In connection with the formation of the Company, the
Company entered into a Master License Agreement with EKI (the "EKI License
Agreement"), pursuant to which the Company has an exclusive, worldwide,
royalty-free license to use and license the EKI technology to manufacture and
sell disposable, single-use containers for packaging or serving food or
beverages intended for consumption within a short period of time (less than 24
hours). Effective January 1, 2001, EKI granted to the Company priority rights to
license certain product applications on an exclusive basis from Biotec, a wholly
owned subsidiary of EKI, in consideration for payment by the Company of a
$100,000 monthly licensing fee to Biotec. In addition, Biotec agreed to render
technical services to the Company, as required, at Biotec's cost plus 5%.
Effective July 29, 2002, the Company restated its agreements with Biotec in a
definitive License & Information Transfer Agreement with Biotec to utilize the
Biotec technology for foodservice applications, including food wraps and cutlery
(the "Biotec License Agreement"). Under the terms of the Biotec License
Agreement, the Company paid or accrued $353,907 and $300,000 during the three
months ended September 30, 2003 and 2002, respectively, and $1,012,374 and
$1,068,313 during the nine months ended September 30, 2003 and 2002,
respectively, consisting of the $100,000 per month licensing fee plus materials
and services provided by EKI, which vary based upon the Company's requirements.
In September 2002, the Company entered into a Loan Agreement with EKI whereby
EKI agreed to extend certain loans to the Company at EKI's sole discretion, at
interest rates of 7% to 10%. As of December 31, 2002 the outstanding principal
amount of outstanding loans was $1,745,000. In January 2003, the Company
borrowed an additional $1,010,000 from EKI under the Loan Agreement, bringing
the total outstanding principal amount of the loans to $2,755,000. As part of
the new convertible debenture financing completed in March 2003 (see Convertible
Debentures), repayment of these loans and related interest was subordinated to
the new debentures with strict covenants governing their repayment. Therefore,
at September 30, 2003, the loans totaling $2,755,000 and related interest of
$252,559 are classified as noncurrent liabilities. In March 2003, the Company
issued to EKI a warrant, which was immediately exercisable, to purchase 83,333
shares of the Company's common stock at $6.00 per share in connection with the
subordination of the loans totaling $2,755,000. The fair value of the warrant
was estimated to be approximately $303,522 using the Black-Scholes option
pricing model and was recorded as a discount on the outstanding loans.
Convertible Debentures
On March 5, 2003, the Company received proceeds of approximately $9.0 million,
net of financing costs of approximately $1.5 million, from the issuance to a
group of institutional investors of 416,667 shares of common stock and $10.55
million in aggregate principal amount of secured convertible debentures due in
2006 (the "2006 Debentures"). The 2006 Debentures bear interest at a rate of
2.0% per annum, payable quarterly in arrears on each January 31, April 30, July
31 and October 31. The holders of the 2006 Debentures have the right to convert
such debentures into the Company's common stock at a conversion price of $6.00
per share. While the 2006 Debentures are outstanding, the conversion price is
subject to adjustment in certain instances, such as a result of stock dividends
and splits, distributions of property to common stockholders, the sale of
substantially all of the Company's assets, the consummation of a merger, or
sales of common stock or common stock equivalents for per share prices lower
than the conversion price in effect. In addition to the holders' conversion
option, after the first anniversary of the issuance of the 2006 Debentures the
Company has the right to force conversion of all or a portion of the outstanding
principal amount of the 2006 Debentures if certain conditions are met, including
a requirement that the closing price of the common stock has been equal to or
greater than 300% of the conversion price for at least the 10 consecutive days
immediately preceding the conversion. The principal amount of the 2006
Debentures is due and payable on March 5, 2006; however, earlier repayment may
occur if the Company receives cash
8
proceeds in excess of $2.65 million (the "Excess Amount") from the sale of debt
or equity securities, equipment sales to unrelated third parties, operating
revenues, or any cash that becomes available to the Company as a result of a
reduction in a $3.5 million letter of credit the Company issued to a third party
in 1998. If the Excess Amount arises, the holders of the 2006 Debentures can
elect to require one third of such amount to be applied as a 102% prepayment of
principal and interest of the 2006 Debentures.
In accordance with Accounting Principles Board Opinion No. 14, "Accounting for
Convertible Debt and Debt Issued with Stock Purchase Warrants," the Company
allocated the net proceeds of $9.0 million to the 2006 Debentures and the common
stock based their relative fair values. A discount on the 2006 Debentures of
$3.4 million and a discount on the common stock of $604,000 resulted from the
fair value allocation. Based on the conversion price of the 2006 Debentures
relative to the fair market value for a share of the Company's common stock at
the date of issue, the conversion feature of the 2006 Debentures was determined
to have no intrinsic value to the holders. If subsequent to the issuance date
the conversion price of the 2006 Debentures is adjusted downward, the value of
the conversion feature will be re-measured to determine if any beneficial
conversion value should be recorded as of the date the conversion price is
adjusted. The principal amount of the 2006 Debentures of $10.55 million was
recorded as a noncurrent liability, net of a $3.4 million discount. The total
discount on the 2006 Debentures of $3.4 million, which is being amortized to
interest expense over the 36-month term of the 2006 Debentures using the
effective interest method, may be subject to downward adjustments to the extent
partial conversions of the 2006 Debentures occur. These adjustments, if
required, would reduce the discount and reduce additional paid-in capital.
In addition to the $1.5 million of financing costs, the Company also incurred
approximately $646,000 of non-cash costs attributable to 54,167 shares of common
stock issued to the lead purchaser of the 2006 Debentures and two warrants
issued to a placement agent, both of whom received the instruments as
compensation for their services rendered in connection with the transaction. The
fair value of the 54,167 shares of common stock issued to the lead purchaser was
determined to be $247,000, based on the closing price of $4.56 per share of the
Company's common stock on the NASDAQ SmallCap Market on March 5, 2003. The fair
value of approximately $42,000 of the first of the two warrants issued to the
placement agent, which expires in March 2006 and is immediately exercisable by
the placement agent to purchase 28,810 shares of the Company's common stock for
$10.08 per share, was estimated using the Black Scholes option-pricing model and
is reflected in the accompanying financial statements as an increase in
additional paid-in capital and as a component of the $4.0 million aggregate
discount on the 2006 Debentures and common stock issued in the March 2003
transaction. The second of the two warrants issued to the placement agent, which
expires in March 2006, is immediately exercisable by the placement agent to
purchase $1.055 million in aggregate principal amount of the 2006 Debentures and
416,667 shares of the Company's common stock, except if, prior to exercise of
the warrant, all of the 2006 Debentures have been redeemed, repurchased or
converted, in which case the portion of the warrant exercisable into the 2006
Debentures becomes exercisable into common stock as if the 2006 Debentures
included in the warrant had been converted to common stock. The exercise price
of the convertible debenture portion of the warrant is $1,200 for each $1,000 of
principal and is subject to adjustment consistent with the provisions of the
2006 Debentures. The exercise price of the common stock portion of the warrant
is $7.20 per share. The estimated fair value of this warrant was reflected in
the financial statements as a warrant obligation and as a component of the $4.0
million aggregate discount on the 2006 Debentures and common stock issued in the
March 2003 financing transaction. At September 30, 2003, the Company evaluated
the current value of this warrant, considering its current cash flow
projections, continued operating losses, the prospects of raising additional
equity capital, the significant excess of the conversion price to the current
stock price and the volatility in the Company's stock price. Based upon these
factors, the Company determined that the likelihood of the warrant being
exercised is remote and has written off the balance of the warrant obligation as
of September 30, 2003, resulting in a $0.5 million gain in the three months
ended September 30, 2003 that is reflected in "Other (income) expense" in the
Statements of Operations.
In connection with the March 2003 financing transactions, the Company prepaid
$5.2 million of the $8.2 million principal amount outstanding of the convertible
debentures due in 2007 (the "2007 Debentures"), resulting in a prepayment
penalty of $208,000. The Company also issued to the holders of the 2007
9
Debentures 52,083 shares of common stock, valued at $237,500 based upon the
closing price of the Company's common stock on the NASDAQ SmallCap Market of
$4.56 per share on March 5, 2003. In addition, one of the holders of the 2007
Debentures exchanged $2.0 million aggregate principal amount of 2007 Debentures
for $2.0 million aggregate principal amount of 2006 Debentures and 78,989 shares
of common stock valued at approximately $360,000 based upon the closing price of
the Company's common stock of $4.56 per share on March 5, 2003. In connection
with the prepayment and exchange transactions, the Company incurred cash
transaction costs of approximately $296,000, excluding the prepayment penalty.
The Company recognized a $1.7 million loss upon extinguishment of the 2007
Debentures through the prepayment and exchange. The prepayment of the 2007
Debentures and the debenture exchange resulted in the release to the Company of
$2.0 million of restricted cash.
The issuance of the 2006 Debentures, prepayment of the 2007 Debentures (from
restricted cash) and the debenture exchange provided the Company with aggregate
net proceeds of approximately $11.0 million.
During the quarter ended March 31, 2003, $1.0 million principal amount of the
2006 Debentures was converted into 166,667 shares of common stock resulting in
the approximately $665,000 carrying amount of the 2006 Debentures being
transferred to common stock.
During the quarter ended June 30, 2003, $850,000 principal amount of the 2006
Debentures was converted into 141,667 shares of common stock resulting in the
approximately $773,000 carrying amount of the 2006 Debentures being transferred
to common stock.
During the quarter ended September 30, 2003, $3.325 million principal amount of
the 2006 Debentures was converted into 554,167 shares of common stock resulting
in the approximately $2.5 million carrying amount of the 2006 Debentures
being transferred to common stock.
At September 30, 2003, the outstanding principal balance of 2006 Debentures was
$7.375 million, which is reflected on the accompanying balance sheet net of an
unamortized discount of approximately $1.8 million.
In October 2003, $575,000 principal amount of the 2006 Debentures was converted
into 95,833 shares of common stock, reducing the outstanding principal balance
of 2006 Debentures to $6.8 million.
In January and February 2003, the Company forced the conversion of $800,000
principal amount of the 2007 Debentures for 139,599 shares of common stock,
resulting in the release to the Company of $800,000 of restricted cash. In June
2003, the holders converted $491,000 principal amount of 2007 Debentures for
81,833 shares of common stock, resulting in the release to the Company of
$491,000 of restricted cash. In July 2003, the Company forced the conversion of
the remaining $509,000 principal amount of 2007 Debentures for 132,552 shares of
common stock, resulting in the release to the Company of $509,000 of restricted
cash.
In connection with the March 2003 financing transactions, EKI agreed to
subordinate the repayment of its outstanding loans totaling $2,755,000 to the
Company's payment obligations under the 2006 Debentures. In addition, EKI and
Biotec agreed to subordinate certain payments to which they were otherwise
entitled under the Biotec License Agreement (other than their respective
percentages of any royalties received by the Company) to the satisfaction of the
Company's payment obligations under the 2006 Debentures. They further agreed not
to assert any claims against the Company for breaches of the Biotec License
Agreement (other than the assertion of certain equitable remedies to enjoin the
Company from, for example, selling products outside its field of use) until such
time as the Company's obligations under the 2006 Debentures are satisfied in
full. EKI and Biotec also agreed to allow the Company to pledge their respective
interests in the EKI and Biotec License Agreements to secure the Company's
obligations under the 2006 Debentures, and certain additional concessions were
made by EKI and Biotec to permit the Company greater flexibility in selling its
rights under the EKI and Biotec License Agreements to third parties in an
insolvency context. These rights terminate upon the satisfaction in full of the
obligations under the 2006 Debentures. In consideration for its willingness to
subordinate the payments and advances that are owed to it, in March
10
2003 the Company issued to EKI a warrant, expiring in ten years, to acquire
83,333 shares of the Company's common stock for $6.00 per share. The fair value
of the warrant was estimated to be approximately $303,522 using the
Black-Scholes option pricing model and was recorded as a discount on the
outstanding loans.
Commitments
During 1998, EKI entered into certain agreements with an equipment manufacturer
providing for the purchase by EKI of certain technology applicable to
starch-based disposable packaging. EKI licenses such technology to the Company
on a royalty-free basis pursuant to the License Agreement. In connection with
the purchase, and pursuant to the terms of a letter agreement with EKI, the
Company agreed to pay the seller of the technology $3.5 million on or about
December 31, 2003, which obligation is secured by a letter of credit, which in
turn is secured by $3.5 million of the Company's restricted cash. The Company's
obligation to the seller of the technology will be reduced by 5% of the purchase
price of any equipment purchased from the seller of the technology by EKI, the
Company or their respective licensees prior to the obligation payment date.
While the Company believes demand for such equipment will arise in the future,
it is unable to estimate when such demand will occur or if such demand will
result in any reduction of this obligation. As a result of these uncertainties
and since the obligation will become payable on or about December 31, 2003, the
Company established a liability as of December 31, 2002 for the $3.5 million
commitment.
In addition, the Company would be required to pay the seller $3.0 million over
the five-year period commencing January 1, 2004 if EKI, the Company or their
respective licensees make active use of the technology and have not purchased,
by December 31, 2003, at least $35.0 million of equipment from the seller. As of
September 30, 2003, the Company and its respective licensees have neither
actively used the technology nor purchased equipment from the seller. The
Company does not plan to make active use of the technology during the year
ending December 31, 2003. EKI has agreed to indemnify the Company to the extent
the Company is required to pay any portion of this $3.0 million obligation
solely as a result of EKI's or its licensees' active use of such patents and
related technology (other than use by the Company or its sublicenses). The $3.0
million obligation to the seller of the technology is subject to reduction in an
amount equal to 5% of the purchase price of any equipment purchased from the
seller by EKI, the Company or their sublicenses during the five-year period
commencing January 1, 2004.
Property and Equipment
The cost and accumulated depreciation of property and equipment at September 30,
2003 and December 31, 2002 were as follows:
September 30, December 31,
2003 2002
-------------------- ------------------
Commercial Manufacturing Equipment
Goettingen, Germany............................................ $ 4,000,000 $ 4,000,000
Other Property and Equipment
Product development center..................................... 1,316,584 2,077,438
Office furniture and equipment................................. 718,596 742,931
Leasehold improvements......................................... - 521,187
-------------------- ------------------
2,035,180 3,341,556
Total cost.............................................................. 6,035,180 7,341,556
Less: Accumulated depreciation and amortization........................ (1,898,154) (2,865,382)
-------------------- ------------------
Property and equipment - net............................................ $ 4,137,026 $ 4,476,174
==================== ==================
11
The commercial production line in Goettingen, Germany is being financed and
constructed by the Company for the Company's joint venture with Huhtamaki Oyj
("Huhtamaki"). During the third quarter of 2002 the company obtained quotations
from various machinery suppliers and determined that the cost to build an
identical line was approximately $4.0 million. The Company wrote the carrying
value of the line down to its estimated replacement cost.
As the Company sold non-essential machine shop equipment and excess office
furniture and equipment in 2003, the related cost and accumulated depreciation
were removed from the applicable asset account and Accumulated depreciation,
respectively. At the expiration of the leases at the Company's Santa Barbara and
Goleta, California facilities in 2003, all leasehold improvements were fully
amortized. Due to the relocation to new office space in Santa Barbara, the
Company removed the fully amortized leasehold improvements from both the
Leasehold improvements and Accumulated amortization accounts.
Stock Options
The Company accounts for stock options in accordance with the provisions of
Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued
to Employees," and complies with the disclosure provisions of Statement of
Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based
Compensation." Under APB Opinion No. 25, compensation expense is based on the
difference, if any, on the date of grant, between the fair value of the
Company's common stock and the exercise price of the option. For disclosure
purposes, to measure stock-based compensation in accordance with SFAS No. 123,
"Accounting for Stock-Based Compensation," the fair value of each option grant
is estimated on the date of grant using the Black-Scholes option-pricing model.
The fair value of each option grant is then amortized as pro forma compensation
expense over the vesting period of the options. The following table sets forth
the pro forma net loss and loss per share resulting from applying SFAS No. 123.
Three Months Nine Months
Ended September 30, Ended September 30,
--------------------------------- -----------------------------------
2003 2002 2003 2002
-------------- --------------- ---------------- ---------------
Net Loss as reported........................... $2,920,797 $6,785,374 $13,299,708 $24,157,521
Deduct: Stock-based employee compensation
expense included in reported net loss, net
of tax...................................... -- -- -- --
Add: Total stock-based employee compensation
determined under fair value based method
for all awards, net of tax.................. 498,509 1,777,375 695,320 2,010,093
-------------- --------------- ---------------- ---------------
Pro forma net loss............................. $3,419,306 $8,562,749 $13,995,028 $26,167,614
Net loss per common share
As reported................................. $0.21 $0.59 $1.02 $2.19
Pro forma................................... 0.25 0.74 1.08 2.37
In December 2002, the Financial Accounting Standards Board issued SFAS No. 148,
"Accounting for Stock-Based Compensation - Transition and Disclosure - An
Amendment of FASB Statement No. 123." SFAS No. 148 provides alternative methods
of transition for a voluntary change to the fair value based method of
accounting for stock-based employee compensation and requires prominent
disclosures in both annual and interim financial statements about the method of
accounting for stock-based employee compensation and the effect of the method
used on reported results. The Company has elected not to adopt the recognition
and measurement provisions of SFAS No. 123 and continues to account for its
stock-based employee compensation plans under APB Opinion No. 25 and related
interpretations and therefore the transition provisions will not have an impact
on the Company's financial position or results of operations. The required
expanded interim disclosures are provided above.
Subsequent Events
Subsequent to September 30, 2003, the Company's Board of Directors approved an
amendment, effective as of October 31, 2003, to the Company's Certificate of
Incorporation to effect a reverse split of the Company's common stock. This
action by the Board of Directors followed approval by 88% of the stockholders of
a proposal at the 2003 Annual Meeting that authorized the Board to take such
action. The decision by the Board of Directors was prompted by the need to
maintain compliance with certain covenants of the Company's 2006 Debentures that
require the Company to retain its listing on a national market. To retain its
listing on the NASDAQ SmallCap Market, the Company's common stock must trade
above a $1.00 minimum bid price for ten consecutive trading days prior to
November 18, 2003.
After careful analysis, the Company's Board approved the final ratio for the
split at one-for-twelve (1:12), whereby each twelve shares of the Company's
issued and outstanding common stock was automatically converted into one share
of new common stock. The percentage of the Company's stock owned by each
shareholder remained the same. No fractional shares were issued, and instead,
the Company's transfer agent will aggregate and sell any fractional shares on
the open market and will distribute the pro rata share of the cash proceeds to
the holders of fractional share interests.
The reverse split has been retroactively reflected in these financial
statements.
In conjunction with the reverse split, the authorized shares of common stock
were reduced from 200,000,000 to 25,000,000 as of October 31, 2003.
12
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
Forward Looking Statements
Information contained in this Quarterly Report on Form 10-Q, including
"Management's Discussion and Analysis of Financial Condition and Results of
Operations," contains forward-looking statements within the meaning of the
Private Securities Litigation Reform Act of 1995, as amended. These statements
may be identified by the use of forward-looking terminology such as "may,"
"will," "expect," "anticipate," "estimate," or "continue," or the negative
thereof or other comparable terminology. Any one factor or combination of
factors could cause the Company's actual operating performance or financial
results to differ substantially from those anticipated by management that are
described herein. Investors should carefully review the risk factors set forth
in other Company reports or documents filed with the Securities and Exchange
Commission, including Forms 10-Q, 10-K, 10-K/A and 8-K. Factors influencing the
Company's operating performance and financial results include, but are not
limited to, changes in the general economy, the availability of financing,
governmental regulations concerning, but not limited to, environmental issues,
and other risks and unforeseen circumstances affecting the Company's business.
This Quarterly Report on Form 10-Q should be read in conjunction with the
Company's Annual Report on Form 10-K/A for the fiscal year ended December 31,
2002.
Critical Accounting Policies
The preparation of financial statements and related disclosures in conformity
with generally accepted accounting principles requires management to make
judgments, assumptions and estimates that affect the amounts reported in the
Company's financial statements and the accompanying notes. The amounts of assets
and liabilities reported in the Company's balance sheet and the amounts of
expenses reported for each fiscal period are affected by estimates and
assumptions which are used for, but not limited to, the accounting for asset
impairments. Actual results could differ from these estimates. The following
critical accounting policies are significantly affected by judgments,
assumptions and estimates used in the preparation of the consolidated financial
statements.
Estimated Net Realizable Value of Property and Equipment. The Company has
been engaged in the development of manufacturing equipment to validate
acceptance of EarthShell products and their pricing. To this end the Company
constructed manufacturing lines in Owings Mills, Maryland, in Goleta, California
and in Goettingen, Germany. The Company evaluates the recoverability of property
and equipment whenever events or changes in circumstances indicate that the
carrying value of an asset may not be recoverable. If there is an indication
that the carrying value of an asset may not be recoverable and the estimated
future cash flows (undiscounted and without interest charges) from the use of
the asset are less than the carrying value, a write-down is recorded to reduce
the related asset to its estimated fair value.
The Company's ongoing business plans for 2003 call for the transfer of
operational and financial control of the manufacturing line in Germany to the
Company's manufacturing licensee, PolarCup EarthShell ApS. At such time as the
machinery is demonstrated to perform at an agreed upon level, the Company
expects to receive reimbursement for the replacement value of the line. The
Company is carrying the equipment at its expected replacement value based on
quotations from various equipment suppliers for the cost of an identical line.
Failure of the equipment to perform at a level satisfactory to the licensee or
failure to conclude the transfer of the line to the licensee may require the
Company to consider alternative approaches to utilize the equipment, such as
finding an alternate licensee to take over, relocating the equipment, or
dismantling the line. Any one of these alternatives could have a negative
economic impact on the carrying value of the equipment.
Accrued Purchase Commitment. At March 30, 1998, a certificate of deposit for
$3.5 million was opened as collateral for the letter of credit related to the
Company's obligations under a letter agreement between the Company's controlling
stockholder, EKI, and the Company relating to a patent purchase agreement
between EKI and a third party, as discussed in the Commitments note, and is
classified as restricted cash on the balance sheet at December 31, 2002 and
September 30, 2003. As of December 31, 2002 and September 30, 2003, the $3.5
million certificate of deposit and the related accrued purchase commitment are
both classified as current in the accompanying balance sheet since the
obligation will become payable on or about December 31, 2003.
Fair Value of Warrant Obligation. In connection with the March 2003 financing
transactions, the Company issued to a placement agent a warrant, which expires
in March 2006, that is immediately exercisable by the placement agent to
purchase $1.055 million in aggregate principal amount of the 2006 Debentures and
41,667 shares of the Company common stock, except if, prior to exercise of the
warrant, all of the 2006 Debentures have been redeemed, repurchased or
converted, in which case the portion of the warrant exercisable into the 2006
Debentures becomes exercisable into common stock as if the 2006 Debentures
included in the warrant had been converted to common stock. The exercise price
of the convertible debenture portion of the warrant is $1,200 for each $1,000 of
principal and is subject to adjustment consistent with the provisions of the
2006 Debentures. The exercise price of the common stock portion of the warrant
is $7.20 per share. The estimated fair value of this warrant was reflected in
the financial statements as a warrant obligation and as a component of the $4.0
million aggregate discount on the 2006 Debentures and common stock issued in the
March 2003 financing transaction. At September 30, 2003, the Company evaluated
the current value of this warrant, considering its current cash flow
projections, continued operating losses, the prospects of raising additional
equity capital, the significant excess of the conversion price to the current
stock price and the volatility in the Company's stock price. Based upon these
factors, the Company determined that the likelihood of the warrant being
exercised is remote and has written off the balance of the warrant obligation as
of September 30, 2003, resulting in a $0.5 million gain in the three months
ended September 30, 2003 that is reflected in "Other (income) expense" in the
Statements of Operations.
13
Basis of Financial Statement Presentation. While the Company is continuing
to reduce its operating expenses and is working to cause one or more of its
licensees to purchase and install equipment to manufacture EarthShell
Packaging(R) in order to generate royalty revenue to the Company, the Company
will need to raise additional financing to meet its current obligations and to
cover operating expenses through the year ending December 31, 2003. This
additional financing could be in the form of new financing or the receipt of
funds from the transfer of manufacturing lines to its operating partners. The
Company cannot be certain that it will be able to raise additional financing by
December 31, 2003, that additional financing will be available to it, or, if
available, that the terms will be satisfactory, or that it will be able to
negotiate mutually agreeable terms for the transfer of the manufacturing lines
to its operating partners. If the Company is not successful in raising
additional capital or transferring the manufacturing lines, it may not be able
to continue as a going concern. The consolidated financial statements do not
include any adjustments relating to the recoverability and classification of
recorded asset amounts or the amounts and classification of liabilities that
might be necessary should the Company be unable to continue as a going concern.
(See Liquidity and Capital Resources at September 30, 2003).
Revenue recognition. The Company has been manufacturing and selling initial
quantities of commercial product in cooperation with its strategic partners as
it has worked to demonstrate the commercial viability of its products and
manufacturing processes. During its development phase, the Company has recorded
the proceeds from such sales since its inception as an offset to the cost of the
demonstration manufacturing operations. As the Company transitions the
commercial manufacturing of its products to its licensees and begins to earn
royalties under its license agreements, it intends to reevaluate its revenue
recognition policy.
The key accounting estimates and policies are reviewed with the Audit Committee
of the Board of Directors.
Overview of Operations
Three Months Ended September 30, 2003 Compared with the Three Months Ended
September 30, 2002.
The Company's net loss decreased $3.9 million to $2.9 million from $6.8 million
for the three months ended September 30, 2003 compared to the three months ended
September 30, 2002, respectively.
Total Research and Development Expenses. Total research and development expenses
are comprised of Related party license fee and research and development expenses
and Other research and development expenses. Total research and development
expenses for the development of EarthShell Packaging(R) decreased $1.6 million
to $1.6 million from $3.2 million for the three months ended September 30, 2003
compared to the three months ended September 30, 2002, respectively.
o Related party license fee and research and development expenses are
comprised of the $100,000 monthly licensing fee for the use of the
EarthShell Technology and technical services, both of which were
payable to EKI. Related party license fee and research and development
expenses increased $0.1 million to $0.4 million from $0.3 million for
the three months ended September 30, 2003 compared to the three months
ended September 30, 2002, respectively. This increase is entirely due
to an increase in technical services provided to the Company by
Biotec.
o Other research and development expenses are comprised of personnel
costs, travel and direct overhead for development and demonstration
production, as well as impairment charges on manufacturing property
and equipment constructed for demonstration production purposes. Other
research and development expenses decreased $1.6 million to $1.3
million from $2.9 million for the three months ended September 30,
2003 compared to the three months ended September 30, 2002,
respectively. The decrease in other research and development expenses
was primarily due to the lack of equipment impairment charges in 2003
versus $1.8 million of impairment charges in 2002. This reduction was
partially offset by costs incurred in connection with testing of the
Goettingen, Germany manufacturing equipment during the third quarter
and various non-recurring expenses.
14
Other General and Administrative Expenses. Other general and administrative
expenses are comprised of personnel costs, travel and direct overhead for
marketing, finance and administration. Total general and administrative expenses
decreased $1.0 million to $1.4 million from $2.4 million for the three months
ended September 30, 2003 compared to the three months ended September 30, 2002,
respectively. This was primarily the result of efforts to significantly reduce
general and administrative expenses in 2003, which resulted in reductions in the
following expenses: professional fees and services by $0.5 million, personnel
costs by $0.1 million, travel costs by $0.1 million and insurance costs by $0.1
million. In addition, in the second quarter of 2003 the Company began a program
to satisfy vendors for outstanding aged invoices. As a result of negotiations,
the Company settled and paid outstanding accounts payable of approximately $0.4
million in the third quarter at a discount of approximately $0.2 million.
Depreciation and Amortization Expense. Depreciation and amortization expense
decreased $0.7 million to $0.1 million from $0.8 million for the three months
ended September 30, 2003 compared to the three months ended September 30, 2002,
respectively. The decrease in depreciation expense is primarily attributable to
the write down of fixed assets as a result of the impairment of equipment to net
realizable value during 2002.
Interest Expense. Interest expense is comprised of Related party interest
expense and Other interest expense.
o Related party interest expense of $0.1 million for the three
months ended September 30, 2003 is interest accrued on outstanding
loans made to the Company by EKI under the Loan Agreement (see
Related Party Transactions), plus accretion of the discount
related to the warrants issued in conjunction with the March 2003
financing transactions.
o Other interest expense increased $0.2 million to $0.3 million from
$0.1 million for the three months ended September 30, 2003
compared to the three months ended September 30, 2002,
respectively. Other interest expense for the three months ended
September 30, 2003 is primarily composed of accretion of the
discount and interest accrued on the 2006 Debentures. Other
interest expense for the three months ended September 30, 2002 was
primarily composed of the accretion of the discount on the 2007
Debentures.
Gain on Sales of Property and Equipment. Gain on sales of property and equipment
of $.1 million for the three months ended September 30, 2003 primarily
represents the excess of proceeds received from the sale of non-essential
machine shop equipment and excess office furniture and equipment over its net
book value.
Other (Income) Expense. Other income of $0.5 million for the three months ended
September 30, 2003 represents the gain realized in connection with the write-off
of the warrant obligation as of September 30, 2003 (see Convertible
Debentures).
Debenture Conversion Costs. Debenture conversion costs of $0.1 million and $0.3
million for the three months ended September 30, 2003 and 2002, respectively,
represent the prorated portion of the original discount attributed to the 2007
Debentures converted during the respective periods.
Nine Months Ended September 30, 2003 Compared with the Nine Months Ended
September 30, 2002.
The Company's net loss decreased $10.9 million to $13.3 million from $24.2
million for the nine months ended September 30, 2003 compared to the nine months
ended September 30, 2002, respectively.
Total Research and Development Expenses. Total research and development expenses
are comprised of Related party license fee and research and development expenses
and Other research and development expenses. Total research and development
expenditures for the development of EarthShell Packaging(R) decreased $8.6
million to $5.9 million from $14.5 million for the nine months ended September
30, 2003 compared to the nine months ended September 30, 2002, respectively.
o Related party license fee and research and development expenses are
comprised of the $100,000 monthly licensing fee for the use of the
EarthShell Technology and technical services, both of which were
payable to EKI. Related party research and development expenses
decreased $0.1 million to $1.0 million from $1.1 million for the nine
months ended September 30, 2003 compared to the nine months ended
September 30, 2002, respectively. This decrease is entirely due to a
reduction in technical services provided to the Company by Biotec.
15
o Other research and development expenses are comprised of personnel
costs, travel and direct overhead for development and demonstration
production, as well as impairment charges on manufacturing property
and equipment constructed for demonstration production purposes. Other
research and development expenses decreased $8.5 million to $4.9
million from $13.4 million for the nine months ended September 30,
2003 compared to the nine months ended September 30, 2002,
respectively. The decrease in other research and development expenses
was primarily due to concluding the demonstration manufacturing of
hinged-lid containers in Owings Mills, Maryland at the end of the
second quarter of 2002. While the majority of the expenses incurred in
the nine months ended September 30, 2002 related to the Owings Mills
demonstration manufacturing, it also included expenses related to the
commencement of demonstration manufacturing of bowls and plates in
Goleta, California. Other research and development expenses for the
nine months ended September 30, 2003 related to the ongoing
demonstration manufacturing in Goleta through mid-April and to the
start-up in mid-May of a new manufacturing line for plates and bowls
built and financed by Detroit Tool and Engineering Company (DTE) at
their Lebanon, Missouri facility. In early August 2003, the Company
discontinued its day-to-day support of manufacturing activities at
DTE. In keeping with its business model, the Company will hereafter
focus primarily on the licensing of its foam analog material and other
technologies, and all future manufacturing and production will be the
responsibility of current or new licensees as they install and run
equipment to produce EarthShell Packaging(R) in their own facilities.
The nine months ended September 30, 2003 also included expenses
incurred to vacate the Goleta facility at the expiration of the lease
on May 31. The nine months ended September 30, 2002 included
impairment charges of $1.9 million
Other General and Administrative Expenses. Other general and administrative
expenses are comprised of personnel costs, travel and direct overhead for
marketing, finance and administration. Total general and administrative expenses
decreased $2.6 million to $4.4 million from $7.0 million for the nine months
ended September 30, 2003 compared to the nine months ended September 30, 2002,
respectively. This was primarily the result of efforts to significantly reduce
general and administrative expenses in 2003, which resulted in reductions in the
following expenses: professional fees and services by $0.5 million, personnel
costs by $0.2 million, travel costs by $0.2 million and facility costs by $0.2
million. In addition, in the second quarter of 2003 the Company began a program
to satisfy vendors for outstanding invoices. As a result of negotiations, the
Company settled and paid outstanding accounts payable of approximately $1.0
million at a discount of approximately $0.6 million.
Depreciation and Amortization Expense. Depreciation and amortization expense
decreased $2.1 million to $0.3 million from $2.4 million for the nine months
ended September 30, 2003 compared to the nine months ended September 30, 2002,
respectively. The decrease in depreciation expense is primarily attributable to
the write down in fixed assets as a result of the impairment of equipment to net
realizable value during 2002.
Interest Expense. Interest expense is comprised of Related party interest
expense and Other interest expense.
o Related party interest expense of $0.3 million for the nine months
ended September 30, 2003 is primarily interest accrued on
outstanding loans made to the Company by EKI under the Loan
Agreement (see Related Party Transactions), plus accretion of the
discount related to the warrants issued in conjunction with the
March 2003 financing transactions.
Although the outstanding loans will accrue approximately $0.3
million in annual interest expense, payment of the interest is
subordinated to the 2006 Debentures. Therefore, the related party
interest expense will not be paid in cash until the 2006
Debentures have been converted or the obligation satisfied in
full.
o Other interest expense increased $1.1 million to $1.2 million
from $0.1 million for the nine months ended September 30, 2003
compared to the nine months ended September 30, 2002,
respectively. Other interest expense for the nine months ended
September 30, 2003 is primarily comprised of accretion of the
discount on the 2006 Debentures and a beneficial conversion
charge in the amount of $360,000 due to a change in the 2007
Debentures conversion price. In addition, Other interest expense
for the nine months ended September 30, 2003 also included
accretion of the discount on the 2007 Debentures and interest
accrued on the 2006 and 2007 Debentures. Interest expense from
accretion of the discount and accrued interest payable on the
2006 Debentures will be approximately $0.8 million per year until
they expire or are converted into common stock.
Gain on Sales of Property and Equipment. Gain on sales of property and equipment
of $.2 million for the nine months ended September 30, 2003 primarily represents
the excess of proceeds received from the sale of non-essential machine shop
equipment and excess office furniture and equipment over its net book value. As
the Company continues to focus on the licensing of its foam analog material and
other technologies, it will continue to liquidation non-essential product
development center equipment and excess office furniture and equipment.
Other (Income) Expense. Other income of $0.4 million for the three months ended
September 30, 2003 represents the net gain realized in connection with the
write-off of the balance of the warrant obligation as of September 30, 2003 (see
Convertible Debentures).
Loss on Extinguishment of Debentures. In connection with the March 2003
financing transactions, the Company prepaid $5.2 million of the outstanding $8.2
million principal amount of the 2007 Debentures, resulting in a prepayment
penalty of $208,000. The Company also issued the holders of the 2007 Debentures
52,083 shares of common stock, valued at $237,500 based upon the closing price
of the Company's common stock of $4.56 per share on March 5, 2003. In addition,
one of the holders of the 2007 Debentures exchanged $2.0 million aggregate
principal amount of 2007 debentures for $2.0 million aggregate principal amount
of 2006 Debentures and 78,989 shares of common stock valued at approximately
$360,000 based upon the closing price of the Company's common stock of $4.56 per
share on March 5, 2003. In connection with the prepayment and exchange
transactions, the Company incurred cash transaction costs of approximately
$321,000, excluding the prepayment penalty. In addition, the Company incurred a
charge of approximately $0.9 million for the prorated portion of the original
discount attributed to the $7.2 million of the 2007 Debentures repaid and
exchanged. Therefore, the Company recognized a $1.7 million loss upon
extinguishment of the 2007 Debentures through the prepayment and exchange.
16
Debenture Conversion Costs. Debenture conversion costs of $0.2 million and $0.3
million for the nine months ended September 30, 2003 and 2002, respectively,
represent the prorated portion of the original discount attributed to the 2007
Debentures converted during the respective periods.
Liquidity and Capital Resources at September 30, 2003
Cash Flow. The Company's principal use of cash for the nine months ended
September 30, 2003 was to fund operations. Net cash used in operations was $12.3
million for the nine months ended September 30, 2003. Net cash provided by
investing activities was $0.2 million for the nine months ended September 30,
2003. Net cash provided by financing activities was $13.5 million for the nine
months ended September 30, 2003. As of September 30, 2003 the Company had
unrestricted cash and related cash equivalents totaling $1.5 million.
Capital Requirements. The Company paid or accrued $1,320 in capital
expenditures for the nine months ended September 30, 2003. Construction of the
commercial line installed in cooperation with Huhtamaki at its Goettingen,
Germany facility was largely completed in 2002. Therefore the Company does not
expect to make significant capital expenditures in the years 2003 or 2004.
Sources of Capital. As part of the Company's initial public offering on March
27, 1998, the Company issued 877,193 shares of common stock, for which it
received net proceeds of $206 million. On April 18, 2000 and January 4, 2001,
the Company filed shelf registrations statements for 416,667 and 1.25 million
shares, respectively, of the Company's common stock. During the years ended
December 31, 2002, 2001 and 2000 the Company sold 145,176, 1.1 million and
371,431 shares of common stock in private transactions under such registration
statements and received net proceeds from such sales of approximately $2.3
million $30.5 million and $10.5 million, respectively. All shares available
under such registration statements were sold as of December 2002.
In December of 2001 the Company filed a shelf registration statement providing
for the sale of up to $50 million of securities, including secured or unsecured
debt securities, preferred stock, common stock, and warrants. These securities
may be offered, separately or together, in distinct series, and in amounts, at
prices and on terms to be set forth in the prospectus contained in the
registration statement, and in subsequent supplements to the prospectus. During
the year ended December 31, 2002, the Company sold 1.9 million shares of common
stock in negotiated transactions under such registration statement and received
net proceeds from such sales of $19.6 million.
On August 12, 2002 the Company issued $10 million in aggregate principal amount
of the 2007 Debentures to institutional investors. These debentures bear
interest at a rate of 1.5% per annum. The holders of these debentures had the
right to convert the debentures into the Company's common stock at an initial
conversion price of $15.60 per share, which has been reduced to $6.00 per share
as a result of anti-dilution adjustments. Based on the conversion price relative
to the fair market value of the common stock at the date of issue, the
debentures were deemed to have no beneficial conversion feature. The proceeds
from the debentures are held in restricted accounts linked to irrevocable
letters of credit in favor of the debenture holders such that unrestricted
access to the proceeds from the sale of the debentures occurs only upon
conversion of the debentures into shares of the Company's common stock. In
addition to the holders' conversion option, under certain circumstances, the
Company has the right to force conversion of up to $500,000 of the debentures
per week at a 15% discount to the market price of the Company's stock. Subject
to certain conditions set forth in the debentures, the Company may prepay the
debentures upon twenty business days notice for 104% of the outstanding
principal balance of the debentures. If during any consecutive 90 day period
following August 12, 2002, the holders of the debentures or the Company have not
converted more than an aggregate of $3.0 million of the original principal
amount of $10.0 million or, on August 12, 2003 the holders of the debentures or
the Company have not converted more that an aggregate of $7.5 million of the
original principal amount of $10.0 million, the holder of the debenture may
require the Company to prepay all or a portion of the debentures for an amount
in cash equal to the principal amount of the debenture to be prepaid, plus all
accrued and unpaid interest, such amount being payable on the 20th trading day
following the Company's receipt of a prepayment notice. During the third quarter
of 2002, the Company forced conversion of $1.0 million of the debentures for
166,667 shares of common stock, reducing the outstanding balance to $9.0
million. In the first quarter of 2003 the Company forced conversion of an
additional $800,000 of the debentures for 139,599 shares of common stock. In
March 2003, as part of a new convertible debenture financing, the Company repaid
$5.2 million of the debentures, and also exchanged $2.0 million of these
debentures for new 2006 Debentures which are not secured by cash, thereby
releasing the related cash. In connection with this restructuring, the Company
issued approximately 0.6 million shares of common stock to the original
debenture holders. In the second quarter of 2003 the holders converted $491,000
of the debentures for 81,833 shares of common stock. In July 2003 the Company
forced the conversion of the remaining $509,000 of the debentures for 132,552
shares of common stock.
17
During 2002, the Company's largest shareholder, EKI, made various simple
interest working capital loans to the Company. These loans bear interest at a
rate of 7% or 10% per annum, and are payable on demand. As of December 31, 2002,
the outstanding principal balance of these loans was $1,745,000. In January
2003, EKI made additional working capital loans to the Company totaling
$1,010,000. Some of these loans were not repaid at their stated maturity, and
thereby became convertible, at EKI's election, into shares of the Company's
common stock. As part of the issuance and sale of the 2006 Debentures completed
in March 2003, repayment of these loans totaling $2,755,000 has been
subordinated to the 2006 Debentures with strict covenants governing repayment of
such loans.
In March 2003, the Company issued and sold $10.55 million in aggregate principal
amount of the 2006 Debentures to a group of institutional investors. After
transaction fees, the Company realized net proceeds of approximately $9.0
million, which, together with the $2.0 million realized as a result of the
exchange of such amount of the 2006 Debentures for a like amount of the 2007
Debentures discussed above, means that the Company gained net proceeds of
approximately $11.0 million from the two transactions. In the first quarter of
2003, $1.0 million of the 2006 Debenture principal was converted into 166,667
shares of common stock. During the second quarter ended June 30, 2003, $850,000
of the 2006 Debenture principal was converted into 141,667 shares of common
stock. During the quarter ended September 30, 2003, $3,325,000 of the Debenture
principal was converted into 554,167 shares of common stock. As of September 30,
2003 there was an aggregate balance of $7.375 million of the 2006 Debentures
outstanding. Subsequent to September 30, 2003, $575,000 of the 2006 Debenture
principal was converted into 95,833 shares of common stock.
While the Company is continuing to reduce its operating expenses and is working
to cause one or more of its licensees to purchase and install equipment to
manufacture EarthShell Packaging(R) in order to generate royalty revenue to the
Company, the Company will need to raise additional financing to meet its current
obligations and to cover operating expenses through the year ending December 31,
2003. The Company cannot be certain that it will be able to raise additional
financing by December 31, 2003, that additional financing will be available to
it, or, if available, that the terms will be satisfactory, or that it will be
able to negotiate mutually agreeable terms for the transfer of the manufacturing
lines to its operating partners. If the Company is not successful in raising
additional capital or transferring the manufacturing lines, it may not be able
to continue as a going concern.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
The Company's treasury function controls all decisions and commitments regarding
cash management and financing arrangements. Treasury operations are conducted
within a framework that has been authorized by the board of directors.
The Company is exposed to interest rate risk on its fixed rate convertible
debentures and notes payable. As of September 30, 2003, these fixed rate debt
obligations totaled $10.2 million. The 2006 Debentures bear interest at a fixed
rate of 2% per annum. The notes payable bear interest at a fixed rate of 10% per
annum. While generally an increase in market interest rates will decrease the
value of this debt, and decreases in rates will have the opposite effect, we are
unable to estimate the impact that interest rate changes will have on the value
of the substantial majority of this debt as there is no active public market for
this debt.
Item 4. Controls and Procedures
Evaluation of disclosure controls and procedures. Based on their evaluation of
the Company's disclosure controls and procedures as of the end of the period
covered by this quarterly report on Form 10-Q, the Company's Chief Executive
Officer and Chief Financial Officer evaluated the effectiveness of the design
and operation of the Company's disclosure controls and procedures (as defined in
Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as
amended (the "Exchange Act")) pursuant to Rule 13a-15 of the Exchange Act. Based
upon that evaluation, the Company's Chief Executive Officer and Chief Financial
Officer concluded that the Company's disclosure controls and procedures are
effective to ensure that the Company is able to collect, process and disclose
the information it is required to disclose in the report it files with the
Securities and Exchange Commission within the required time periods.
Changes in internal control over financial reporting. The Company maintains a
system of internal control over financial reporting (as defined in Rules
13a-15(f) and 15d-15(f) under the Exchange Act). No significant changes in the
Company's internal control over financial reporting have come to management's
attention during the Company's last fiscal quarter that have materially
affected, or are likely to materially affect, the Company's internal control
over financial reporting.
Part II. Other Information
Item 1. Legal Proceedings
In September 2003, two lawsuits were filed against the Company by Green
Packaging ("GP") and Green Earth Packaging ("GEP"), both of whom have signed
license agreements with the Company permitting their use of the Company's
proprietary, biodegradable-packaging technology. The first lawsuit alleges
breach of an oral contract involving manufacturing equipment that GP and GEP
purchased in order to manufacture biodegradable packaging using the Company's
proprietary technology and seeks contract damages in excess of $2 million. The
second lawsuit alleges violations of California's antitrust law and Unfair
Practices Act involving the commercial viability of the biodegradable-packaging
technology that the Company licensed to GP and GEP and seeks unspecified damages
in excess of $10 million. Although the Company believes both lawsuits are
without merit and intends to vigorously defend against them, an adverse decision
in either case would materially adversely impact the financial condition of the
Company.
Item 2. Changes in Securities and Use of Proceeds
Not applicable
Item 3. Defaults Upon Senior Securities
Not applicable
Item 4. Submission of Matters to a Vote of Security Holders
Not applicable
Item 5. Other Information
Not applicable
Item 6. Exhibits and Reports on Form 8-K
The Company filed two reports on Form 8-K during the quarter ended September 30,
2003, and two reports on Form 8-K subsequent to September 30, 2003 but prior to
the filing of this Form 10-Q. Information regarding the items reported on is as
follows:
Date Item Reported On
- ------------------------- -----------------------------------------------
July 31, 2003 Engagement of Farber & Hass LLP as the Company's
independent public accountants.
August 15, 2003 Press release of the Company dated August 15, 2003,
relating to the Company's earnings for the second
quarter ended June 30, 2003.
October 17, 2003 Press release of the Company dated October 20,
2003, regarding a reverse stock split.
October 30, 2003 Press release of the Company dated October
30, 2003, relating to the Company's earnings
for the third quarter ended September 30, 2003.
31.1 Certification of the CEO pursuant to Rules 13a-14 and 15d-14 under the
Securities Exchange Act of 1934, as amended, as adopted pursuant to Section
302 of the Sarbanes-Oxley Act of 2002.
31.2 Certification of the CFO pursuant to Rules 13a-14 and 15d-14 under the
Securities Exchange Act of 1934, as amended, as adopted pursuant to Section
302 of the Sarbanes-Oxley Act of 2002.
32.1 Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.
18
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned.
EarthShell Corporation
Date: November 11, 2003 By: /s/ D. Scott Houston
--------------------
D. Scott Houston
Chief Financial Officer
(Principal Financial Officer and Duly Authorized Officer)
19