CATALYTICA ENERGY SYSTEMS INC - 10-Q Quarterly Report

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 8, 2004 there were outstanding 17,889,892 shares of the Registrant’s common stock, par value $0.001, which is the only class of common stock outstanding.

Description of Business. Catalytica Energy Systems, Inc. (“Catalytica Energy,” “the Company,” “we,” “us” or “our”) provides innovative emissions solutions to ease the environmental impact of combustion-related applications in the power generation and transportation industries. The Company offers a variety of services for coal-fired power plants and other fossil fuel-fired power generation facilities that use selective catalytic reduction (“SCR”) systems to reduce nitrogen oxides (“NOx”) emissions. These services include SCR catalyst cleaning and regeneration, SCR system management services to optimize efficiency and reduce overall operating and maintenance costs, and consulting services related to the design of SCR systems (collectively “SCR Catalyst and Management Services”). Our business activities also include the design, development, manufacture and servicing of advanced products based on our proprietary catalyst and fuel processing technologies to offer cost-effective solutions for reducing NOx emissions from diesel engines and natural gas-fired turbines. Our diesel fuel processing technology is designed to enable significant NOx reduction from mobile, stationary and off-road diesel engine applications. Our commercially-available catalytic combustion solution, Xonon Cool Combustion^®, enables gas turbines to achieve ultra-low NOx emissions. Other activities include the development of fuel processing systems for fuel cell use in stationary, auxiliary and back-up power applications.

Unaudited Interim Financial Information. 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 accounting principles generally accepted in the United States 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 nine-month period ended September 30, 2004 are not necessarily indicative of the results that may be expected for the full fiscal year ending December 31, 2004. 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 our Annual Report on Form 10-K for the year ended December 31, 2003 filed with the Securities and Exchange Commission on March 30, 2004.

Reclassifications. Effective January 1, 2004, the Company elected to reclassify certain expenses in its consolidated statements of operations. Costs of revenue-producing research and development (“R&D”) programs have been reclassified from research and development to cost of revenues. These reclassifications resulted in an increase to cost of revenues and a decrease to research and development of $1,209,000 and $3,420,000 for the three and nine-months ended September 30, 2003.

Development Stage. Since inception, the Company was considered a development stage company, as defined in Statement of Financial Accounting Standards (“SFAS”) No.7, “Accounting and Reporting by Development Stage Enterprises.” In February 2004, the Company acquired SCR-Tech, LLC (“SCR-Tech”), a company with established commercial operations in the area of innovative NOx solutions, and as such, left the development stage. The Company expects to continue making significant investments in research and development as it expands its product development and commercialization programs.

Revenues. The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the price is fixed or determinable and collection is reasonably assured. Research and development revenues are earned as contractual services are performed and are recognized in accordance with contract terms, principally based on reimbursement of total costs and expenses incurred. No amounts recognized as revenue are refundable. In return for funding, collaborative partners may receive certain rights in the commercialization of the resulting technology. The contracts are also subject to periodic review by the funding partner, which may result in modifications, including reduction or termination of funding. Revenues related to SCR catalyst regeneration and cleaning services are recognized when the service is completed. We recognize revenue from our management and consulting services as work is performed. Costs associated with the performance of services are generally expensed as incurred.

Accounts Receivable. Accounts receivable consists of trade receivables generated from research and development contracts, trade receivables from SCR Catalyst and Management Services and revenues in excess of billings from SCR Catalyst and Management Services. Trade receivables are recorded at the invoiced amount. Payment terms for SCR catalyst regeneration and cleaning services are typically defined in the contract for services rendered. Revenues may be earned for those services in advance of amounts billable to the customer and are recognized when the service is complete, unless the contract terms will not result in invoice generation within six months from the date of completion of those services. Revenues recognized in excess of amounts billed are recorded as accounts receivable. Revenues in excess of billings represented $733,000 and $0 of net accounts receivable as of September 30, 2004 and December 31, 2003, respectively.

Goodwill and Other Intangible Assets. The Company accounts for goodwill and other intangible assets in accordance with the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets.” Pursuant to SFAS No. 142, goodwill and other intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but instead tested for impairment at least annually in accordance with the provisions of SFAS No. 142. SFAS No. 142 also requires that intangible assets with estimable useful lives be amortized over their respective estimated useful lives to their estimated residual values and reviewed for impairment in accordance with SFAS No. 144, “Accounting for Impairment or Disposal of Long-Lived Assets.”

Goodwill represents the excess of costs over fair value of acquired net assets, including other intangible assets. Other intangible assets that have finite useful lives, including patents, trademarks, trade secrets and other purchased technology, are recorded at fair value at the time of the acquisition, and are carried at such value less accumulated amortization. The Company amortizes these intangible assets on a straight-line basis over their useful lives, estimated at ten years.

Segment Disclosure. Catalytica Energy operates as one business segment. Consequently, segment disclosure as of and for the three and nine-month periods ended September 30, 2004 and 2003 is not provided.

Use of Estimates. The preparation of consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.

Basic and diluted net loss per share is presented in accordance with SFAS No. 128, “Earnings Per Share.” The Company’s potentially dilutive securities (stock options) were anti-dilutive for the three and nine-month periods ended September 30, 2004 and 2003 because the Company incurred a net loss for each of those periods. Therefore such potentially dilutive securities have been excluded from the computation of weighted-average shares outstanding used in computing diluted net loss per share. Total potentially dilutive securities outstanding as of September 30, 2004 and 2003 were approximately 3,190,000 and 2,596,000, respectively. The following table sets forth the computation of basic and diluted net loss per share attributable to common stockholders:

The Company accounts for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and has adopted the disclosure-only alternative of SFAS No. 123, “Accounting for Stock-based Compensation,” and SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure.” Any deferred stock compensation calculated under APB Opinion No. 25 and related interpretations is amortized over the vesting period of the individual options, generally four years, using the straight-line method of amortization.

Stock-based awards to non-employees are accounted for at fair value, as generally calculated using the Black-Scholes model, in accordance with SFAS No. 123 and Emerging Issues Task Force Consensus No. 96-18, “Accounting for Equity Instruments that are Issued to other than Employees for Acquiring, or in Conjunction with Selling, Goods or Services” (“EITF 96-18”). Related options are subject to re-measurements over their vesting terms at the end of each reporting period.

Had compensation cost for Catalytica Energy’s stock-based compensation plan for employees and directors been determined based on the fair value at the grant dates consistent with the method of SFAS No. 123, the Company’s net loss would have been increased to the pro forma amounts indicated below:

On February 20, 2004, we acquired 100% of the outstanding member interests of SCR-Tech and certain patents and related intellectual property. SCR-Tech is a provider of catalyst regeneration technologies and management services for SCR systems, which are used by coal-fired plants and other fossil fuel-fired power generating facilities to reduce NOx emissions. As a result of the acquisition, the Company is expanding its commercial operations and leveraging its expertise in NOx control and catalysis within multiple markets. In addition to an initial cash payment of $3,518,000, we are obligated to the following payments:

Upon closing of the acquisition, $7,433,000 was recorded as an investment in SCR-Tech; consisting of $3,518,000 initial cash payment, $237,000 due diligence costs incurred through closing, $545,000 accrued liability and $3,133,000 present value of estimated future acquisition payments. Goodwill of $4,496,000 and other intangible assets of $1,727,000 were recorded as part of this purchase. The intangible assets will be amortized over their estimated useful lives of ten years. Goodwill and other intangible assets will be reviewed for impairment at each year-end. The results of operations for SCR-Tech for the period February 21, 2004 through September 30, 2004 are included in the consolidated statements of operations, cash flow and balance sheets as of and for the nine-months ended September 30, 2004.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This Management’s Discussion and Analysis of Financial Condition and Results of Operations and other parts of this Report on Form 10-Q contain forward-looking statements that involve risks and uncertainties. The words “anticipates,” “believes,” “expects,” “intends,” “will” and similar expressions identify forward-looking statements which are based on information available to us on the date hereof. We assume no obligation to update any such forward-looking statements.

Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those set forth in “Risks That Could Affect Our Financial Condition and Results of Operations” and elsewhere in this Quarterly Report on Form 10-Q.

Catalytica Energy Systems, Inc. (“Catalytica Energy,” the “Company,” “we” or “us”) was incorporated in Delaware as a subsidiary of Catalytica, Inc. in June 1995. Catalytica Energy operated as part of Catalytica, Inc.’s research and development activities from inception through the date of its incorporation as a separate entity. In December 2000, Catalytica Advanced Technologies, Inc., another subsidiary of Catalytica Inc., was merged into us, and the combined entity was spun out from Catalytica, Inc. as Catalytica Energy Systems, Inc., a separate, stand-alone public company.

Catalytica Energy Systems, Inc. provides innovative emissions solutions to ease the environmental impact of combustion-related applications in the power generation and transportation industries. The Company offers a variety of services for coal-fired power plants and other fossil fuel-fired power generation facilities that use selective catalytic reduction (“SCR”) systems to reduce nitrogen oxides (“NOx”) emissions. These services include SCR catalyst cleaning and regeneration, SCR system management services to optimize efficiency and reduce overall operating and maintenance costs, and consulting services related to the design of SCR systems (collectively “SCR Catalyst and Management Services”). Our business activities also include the design, development, manufacture and servicing of advanced products based on our proprietary catalyst and fuel processing technologies to offer cost-effective solutions for reducing NOx emissions from diesel engines and natural gas-fired turbines. Our diesel fuel processing technology is designed to enable significant NOx reduction from mobile, stationary and off-road diesel engine applications. Our commercially-available catalytic combustion solution, Xonon Cool Combustion^®, enables gas turbines to achieve ultra-low NOx emissions. Other activities include the development of fuel processing systems for fuel cell use in stationary, auxiliary and back-up power applications.

We are growing our business through a product and market diversification strategy in the area of NOx control. Increasingly stringent air quality regulations have resulted in tighter emissions restrictions being imposed on a variety of combustion-related applications. NOx emissions, which are a precursor to smog formation, have become a primary target of government-imposed emissions regulations, creating a significant opportunity for innovative, cost-effective NOx control solutions.

In February 2004, we acquired SCR-Tech, the North American leader in catalyst regeneration technologies and management services for SCR systems used by coal-fired power plants and other utility-scale power generating facilities to reduce NOx emissions. Under the terms of the acquisition, we made an initial cash payment of approximately $3.5 million. In September 2004, we made a subsequent cash payment of $545,000, triggered by completion of certain training and the delivery to us of certain additional acquired assets. We also will be obligated to make deferred payments of approximately $7.5 million over a 10 to 15-year period beginning in 2005, including contingent payments relating to the acquisition of intellectual property and exclusive NAFTA ownership of patents and relating to the retention of a key employee. In addition, earn-out payments may be due between 2005 and 2009, contingent upon revenue and cash flow generation in excess of established targets.

The addition of SCR-Tech strategically broadens and diversifies our product and service offerings to the growing emissions control market for coal-fired power plants and accelerates our penetration of the NOx control marketplace. We believe the acquisition of SCR-Tech has created a solid foundation for future growth and has strengthened our ability to continue pursuing development and commercialization efforts in other areas of our business, while also targeting additional business opportunities in the area of NOx control. Through our SCR-Tech subsidiary, we are now offering catalyst cleaning, rejuvenation and regeneration, as well as SCR Catalyst and Management Services, to help plant operators optimize their SCR system operation while also reducing operating and maintenance costs.

We have commercialized and are marketing Xonon Cool Combustion^®, a breakthrough pollution prevention technology that enables natural gas-fired turbines to achieve ultra-low emissions power production through a proprietary catalytic combustion process. We believe our Xonon Cool Combustion^® product is the only commercially available pollution prevention technology proven to achieve ultra-low NOx emissions of less than 3 parts per million (“ppm”) during combustion. Our Xonon^® system is integrated within a gas turbine, replacing the conventional flame-based combustion system with a catalytic process that combusts fuel at temperatures below the threshold at which NOx forms.

Consistent with our product and market diversification strategy, we are leveraging our catalyst technology expertise with a proven fuel processing competency to offer innovative new engine and retrofit diesel emissions reduction solutions, targeted at helping diesel engine OEMs and end-use customers meet stricter diesel emissions standards in the U.S. and internationally. To address the growing emissions control market for diesel engine applications, we have developed and are now refining a proprietary fuel processor technology, which is designed to significantly improve the performance of NOx trap (also known as NOx adsorber) systems to enable a high-performing and cost-effective NOx reduction solution. For new engine applications, our Xonon fuel processor (“XFP”) technology is designed to help diesel OEMs achieve a 90% reduction in NOx. For mobile retrofit applications, our XFP technology is being designed to offer an easy integration, bolt-on solution for diesel engines currently in service to address growing urban smog issues by achieving up to a 50% reduction in NOx. For stationary diesel applications, our XFP technology is being designed to offer a cost-effective solution to achieve a greater than 90% reduction in NOx to help end-users generate improved economics from their stationary power sources while maintaining compliance with increasingly stringent emissions regulations.

As a result of our acquisition of SCR-Tech in February 2004, our fiscal 2004 year-to-date revenue mix has materially changed. Prior to the acquisition of SCR-Tech, primarily all of our revenues resulted from research and development contracts funded by gas turbine manufacturers, government sources or research institutions, as well as contracted and collaborative research. We anticipate SCR-Tech will provide approximately one-half of our revenues in 2004. However, we have only a limited operating and ownership experience with SCR-Tech, which creates a number of uncertainties regarding the business and operating results of SCR-Tech. These include: uncertainties arising from integrating our management, technology and systems with SCR-Tech; the timing and receipt of payment for SCR-Tech services; the nature and type of revenue and revenue recognition policies with respect to SCR-Tech’s business; and the significant business and financial risks discussed herein relating to SCR-Tech, which cannot yet be fully evaluated due to the limited operating experience and lack of comparable periods of operations. As a result, our financial results for the first nine months of 2004 should be considered in this context.

We continue to expect substantial losses during the next few years as we seek to expand commercialization of our Xonon Cool Combustion^® product, develop NOx control systems for diesel engines, expand our SCR Catalyst and Management Services and pursue other opportunities that leverage our core technologies or business focus, including additional potential acquisitions. These activities involve significant potential financial commitments, and there can be no assurance we will have sufficient funds to successfully develop our business or that any of our business operations will be profitable.

Our discussion and analysis of financial condition and results of operations is 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 consolidated 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.

Our significant accounting policies are disclosed in Note 1 to the consolidated financial statements contained in our Annual Report on Form 10-K for the year ended December 31, 2003 filed with the Securities and Exchange Commission on March 30, 2004. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.

We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the price is fixed or determinable and collection is reasonably assured. Research and development revenues are earned as contractual services are performed and are recognized in accordance with contract terms, principally based on reimbursement of total costs and expenses incurred. No amounts recognized as revenue are refundable. In return for funding, collaborative partners may receive certain rights in the commercialization of the resulting technology. The contracts are also subject to periodic review by the funding partner, which may result in modifications, including reduction or termination of funding. Revenues related to SCR catalyst regeneration and cleaning services are recognized when the service is completed. We recognize revenue from our management and consulting services as work is performed. Costs associated with the performance of services are generally expensed as incurred.

We account for goodwill and other intangible assets in accordance with the provisions of Statement of Financial Accounting Standards (SFAS) No. 142, “Goodwill and Other Intangible Assets.” Goodwill represents the excess of costs over fair value of acquired net assets, including other intangible assets. Other intangible assets that have finite useful lives, including patents, trademarks, trade secrets and other purchased technology, were recorded at fair value at the time of the acquisition, and are carried at such value less accumulated amortization. We amortize these intangible assets on a straight-line basis over their useful lives, estimated at ten years.

We maintain an allowance for doubtful accounts for estimated losses resulting from the inability of our customers or funding partners to make required payments. This allowance is based on specific customer account reviews and historical collections experience. 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 to provide for a potential default on repayment of a note. 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 changes in market prices, we periodically write down our inventory of certain precious metals used in our products 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 would be required.

Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 109, “Accounting for Income Taxes”, requires that a valuation allowance be established when it is more likely than not that all or a portion of a deferred tax asset will not be realized. SFAS No. 109 further states that it is difficult to conclude that a valuation allowance is not needed when there is negative evidence such as cumulative losses in recent years. As a result we have recorded a full valuation allowance against our deferred tax assets and expect to continue to record a full valuation allowance on future tax benefits until we reach profitability.

We record a reserve for contingencies, including litigation settlements, when a liability becomes probable and estimable. The amount we record for litigation reserves is based upon our best estimate at the time and is subject to change as facts we become aware of change or ultimate determinations or settlements are made.

The following summary presents the results of operations and percentage change by comparable period for the three and nine-month periods ended September 30, 2004:

Revenues. Revenues in the periods presented include revenue generated from SCR Catalyst and Management Services (after February 20, 2004). SCR Catalyst and Management Services revenues are primarily generated from catalyst cleaning and regeneration services. Additionally, the Company provides management and consulting

services related to the design, operating efficiency, and overall operating and maintenance costs of SCR systems. In addition, revenues in the periods presented include revenues generated from research and development (“R&D”) contracts funded by gas turbine manufacturers and government sources for fuel processor, diesel and gas turbine technology development. These R&D contracts provide for partial recovery of our direct and indirect costs.

We expect to continue to pursue funded research programs. Most of our R&D contracts are subject to periodic review by our funding partner, which may result in modifications, termination of funding or schedule delays. We cannot ensure we will continue to receive R&D 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”). The timing of revenues varies from year to year, and from contract to contract, based on the terms agreed upon by us and the customer or funding party. Due to the nature of our revenue sources, period-to-period comparisons of revenue are not necessarily meaningful and should not be relied upon as indications of future performance.

The majority of the increase in revenue during the three-month period ended September 30, 2004 compared to the corresponding period of 2003 consists of the following: incremental revenue of $1,070,000 from SCR Catalyst and Management Services following the Company’s acquisition of SCR-Tech in February 2004 and a $360,000 increase in revenue from new diesel R&D programs commencing in the third quarter, offset by a $526,000 reduction in government and OEM funding, as development efforts under certain gas turbine programs were completed.

The majority of the increase in revenue during the nine-month period ended September 30, 2004 compared to the corresponding period of 2003 consists of the following: incremental revenue of $2,019,000 from SCR Catalyst and Management Services and a $360,000 increase in revenue from new diesel R&D programs commencing in the third quarter, offset by a $837,000 reduction in government and OEM funding, as development efforts under certain gas turbine programs were completed.

We expect total revenue for the year ending December 31, 2004 will be in excess of 2003 revenue, due to the addition of SCR Catalyst and Management Services to our overall NOx solutions offerings. We expect R&D revenue during the year ending December 31, 2004 will be less than during 2003 due to reduced availability of funding from governmental agencies and OEM partners resulting from challenging market conditions in the gas turbine industry. R&D revenue will continue to be provided primarily by government agencies, with a Department of Energy (“DOE”) fuel processor program comprising the majority of that revenue.

Cost of Revenues. Expenses relating to government and OEM funded programs are classified as cost of revenues. Expenses relating to internally funded programs are classified as R&D. Accordingly, shifts in effort between government and OEM funded programs versus internally funded programs can produce period-to-period variances in cost of revenues and R&D.

Cost of revenues attributable to SCR Catalyst and Management Services include direct labor, plant management wages, fringe benefits, facility rent, chemicals, depreciation, supplies and third party consulting services, and are expensed as incurred. Cost of revenues related to R&D contracts consist of direct expenses including direct labor, fringe benefits, travel, consulting and other third party professional services, supplies and R&D overhead, and are expensed as incurred. R&D overhead is applied to government and OEM funded programs based on total non-direct program expenses incurred as a percentage of direct program expenses.

The increase in cost of revenues during the three-month period ended September 30, 2004 compared to the corresponding period of 2003 resulted from $586,000 in incremental expenses from SCR Catalyst and Management Services, offset by a $470,000 decrease in cost of R&D contracts, resulting from reduced activity relating to OEM and government contracts, in addition to reduced overhead between comparative periods. The reduction in overhead resulted from focused expense reduction efforts and increased utilization of internal resources.

The cost of revenues during the nine-month period ended September 30, 2004 was flat compared to the corresponding period of 2003. The cost of revenues for the nine-month period ended September 30, 2004 compared to the corresponding period of 2003 included a $1,409,000 decrease in cost of R&D contracts, resulting from reduced activity relating to OEM and government contracts, combined with reduced overhead between comparative periods, offset by $1,407,000 in incremental expenses from SCR Catalyst and Management Services.

Research and Development Expenses. R&D expenses include compensation and benefits 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, facilities and information technology costs. We expense all R&D costs as incurred.

The majority of the increase in R&D expenses during the three-month period ended September 30, 2004 compared to the corresponding period of 2003 consists of the following: a $264,000 increase in direct labor and fringe benefits incurred on internally funded programs, primarily related to development of diesel applications, and a $96,000 increase in supplies resulted from increased efforts associated with our diesel NOx reduction technology development, including the manufacture of prototypes for various test activities.

The majority of the increase in R&D expenses during the nine-month period ended September 30, 2004 compared to the corresponding period of 2003 consists of the following: a $818,000 increase in direct labor and fringe benefits incurred on internally funded programs, offset by staff reductions in early 2003 resulting in a $409,000 decrease in salaries, severance and related expenses during the first nine months of 2004.

We expect R&D expenses for the year ending December 31, 2004 will be in excess of 2003 expenses due to increased development efforts in internally funded programs. We expect total program expenses (internally funded and government and OEM funded) for the year ending December 31, 2004 will be less than 2003 expenses as a result of expense reduction efforts over the past several periods.

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 IT costs.

The majority of the decline in SG&A during the three-month period ended September 30, 2004 compared to the corresponding period of 2003 consists of the following: a $274,000 decrease in depreciation due to several assets which became fully depreciated at the end of 2003, offset by $253,000 of incremental expenses from SCR Catalyst and Management Services. Several other expense categories account for the remainder of the variance, none of which was individually significant.

The majority of the decline in SG&A during the nine-month period ended September 30, 2004 compared to the corresponding period of 2003 consists of the following: a $372,000 reduction in personnel-related expenses, primarily related to a February 2003 reduction in force and several assets fully depreciated at the end of 2003, resulting in an $863,000 decrease in depreciation expense. Partially offsetting these decreases were increases resulting from $555,000 of incremental expenses from SCR Catalyst and Management Services and $215,000 of increased net rent expense resulting from the scheduled termination of building lease and sublease arrangements at the end of 2003 and the negotiation of new leases for 2004-2005.

We expect SG&A for the year ending December 31, 2004 will be lower than 2003 as a result of expense reduction efforts over the past several periods.

Interest and Other Income. Interest income is generated from money market and short-term investments. Other income consists of rental income generated from the leasing of certain portions of our Gilbert, Arizona building.

Interest income during the three and nine-month periods ended September 30, 2004 was $12,000 and $158,000 lower, respectively, than that during the corresponding periods of 2003 due to lower average cash and short-term investments balances resulting from funding of operations and cash outlays in the first quarter of 2004 relating to the purchase of SCR-Tech. Other income during the three and nine-month periods ended September 30, 2004 was $12,000 and $95,000 higher, respectively, than that during the corresponding periods of 2003, as we began leasing out a portion of our Gilbert manufacturing facility during the second half of 2003. We expect interest and other income will decline during the full year ending December 31, 2004 compared to fiscal 2003 as we continue to use cash to fund operations and further commercialize our technologies.

Interest Expense. Interest expense reflects amounts incurred under long-term debt and capital lease obligations.

Interest expense during the three and nine-months ended September 30, 2004 was $102,000 and $229,000 higher, respectively, than the corresponding periods of 2003 due to the amortization of imputed interest on future payments recorded as part of the SCR-Tech purchase, which began in March 2004. These payments were recorded at the present value of future cash flows. The amortization of the imputed interest will bring the net carrying values to the amounts due at the applicable payment dates. We expect interest expense will increase for the year ending December 31, 2004 compared to that during 2003 due to the recognition of that interest amortization.

Income Taxes. No benefit from income taxes was recorded on the losses incurred during the three and nine-month periods ended September 30, 2004 and 2003 because the expected benefit, computed by applying statutory tax rates to the net loss, was offset by an increase in the valuation allowance for deferred tax assets.

Prior to our spin-off in December 2000, 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. Through September 30, 2004, a portion of the proceeds from the capital contribution and our public offering have been used to fund our ongoing research and development efforts including the commercialization of the Xonon Cool Combustion^® technology, the purchase of our commercial manufacturing and administrative facility in Gilbert, Arizona, the purchase of SCR-Tech and for general corporate purposes. The remaining funds have been invested in commercial and government short-term paper.

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 was scheduled to mature in April 2007. In August 2004, the remaining $2,940,254 principal balance on this loan was refinanced with a five-year term loan which bears interest at a fixed annual rate of 6.5% and matures in April 2009. Under terms of this new loan, payments of principal and interest totaling $19,105 are due monthly with a final principal payment of $2,737,228 due at maturity. This loan is secured by a deed of trust in the acquired real property.

In February 2004, we acquired 100% of the outstanding member interests of SCR-Tech and acquired certain patents and related intellectual property rights for an initial cash payment of $3,518,000 (see Note 4 of Notes to Unaudited Consolidated Financial Statements). We believe the contingencies associated with the Contingent Employment Payments and the Acquired Asset Payments will be met and the amounts will be paid in their entirety. Given the revenue and cash flow hurdles and limitations associated with the earnout payments, we believe these payments will not have a negative impact on cash flow or liquidity. Further, we anticipate that a substantial portion of the remaining payments associated with our acquisition of SCR-Tech should be funded by the cumulative cash flow from SCR Catalyst and Management Services.

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. In addition, we may enter into acquisitions or strategic arrangements which could require the use of cash or additional equity or debt financing. In this regard, we have from time to time and may continue to enter into discussions with third parties regarding potential acquisitions of businesses that could complement our current products, expand the breadth of our markets or enhance our products, services or technical capabilities. Any transaction consummated as a result of such discussions could materially and adversely impact our liquidity and capital resources.

We expect to devote substantial capital resources to further commercialize our technologies, hire and train our production staff, further develop and expand our manufacturing capacity, begin additional production activities and continue our research and development activities. As a result, we expect we will expend significant amounts of cash beyond September 2005. The nature and extent of such cash usage is uncertain at this time. We believe our available cash, cash equivalents and short-term investments as of September 30, 2004 will provide sufficient capital to fund operations as presently planned for at least the next twelve months.

Our net change in cash, cash equivalents and short-term investments (“Cash Consumption”) was $13,761,000 for the nine-months ending September 30, 2004 including payments of $3,518,000 for the acquisition of SCR-Tech during the first quarter and $545,000 during the third quarter for completion of certain training and the transfer of certain assets related to the acquisition of SCR-Tech. We anticipate Cash Consumption of between $17 million and $18 million for the full year ending December 31, 2004.

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.

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 of a product incorporating the funded technology, are achieved. Currently, we have four such arrangements with Tanaka Kikinzoku Kogyo K.K. (“Tanaka”), Gas Technology Institute (“GTI”) (formerly known as Gas Research Institute), the California Energy Commission (“CEC”) and Woodward Governor Company (“WGC”).

A significant amount of the development effort related to our catalytic combustion technology was funded by Tanaka under a January 1995 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 megawatt (“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 January 2005, and we have no further royalty obligations to Tanaka after 2005.

In January 2000, we entered into a funding arrangement with GTI to fund the development of our Xonon combustor and to 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.

In September 1998, 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 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 paid WGC $100,000 in January 2003 and an additional $100,000 in January 2004. These guaranteed payments totaling $250,000 were recorded as a component of selling, general and administrative expenses during the three months ended March 2002 and 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 in April 2002 representing a pre-payment of the control technology license fees for our first four $50,000 sublicenses of the WGC control technology. This payment was recorded as a component of selling, general and administrative expenses in March 2002. 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.

The following risk factors could materially and adversely affect our future operating results, financial condition, the value of our business, and the price of our common stock and also could cause actual events to differ materially from those predicted in the forward-looking statements we make about our business. Investors are encouraged to carefully consider the risks described below before making decisions related to buying, holding or selling our common stock.

The following risks apply to and may adversely affect our specific business programs, products and opportunities, as more specifically described below.

We have incurred significant continuing losses since inception, we anticipate continued significant losses and we may never achieve profitability.

As of September 30, 2004, we had an accumulated deficit of $121,689,000 and we incurred a net loss of $2,696,000 and $9,941,000 during the three and nine-months ended September 30, 2004, respectively. We expect to continue to incur net losses for at least the next several years. We have only recently acquired a business with any commercially-available services, we have not yet recorded any significant revenue from commercial sales of our Xonon products, and there can be no assurance we will ever reach profitability. If we fail to achieve profitability, we ultimately will not have sufficient funds to continue our operations. Even if we do achieve profitability, we may be unable to sustain or increase our profitability in the future.

We recently left the development stage and your basis for evaluating us is limited.

In February 2004, we completed the acquisition of SCR-Tech and, as a result, left the development stage. Our activities prior to such acquisition primarily consisted of developing innovative catalytic NOx solutions based on our proprietary catalyst and fuel processing technologies as well as pursuing application engineering and manufacturing activities in support of commercialization efforts associated with our Xonon Cool Combustion^® system for gas turbines. Accordingly, there is only a limited historical basis upon which you can evaluate our business and prospects. You should consider the challenges, expenses and difficulties we will face as an early stage commercial company seeking to develop, manufacture and sell new products and services.

We may need significant additional capital and we may be unable to raise additional capital to complete our product development and commercialization plans or achieve profitability.

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 positive cash flows from operations. 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, any of which could require the use of cash or additional equity or debt financing. In this regard, our recent acquisition of SCR-Tech required significant cash outlays and will require significant additional cash outlays over the next few years. Although we believe that a substantial portion of the remaining payments associated with our acquisition of SCR-Tech should be funded by the cumulative cash flow from SCR Catalyst and Management Services, there can be no assurance that such funds will prove to be sufficient to make any portion of such payments and that such payments will not need to be funded partially or entirely from our capital resources. While we believe our available cash, cash equivalents and short-term investments in the amount of $38,921,000 as of September 30, 2004 will provide sufficient capital to fund operations as presently planned for at least the next twelve months, there can be no assurance that such funds will prove to be sufficient for such period or any other period of operations.

We may need to raise additional funds to develop further our diesel emissions reduction solutions, achieve full commercialization of the Xonon Cool Combustion^® system for additional gas turbine applications, meet our purchase payment obligations resulting from the SCR-Tech acquisition, develop other potential products such as our fuel processor technology for PEM fuel cells or other programs, and to meet other capital requirements. We may require substantial additional funds to achieve sufficient commercial success to allow for profitable operations. Any such additional funding requirements may be significant, 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 holders of common stock.

The recent acquisition of SCR-Tech and any additional acquisitions we may make could disrupt our business and harm our financial condition.

As part of our growth strategy, we intend to review opportunities to acquire other businesses or technologies that would complement our current products, expand the breadth of our markets or enhance our technical capabilities. We have limited experience in making acquisitions. SCR-Tech was our first acquisition, and there can be no assurance this acquisition will prove to be successful or ultimately beneficial to us. See “Additional Risks Relating to SCR Catalyst and Management Services.” The SCR-Tech acquisition and any future acquisitions entail a number of risks that could materially and adversely affect our business and operating results, including but not limited to:

The market price of our common stock is highly volatile and has declined significantly since our stock began trading in December 2000. Factors that could cause fluctuation and further declines in our stock price may include, but are not limited to:

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.

We may have difficulty managing our current operations or any expansion of our operations.

Currently our management team is responsible for the operations of our recently acquired SCR-Tech business, our Xonon gas turbine program, our diesel program, exploring and evaluating potential acquisitions or other business opportunities, and other programs. In light of employee headcount reductions within the past two years, including management level employees, and the increasing number of federal and NASDAQ securities regulatory requirements, substantial additional burdens have been placed on our management. It may prove difficult for the current management to successfully operate these differing areas and meet the demands and requirements of differing business activities. In addition, we would expect to undergo growth in the number of our employees, the size of our physical plant and the scope of our operations as we commercialize our products and demand for our products increases. Expansion of our manufacturing operations will require significant management attention. This expansion could 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, diesel engines or other products, to continue to develop and commercialize our technology, to effectively market our products 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 qualified management and technical personnel. We do not know whether we will be successful in hiring or retaining these qualified personnel. Our inability to hire qualified personnel on a timely basis, or the departure of key employees, could harm our expansion and commercialization plans. In this regard, during 2003, we employed a new CEO, reduced the number of employees, including management level employees, and streamlined our operations. This may adversely affect our ability to retain additional necessary employees if required.

If we are unable to protect our intellectual property, or our intellectual property protection efforts are unsuccessful, 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. In this regard, we recently entered new pollution control solution markets in which we do not have as broad of intellectual property protection as we do in the NOx control solutions area. Consequently, our ability to compete effectively in such new markets may be adversely affected. The ability of others to use our intellectual property could allow them to duplicate the benefits of our products 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. Further, a patent issued covering one use of our technology may not be broad enough to cover uses of that technology in other business areas. 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 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. Any inability on our part 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.

Certain of our manufacturing equipment is unique to our business and would be difficult and expensive to repair or replace.

Certain of the capital equipment used in the manufacture of our products has been developed and made specifically for us and would be difficult to repair or replace if it were to become damaged or stop working. In addition, certain of our manufacturing equipment is not readily available from multiple vendors. Consequently, any damage to or break down of our manufacturing equipment at a time we are manufacturing commercial quantities of our products may have a material adverse impact on our business.

We are subject to significant potential environmental and product liability exposure.

Since our business relates to NOx and related emissions controls, solutions and services, we are subject to significant potential environmental and product liability risks. These include risks relating to the chemicals and other materials used to manufacture our products and provide our services; risks relating to hazardous waste and hazardous waste disposal; potential environmental damage caused in the manufacture, sale, distribution or operation of our products and services relating thereto; employee and third party injuries from the manufacture, sale, distribution or operation of our products and services relating thereto, including claims by our customers and their end users, including in certain cases, consumers; the inability of our products to meet environmental or other standards imposed by federal, state or local law or by our customers; and other claims relating to our products and services. Because of our very limited experience and the limited distribution of our products and services, we do

not have any experience with the nature or type of claims which may arise from our business. Only limited insurance is available for environmental and product liability claims, and any such claims could have an adverse impact on our business and financial condition. This could be the case even if we ultimately had no liability on any particular claim, since the costs of defending any environmental or product liability claim could be prohibitive.

Many of the risks of our business have only limited insurance coverage and many of our business risks are uninsurable.

Our business operations are subject to potential environmental, product liability, employee and other risks. Although we have insurance to cover some of these risks, the amount of this insurance is limited and includes numerous exceptions and limitations to coverage. Further, no insurance is available to cover certain types of risks, such as acts of God, war, terrorism, major economic and business disruptions and similar events. In the event we were to suffer a significant environmental, product liability, employee or other claim in excess of our insurance or a loss or damages relating to an uninsurable risk, our financial condition could be negatively impacted. In addition, the cost of our insurance has increased substantially in recent years and may prove to become prohibitively expensive, thus making it impractical to obtain insurance. This may result in the need to abandon certain business activities or subject ourselves to the risks of uninsured operations.

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.

Our executive officers, directors and greater than 5% stockholders control approximately one-half 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, 2004, the funds affiliated with Morgan Stanley Capital Partners own approximately 19% of our outstanding common stock. The Morgan Stanley Capital Partners funds also have stockholder rights, including rights to appoint directors and registration rights. As a result, Morgan Stanley Capital Partners 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 Catalytica Pharmaceuticals, Inc., the successor corporation to Catalytica, Inc. For example, we agreed to indemnify DSM for liabilities arising out of our business, the business of CAT and other liabilities of DSM 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. To date, no claims have been made against us pursuant to these indemnification provisions and, at September 30, 2004, we believe the likelihood of any material claim being made against us is remote. However, if any additional liabilities materialize, our financial results could be harmed

In addition to the risks discussed elsewhere, any of which also could adversely impact SCR-Tech and its business, the following additional risks specifically relate to SCR-Tech and could negatively impact SCR-Tech and our entire company.

SCR-Tech has limited operating experience in North America. SCR-Tech may not be able to profitably operate its business.

SCR-Tech commenced commercial operations in its U.S. regeneration facility in March, 2003, and has completed only a limited number of SCR cleaning and regeneration projects. Thus, SCR-Tech does not have a substantial operating history to determine whether it can successfully operate its business under differing environments and conditions or at any level of profitability.

We recently completed the acquisition of SCR-Tech and we have very limited experience with the operations of SCR-Tech.

We completed the acquisition of SCR-Tech in February 2004. SCR-Tech was a privately held company, which commenced commercial operations in the U.S. in March 2003. At the time we acquired SCR-Tech, we had no experience in the SCR-related business and we have just begun to integrate our management, technology and systems with SCR-Tech. In addition, SCR-Tech did not previously have audited financial statements. Thus, there is a risk of unknown financial or other liabilities which could negatively impact SCR-Tech and us. Although we have limited indemnification from the sellers of SCR-Tech, there can be no assurance that any such indemnification would be adequate to cover any unknown liabilities. In addition, unanticipated integration issues in connection with the operations of SCR-Tech as part of our business may develop, and a successful integration may require significant time and expense.

SCR-Tech has required significant assistance of an affiliate of one of its former owners, ENVICA Kat GmbH (“Envica”) to successfully complete certain contracts. In addition, SCR-Tech has been relying to a significant extent on the assistance of Envica on various technical and support matters relating to its business. Although the terms of our acquisition of SCR-Tech provide that Envica will provide continuing intellectual property transfers and training, there can be no assurance that SCR-Tech and its current employees will be ultimately able to successfully operate the business or expand the business. Further, there can be no assurance that SCR-Tech will not incur significant unanticipated technical problems and costs which could adversely affect SCR-Tech’s business.

SCR-Tech typically must provide warranties to its customers relating to the level of success of its cleaning and regeneration services. In the event SCR-Tech is unable to perform a complete regeneration of an SCR catalyst, SCR-Tech may be required to re-perform a regeneration or repay all or part of the fees earned for the regeneration efforts. SCR-Tech also may be required to provide warranties with respect to its other SCR catalyst services provided to its customers. Since SCR-Tech has only a limited operating history in North America, it is not possible to determine the amount or extent of any potential warranty claims that SCR-Tech may incur. There is a risk that any such claims could be substantial and could affect the profitability of SCR-Tech and the financial condition of our Company.

SCR-Tech offers catalyst cleaning, rejuvenation and regeneration, as well as SCR system management and consulting services. The size and growth rate for this market will ultimately be determined by a number of factors, including environmental regulations, the growth in the use of SCR systems to reduce NOx and other pollutants, the length of operation of SCR systems without the need for cleaning, rejuvenation or regeneration, the cost of new SCR catalyst, and other factors, most of which are beyond the control of SCR-Tech. There is limited historical evidence in North America as to the cycle of replacement, cleaning and regeneration of SCR catalyst so as to accurately estimate the potential growth of the business. In addition, the number of times a catalyst can be regenerated is unknown, which also may affect the demand for regeneration in lieu of new catalysts. Any delay in the development of the market could significantly and adversely affect the value of SCR-Tech and the nature of any return on our acquisition of SCR-Tech.

SCR-Tech will be significantly dependent on SCR-Tech’s existing management for the success of its business.

Hans Hartenstein, the president of SCR-Tech, is a key employee and one of the founders of SCR-Tech and is principally responsible for the generation of the business opportunities of SCR-Tech. Certain entities or persons which may be deemed to be affiliates of Mr. Hartenstein received significant sums from us as a result of the closing of the acquisition and these entities or persons will receive significant guaranteed and contingent payments as a result of the purchase of SCR-Tech. Mr. Hartenstein will receive compensation as part of his employment with SCR-Tech. If Mr. Hartenstein fails to perform or otherwise fails to address the challenges faced by SCR-Tech, the business could be materially and adversely affected. Mr. Hartenstein also has other business interests which may adversely affect his performance. SCR-Tech continues to expand and strengthen its management and technical staff to address ongoing operational and growth efforts.

Although we currently have key man insurance on Mr. Hartenstein in the amount of $1 million, if we were to lose his services, he could be difficult to replace, especially in this early stage of development of SCR-Tech.

SCR-Tech is dependent on third parties to perform certain testing required to confirm the success of its regeneration.

In connection with the regeneration of SCR catalyst by SCR-Tech, SCR-Tech must have an independent company provide testing services to determine the level of success of regeneration. We are not aware of any company currently providing such services in the United States. Thus, SCR-Tech must ship samples to Europe for testing, and there are a limited number of third party testing service providers. Without such testing, SCR-Tech cannot perform its regeneration services.

SCR-Tech may be subject to vigorous competition with very large competitors that have substantially greater resources and operating histories.

Although there does not appear to be a direct competitor in the business of SCR catalyst regeneration in North America, a number of companies provide SCR catalyst management, rejuvenation and cleaning services. These companies include Enerfab (which uses a process developed by Envirgy/Integral) and BHK (the parent company of Hitachi America). There also are a number of SCR catalyst manufacturers with substantial parent companies that may seek to maintain market share by significantly reducing or even eliminating all profit margins. These companies include Cormetech Inc. (owned by Mitsubishi Heavy Industries and Corning, Inc.), Argillon GmbH (formerly Siemens), Haldor-Topsoe, Inc. and KWH. Further, if the SCR catalyst regeneration market expands, competitors could emerge. If the intellectual property protection acquired by us becomes weakened, competition could more easily develop.

SCR-Tech will be highly dependent upon the strength of its intellectual property to protect its business.

In addition to the intellectual property risks relating to ongoing dealings with Envica, there can be no assurance the intellectual property acquired by us as part of the acquisition of SCR-Tech will prove sufficient or enforceable. The infringement representation and indemnification from SCR-Tech’s sellers to us is short and of limited value. Further, much of the intellectual property from Envica is in the form of trade secrets, for which patent protection is not available.

SCR-Tech could be subject to environmental risks as a result of the operation of its business and the location of its facilities.

The operation of the SCR-Tech’s business and the nature of its assets create various environmental risks. SCR-Tech leases its site for operations at a property listed on the National Priority List as a Federal Superfund site (under the Comprehensive Environmental Response, Compensation and Liability Act of 1980 (“CERCLA”). Five CERCLA Areas (those areas of concern identified under the CERCLA program) are identified on the property, and while SCR-Tech does not lease any property identified as a CERCLA Area, one such Area has resulted in contamination of groundwater flowing underneath one of the buildings leased by SCR-Tech. Although SCR-Tech has indemnification from Clariant Corporation for any environmental liability arising prior to the operation of SCR-Tech’s business at the site, there can be no assurance that such indemnification will be sufficient or that SCR-Tech could be protected from an environmental claim from the nature of the site. In addition, the operation of SCR-Tech’s business may involve removal of hazardous wastes from catalysts and the use of significant chemical materials. As a result, SCR-Tech could be subject to potential liability from such operations.

SCR-Tech does not own its regeneration facilities and it is subject to risks inherent in leasing the site of its operations.

SCR-Tech does not own its regeneration site; instead it leases it from Clariant Corporation, the U.S. subsidiary of a Swiss-based public company. Although we believe the lease terms are favorable, the dependence on Clariant and the site could subject SCR-Tech to increased risk in the event Clariant experiences financial setbacks or loses its right to operate the site upon which SCR-Tech leases property. This risk is heightened because of the fact the site is a Super Fund site, which increases the risks the site ultimately could be shut down or that Clariant will be financially unable to continue its ownership of the site. It may be difficult to locate to another site on a cost-effective basis, and SCR-Tech’s business could be negatively impacted by any problems with continuing to conduct its operations at its current site.

Because some utilities and independent power producers (“IPPs”) currently operate their SCR units only during the “ozone season” (May 1 – September 30), SCR-Tech’s business opportunities will be more limited than if SCR units were required to operate on a continual basis. The SIP (State Implementation Plan) Call was configured to impose a summer ozone season NOx cap over 19 states and the District of Columbia. During this period, utilities and IPPs will seek to operate their SCR catalysts at maximum capacity so as to reduce NOx emissions during this period. During non-ozone season periods, most operators currently have limited (if any) requirements to run their SCR systems. Unless and until such regulations are tightened, much of SCR-Tech’s business will be concentrated outside ozone season each year. This will result in less business than if SCR units were required to be operated throughout the year and this also may result in quarters of relatively higher cash flow and earnings and quarters where cash flow and earnings may be minimal. These potential fluctuations in revenue and cash flow during a year may be significant and could materially impact our quarterly earnings and cash flow. This may have a material adverse effect on the perception of our business and the market price for our common stock.

In addition to the risks discussed elsewhere, any of which could adversely impact our Xonon-equipped gas turbine business, the following additional risks particularly relate to our Xonon Cool Combustion^® technology for gas turbines and could negatively impact our entire company.

The market for small gas turbines has been adversely impacted by current unfavorable conditions in the power generation and energy markets.

The market for Xonon-equipped gas turbines is dependent on various factors, including those relating to the power generation and energy markets, none of which are under our control. There has been a significant decline in the demand for gas turbines in recent years as a result of a substantial surplus in energy production capacity in the United States and Canada, a slow to emerge demand for distributed generation which especially impacts demand for small gas turbines, and uncertain supplies of natural gas and corresponding substantial increases in natural gas prices, which have reduced the demand for gas turbines of all sizes. The number of gas turbines producing between one and 15 MW of power ordered in North America declined from approximately 53 during the 12-month period from June 1999 to May 2000 to approximately 30 during the 12-month period from June 2002 to May 2003. Regardless of the performance capabilities of Xonon with respect to lowering NOx emissions in gas turbines, if the market for small gas turbines continues to be weak, there will be very limited opportunity for us to sell Xonon catalyst modules and we may be unable to obtain any return on our prior investment and may never achieve profitability. As of the date of this filing, it does not appear the market for small gas turbines will increase in any significant manner in the near future.

Xonon-equipped gas turbines represent an emerging market. If Xonon technology does not attain widespread market acceptance, end-users may be less inclined to purchase turbines equipped with Xonon Cool Combustion^®. If a significant commercial market fails to develop, 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:

We must successfully complete further development and adaptation work before certain Xonon-equipped gas turbines can be shipped.

Incorporating our technology in a specific gas turbine model requires adaptation work by us and the 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 shipments or significant expenses. Delays in completing this work could result in the loss of orders, and the emergence of significant technical issues or resource constraints on the part of OEMs could result in termination by OEMs of their agreements to adapt Xonon to their gas turbines.

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.

We have ongoing programs with three OEMs which are in various stages of commercialization 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. In particular, our development programs with GE Energy and with Solar Turbines to incorporate our Xonon technology into certain of their gas turbines are in various stages of testing and evaluation. Even with positive test results, there can be no assurance that we, GE or Solar will continue these programs. Further, even if these programs continue, they may require significant additional funding and may never result in the commercial launch of a Xonon-equipped GE or Solar gas turbine.

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. Additionally, some of our agreements provide for exclusivity in a limited turbine size range and for limited periods of time. Our OEM agreements generally provide that either party can terminate the agreement, but not necessarily the exclusivity, if technical issues arise that cannot be 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 or prevent us from entering into agreements with other OEMs regarding the application of Xonon to 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. Many of these OEMs develop

and offer alternative emissions control systems in competition with our Xonon systems. 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 Xonon technology with OEMs. At times, 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.

Competition from alternative technologies may adversely affect our Xonon business.

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-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.

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 costly. In addition, any need to develop and implement corrective measures could temporarily delay or permanently prevent 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. This also could result in product or other liability to us for which we may not have insurance or adequate insurance.

We are dependent on third party suppliers for the development and supply of key components for our Xonon products.

We have entered into commercial arrangements with suppliers of the key components of our Xonon system. 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 are unable 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.

We have limited experience manufacturing Xonon modules on a commercial basis.

To date, we have focused primarily on research and development of Xonon 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.

Significant price increases in key materials may reduce our gross margins and profitability of our Xonon modules.

The prices of palladium and platinum, which are used in the production of Xonon modules, can be volatile. For example, during the calendar year 2003, the price of palladium ranged from $148 to $322 per troy ounce and the price of platinum ranged from $603 to $936 per troy ounce. If the long-term costs of these materials were to increase significantly, we would, in addition to recycling materials from reclaimed 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 customers, then our gross margins and profitability would be reduced.

In addition to the risks discussed elsewhere, any of which could adversely impact our efforts to develop NOx control solutions for diesel engines, the following additional risks particularly relate to our efforts to develop NOx control solutions for diesel engines and could negatively impact our entire company.

We may never complete the research and development of a commercially viable NOx control solution for diesel engines.

We are in the very early development stage associated with our NOx control solutions for diesel engines. We do not know when or whether we will successfully complete research and development of a commercially viable product in either the mobile diesel retrofit, mobile diesel OEM, or stationary diesel markets. Economic and technical difficulties may prevent us from completing development of products for diesel engines or commercializing those products. Furthermore, a viable market for our product concept may never develop. This is further complicated by the limited time frame we have to develop a mobile diesel retrofit solution to meet immediate market requirements. If a market were to develop within diesel OEM using our NOx control solutions, we likely would face intense competition from various competitors, including large diesel engine OEMs, and we may be unable to compete successfully. In addition, diesel engine OEMs and other competitors may create technology alternatives that could render our systems obsolete prior to commercialization. Moreover, we may conclude that the potential return from our investment in the diesel markets does not justify our continued investment in these opportunities. Thus, we may at any time terminate any or all of our diesel programs, even if we do develop a commercially viable solution.

We will be dependent on third party development of NOx adsorbers for our diesel products.

Even if our diesel fuel processor is accepted by OEMs, and retrofit integrators and end-use customers, if NOx adsorbers do not evolve to a state of commercial viability, our technology will not ultimately be adopted. Although our diesel fuel processor has the benefit of lessening certain NOx adsorber limitations, significant technological hurdles, including cost, size, durability, operating range and the level of NOx reduction from NOx adsorbers must be overcome for OEMs and retrofit integrators to consider commercialization of our diesel fuel processor in

combination with a NOx adsorber. The failure of third parties to develop solutions to current NOx adsorber limitations in a timely manner will effectively eliminate our diesel fuel processor from market consideration. We may not have any ability to significantly influence the resolution of NOx adsorber issues.

We have only a limited time to take advantage of the mobile retrofit market for diesel engines.

The diesel retrofit market has a limited time frame, since new diesel engines produced in 2007 and beyond likely will not need retrofit products. As older vehicles and other machines using diesel engines are retired from service and replaced with vehicles and other machines using newer diesel engines, the need to retrofit older engines will decline. Thus, in order to take advantage of the diesel retrofit market, we must develop a solution that can quickly come to market and which results in significant NOx reduction with an economically viable fuel penalty and have it verified to comply with federal and state emissions requirements. We have evolved our solution from combining our proprietary diesel fuel processor with a proprietary lean NOx catalyst to combining our proprietary diesel fuel processor with a third-party NOx adsorber. Significant development work remains to fully develop this revised solution for the mobile diesel retrofit market, and we must identify a supplier of the NOx adsorber. Further, even if we can obtain a NOx adsorber supplier, it is likely we will not have our solution verified or certified until at least the end of 2005, and there can be no assurance we will be able to meet such testing requirements or find the necessary market for our retrofit product. Thus, we have expended and may continue to expend significant sums on developing our diesel retrofit solution with no assurance that we will be successful in developing the solution or that we will develop the solution in sufficient time to take advantage of the potential market. Even if we are successful in developing a diesel engine retrofit solution, our product market window will be limited and decreasing in size as vehicles are retired and new diesel engines are introduced into the market. Further, a successful diesel retrofit solution does not imply this technology or a derivative of this technology can be employed in the diesel OEM or stationary markets.

We will be heavily dependent on developing relationships with retrofit integrators in order to enter the mobile diesel retrofit marketplace.

Our mobile diesel retrofit solution does not address a number of significant requirements to enter this market. We will need to develop relationships with integrators who can procure necessary products and services for our solution, including project management, installation of our solution on mobile, stationary or off-road applications with necessary attachments and system controls and other necessary components. Since this will be a retrofit as opposed to an OEM market, we will likely not have the assistance of any of the manufacturers of the original equipment to supply our solution. This may make installation and operation of our diesel retrofit solution more difficult and expensive. We have not yet entered into any agreement with a retrofit integrator and if we cannot do so on an expedited basis, we likely will need to abandon or refocus our diesel retrofit program.

We will be heavily dependent on developing relationships with diesel OEMs and their commitment to adopt and market our diesel fuel processor technology for their diesel engines in order to enter the diesel OEM marketplace; any agreements with these OEMs may limit our market opportunities.

In order to take advantage of the opportunities for NOx control solutions in the diesel OEM market, we must develop a solution that results in significant NOx reduction (as high as 90%) to meet impending United States, European Union or Japanese requirements for diesel engines. This will require us to partner with one or more diesel OEMs. Until we can demonstrate the viability of our diesel fuel processor for the diesel OEM market, it is unlikely we can develop the necessary OEM relationships. In addition, if we are unable to develop a diesel retrofit solution, it is less likely we will develop the necessary credibility with diesel OEMs with respect to our diesel OEM solution.

Even if we are successful in entering into agreements with a diesel OEM, the agreements may provide the OEM with the right to be the exclusive market channel for distribution of our diesel fuel processor and may otherwise limit our ability to enter into other OEM agreements. An agreement may provide for exclusivity for particular engine sizes and for limited periods of time. The agreements also may provide that either party can terminate the agreement, but not necessarily the exclusivity provision. A decision by an OEM to discontinue the commercialization of our diesel fuel processor in its engines could significantly limit or foreclose our access to the market for that OEM’s engines or prevent us from entering into agreements with other OEMs regarding the application of our diesel fuel processor to some of their competing engines.

We may incur significant costs in developing our diesel 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 may incur significant costs in developing our diesel technology with OEMs for the diesel OEM market. Further, the technological development required to meet the requirements for this decade may be significant, and the capital required to be invested in such a development is likely to be substantial. Moreover, there can be no assurance that any solution developed by us will be technically feasible, cost-effective or acceptable to OEMs. We are not likely to recover any significant portion of these costs through contractual reimbursement from the OEMs. Thus, we will likely bear the majority of the development costs ourselves. If OEMs do not complete development work for any reason, we will not be able to recover our development costs through product sales.

We will be dependent on third party suppliers for the supply of key components for our diesel products.

We have not entered into commercial arrangements with suppliers of the key components which may be required for our diesel solutions. We do not know when or whether we will secure arrangements with suppliers of required materials and components for our diesel solutions, even if they are successfully developed, or whether these arrangements will be on terms that will allow us to achieve our objectives. Even if we can develop a commercially viable diesel retrofit or diesel OEM solution, if we are unable 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 diesel solutions.

We may be subject to significant competition from companies with substantially greater resources and market credibility.

The size of the diesel retrofit and diesel OEM markets has attracted a number of significant participants. In the diesel retrofit market, a number of companies have already developed announced solutions in this market, including Johnson Mathey, Englehard, Cleaire and Lubrizol. These participants have substantially greater resources and credibility than we do in this market. In the diesel OEM market, there are a number of significant competitors, some of which have announced solutions to the initial United States requirements for NOx reduction in 2007, including Eaton Corporation and the major diesel OEMs such as Cummins, Caterpillar, Detroit Diesel, ITEC and Volvo. These competitors also have substantially greater resources and credibility than we do in this market. There can be no assurance that we can successfully compete in either the diesel retrofit or diesel OEM markets, even if we were to develop a technologically feasible solution to NOx reduction in these markets

Alternate technologies may provide a more cost effective solution and may provide alternatives to any diesel NOx reduction technology.

Even if we are able to develop and commercialize a NOx reduction solution for diesel engines, there can be no assurance that any such solution will be either practical or cost-effective. Currently, a number of competitors have developed announced NOx solutions in the diesel retrofit market and a number of competitors have developed announced solutions in the diesel OEM market to comply with the United States 2007 regulations. These solutions are based on different technology than the basis for our proposed NOx solution, including clean diesel combustion and low-temperature combustion such as homogenous charge compression ignition. An additional potential competitive threat may come from power generation proven SCR technology. In Europe today, over 100 heavy duty on-road engines are testing SCR technology. Although we believe our proposed solution, if successful, in either the diesel retrofit or diesel OEM market will constitute a cost-effective and competitive solution, no assurance can be given that alternate technologies will not prove to be more reliable or otherwise more successful in the market.

We may have significant warranty and product liability risks arising from our diesel product solutions.

Even if we are able to successfully develop and commercialize NOx control solutions for the diesel retrofit or diesel OEM market, we will be required to provide product warranties. It is unclear as to the nature of these warranties at this time, but the warranties are likely to include NOx reduction at agreed levels for substantial time and/or mileage requirements. If we are unable to satisfy these warranties, we could incur significant liability to diesel OEMs, retrofit market regulators, and potentially end users, including consumers. In addition, the manufacture, sale and distribution of our diesel fuel processor could expose us to potential product liability to customers and end users, including consumers. Any such liability could be significant and may not be insurable.

We have no experience manufacturing our diesel products on a commercial basis.

To date, we have focused primarily on research and development and have no experience manufacturing diesel products on a commercial scale. 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 our diesel products 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. If we decide to outsource some or all of the manufacturing process, we may not find capable third parties to manufacture our product.

ADDITIONAL RISKS RELATING TO FUEL PROCESSING FOR VEHICULAR FUEL CELL APPLICATIONS

In addition to the risks discussed elsewhere, the following additional risks particularly relate to our efforts to develop fuel processing solutions for vehicular fuel cell applications. Any of the other risks discussed elsewhere also may impact these business activities.

We are entirely dependent on the U.S. DOE for the funding of our fuel processing solutions used for vehicular fuel cell applications.

In 2001, we were selected by the DOE for an $11,658,000 cost-shared contract for the development of a compact fuel processor capable of operating on multiple fuels for use with fuel cells in transportation applications. If the DOE curtails or terminates this program, we will likely reduce or terminate our efforts to develop a fuel processor for vehicular PEM fuel cell applications.

We may never complete the research and development of a commercially viable fuel processor to be utilized with PEM fuel cells in an automotive application.

We are in the very early development of a commercially viable fuel processor to be utilized with PEM fuel cells in an automotive application. We do not know when or whether we will successfully complete research and development of a commercially viable product. Economic and technical difficulties may prevent us from completing development of products or commercializing these products. Furthermore, a viable market for our product concept may never develop. If a market were to develop, we could face intense competition from large automotive OEMs, as well as companies currently established in the PEM fuel cell business, and may be unable to compete successfully. In addition, automotive OEMs or PEM fuel cell companies may create technology alternatives that could render our systems obsolete prior to commercialization.

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 in which

we invest 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, government and non-government debt securities. The average duration of our investments in 2004 and 2003 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.

The effect of inflation and changing prices on our operations was 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.

Although we may be subject to litigation from time to time in the ordinary course of our business, we are not currently a party to any material legal proceeding.

The Company filed the following reports on Form 8-K during the quarter ended September 30, 2004:

Current Report on Form 8-K dated August 5, 2004, furnishing a copy of the August 5, 2004 press release announcing the Company’s financial results for the quarter year ended June 30, 2004.

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.


CATALYTICA ENERGY SYSTEMS, INC.
(Registrant)

By:		/s/ ROBERT W. ZACK
		Robert W. Zack
		Vice President of Finance and
		Chief Financial Officer

Signing on behalf of the Registrant and as principal financial officer


		Page No.
PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

Unaudited Consolidated Statements of Operations for the three and nine-month periods ended September 30, 2004 and 2003		3

Consolidated Balance Sheets at September 30, 2004 (Unaudited) and December 31, 2003		4

Unaudited Consolidated Statements of Cash Flows for the nine-month periods ended September 30, 2004 and 2003		5

Notes to Unaudited Consolidated Financial Statements		6

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		9

Item 3. Quantitative and Qualitative Disclosures about Market Risk		31

Item 4. Controls and Procedures		32

PART II. OTHER INFORMATION

Item 1. Legal Proceedings		33

Item 2. Changes in Securities and Use of Proceeds		33

Item 3. Defaults Upon Senior Securities		33

Item 4. Submission of Matters to a Vote of Security Holders		33

Item 5. Other Information		33

Item 6. Exhibits and Reports on Form 8-K		33

Signatures		34


	Three Months Ended September 30,						Nine Months Ended September 30,
	2004			2003			2004			2003
Revenues	$	1,942		$	1,107		$	4,028		$	2,597

Costs and expenses:
Cost of revenues		1,325			1,209			3,418			3,420
Research and development		1,792			1,452			5,677			5,278
Selling, general and administrative		1,547			1,690			5,017			5,486

Total costs and expenses		4,664			4,351			14,112			14,184

Operating loss		(2,722	)		(3,244	)		(10,084	)		(11,587	)

Interest and other income		186			186			550			614
Interest expense		(160	)		(58	)		(407	)		(178	)

Net loss	$	(2,696	)	$	(3,116	)	$	(9,941	)	$	(11,151	)

Basic and diluted net loss per share	$	(0.15	)	$	(0.18	)	$	(0.56	)	$	(0.63	)

Weighted average shares used in computing basic and diluted net loss per share		17,874			17,701			17,836			17,647


	September 30, 2004			December 31, 2003
	(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents	$	28,195		$	32,806
Short-term investments		10,726			19,876
Accounts receivable, net		1,563			567
Inventory		508			460
Prepaid expenses and other assets		419			527

Total current assets		41,411			54,236

Property and equipment:
Land		611			611
Building and leasehold improvements		9,606			11,325
Equipment		10,113			8,776
Less accumulated depreciation and amortization		(12,469	)		(13,636	)

Total property and equipment		7,861			7,076

Goodwill		4,496			—
Other intangible assets		1,626			—
Other assets		338			373

Total assets	$	55,732		$	61,685

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	630		$	380
Accrued payroll and benefits		1,612			1,590
Accrued liabilities and other		1,427			1,411
Current portion of long-term debt and other long-term liabilities		883			135

Total current liabilities		4,552			3,516

Long-term debt and other long-term liabilities		5,514			2,942

Total liabilities		10,066			6,458

Stockholders’ equity:
Common stock		18			18
Additional paid-in capital		167,359			166,977
Deferred compensation		(22	)		(20	)
Retained deficit		(121,689	)		(111,748	)

Total stockholders’ equity		45,666			55,227

Total liabilities and stockholders’ equity	$	55,732		$	61,685


	Nine Months Ended September 30,
	2004			2003
Cash flows from operating activities:
Net loss	$	(9,941	)	$	(11,151	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation of property and equipment		932			1,531
Amortization of investments premium		165			186
Amortization of intangible assets		101			—
Amortization of interest on long-term debt		243			—
Forgiveness of notes receivable from related parties		42			42
Stock based compensation		24			56
Changes in:
Accounts receivable		(233	)		902
Inventory		12			(7	)
Prepaid expenses and other assets		179			54
Accounts payable		(425	)		(88	)
Accrued payroll and benefits		165			(560	)
Accrued liabilities and other		(346	)		(313	)

Net cash used in operating activities		(9,082	)		(9,348	)

Cash flows from investing activities:
Purchase of business		(4,300	)		—
Purchases of investments		(10,164	)		(17,017	)
Maturities of investments		19,149			17,300
Additions to property and equipment, net		(296	)		(923	)

Net cash provided by (used in) investing activities		4,389			(640	)

Cash flows from financing activities:
Net payments on long-term debt and capital lease obligations		(130	)		(173	)
Proceeds from issuance of common stock to employees through stock plans		212			343

Net cash provided by financing activities		82			170

Net decrease in cash and cash equivalents		(4,611	)		(9,818	)
Cash and cash equivalents at beginning of period		32,806			45,965

Cash and cash equivalents at end of period	$	28,195		$	36,147

Additional disclosure of cash flow information:
Deferred compensation for issuance and revaluation of stock options to non-employees	$	27		$	58

Interest paid	$	160		$	170

Debt assumed for purchase of business	$	3,133		$	—


(in thousands, except per share amounts)	Three Months Ended September 30,						Nine Months Ended September 30,
	2004			2003			2004			2003
Numerator for basic and diluted net loss per share - net loss	$	(2,696	)	$	(3,116	)	$	(9,941	)	$	(11,151	)

Denominator for basic and diluted net loss per share - weighted average shares outstanding		17,874			17,701			17,836			17,647

Basic and diluted net loss per share	$	(0.15	)	$	(0.18	)	$	(0.56	)	$	(0.63	)

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	Three Months Ended September 30,						Change					Nine Months Ended September 30,						Change
	2004			2003			Amount			%		2004			2003			Amount			%
Revenues	$	1,942		$	1,107		$	835		75	%	$	4,028		$	2,597		$	1,431		55	%

Costs and expenses:
Cost of revenues		1,325			1,209			116		10	%		3,418			3,420			(2	)	0	%
Research and development		1,792			1,452			340		23	%		5,677			5,278			399		8	%
Selling, general and administrative		1,547			1,690			(143	)	-8	%		5,017			5,486			(469	)	-9	%

Total costs and expenses		4,664			4,351			313					14,112			14,184			(72	)

Operating loss		(2,722	)		(3,244	)		522					(10,084	)		(11,587	)		1,503

Interest and other income		186			186			—		0	%		550			614			(64	)	-10	%
Interest expense		(160	)		(58	)		(102	)	176	%		(407	)		(178	)		(229	)	129	%

Net loss	$	(2,696	)	$	(3,116	)	$	420				$	(9,941	)	$	(11,151	)	$	1,210


(dollars in thousands)	Nine months ended September 30,
(dollars in thousands)	2004			2003
Ending balance of cash, cash equivalents and short-term investments	$	38,921		$	56,484

Net decrease in cash, cash equivalents and short-term investments	$	(13,761	)	$	(10,286	)


Exhibit		Description
10.47		Loan Modification Agreements between the Arizona State Compensation Fund and the Registrant dated August 9, 2004, as amended.

31.1		Certification of Chief Executive Officer pursuant to Rule 13a-14(a) / 15d-14(a) of the Securities Exchange Act of 1934, as amended

31.2		Certification of Chief Financial Officer pursuant to Rule 13a-14(a) / 15d-14(a) of the Securities Exchange Act of 1934, as amended

32.1		Certification of Chief Executive Officer pursuant to 18 U.S.C. 1350.

32.2		Certification of Chief Financial Officer pursuant to 18 U.S.C. 1350.