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EX-32.1 - EX-32.1 - B456 SYSTEMS, INC.a10-12980_1ex32d1.htm
EX-31.2 - EX-31.2 - B456 SYSTEMS, INC.a10-12980_1ex31d2.htm
EX-32.2 - EX-32.2 - B456 SYSTEMS, INC.a10-12980_1ex32d2.htm
EX-10.3 - EX-10.3 - B456 SYSTEMS, INC.a10-12980_1ex10d3.htm
EX-31.1 - EX-31.1 - B456 SYSTEMS, INC.a10-12980_1ex31d1.htm

Table of Contents

 

 

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

(Mark One)

 

x

 

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

 

For the quarterly period ended June 30, 2010

 

OR

 

o

 

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

 

For the transition period from                  to                 

 

Commission file number: 001-34463

 

A123 Systems, Inc.

(Exact name of registrant as specified in its charter)

 

Delaware

 

04-3583876

(State or other jurisdiction of incorporation or

organization)

 

(I.R.S. Employer

Identification No.)

 

 

 

A123 Systems, Inc.

Arsenal on the Charles

321 Arsenal Street

Watertown, Massachusetts

 

02472

(Address of principal executive offices)

 

(Zip Code)

 

617-778-5700

(Registrant’s telephone number, including area code)

 

 

(Former name, former address and former fiscal year, if changed since last 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 o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o  No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer  o

 

Accelerated filer  o

 

 

 

Non-accelerated filer  x

 

Smaller reporting company  o

(Do not check if a smaller reporting company)

 

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o  No x

 

As of August 9, 2010, there were 104,739,660 shares of the registrant’s Common Stock, par value $.001 per share, outstanding.

 

 

 



Table of Contents

 

A123 Systems, Inc.
Quarterly Report on Form 10-Q
For the Quarterly Period Ended June 30, 2010

 

INDEX

 

 

PAGE

 

NUMBER

PART I. FINANCIAL INFORMATION

1

 

 

ITEM 1: Financial Statements (Unaudited)

1

Condensed Consolidated Balance Sheets

1

Condensed Consolidated Statements of Operations

2

Condensed Consolidated Statements of Stockholders’ (Deficit) Equity

3

Condensed Consolidated Statements of Cash Flows

4

Notes to Condensed Consolidated Financial Statements

5

 

 

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

17

ITEM 3: Quantitative and Qualitative Disclosures about Market Risk

30

ITEM 4T: Controls and Procedures

31

 

 

PART II. OTHER INFORMATION

31

ITEM 1: Legal Proceedings

31

ITEM 1A: Risk Factors

32

ITEM 2: Unregistered Sales of Equity Securities and Use of Proceeds

53

ITEM 6: Exhibits

53

Signatures

54

 

 

EX-10.1 Lease Agreement, dated May 19, 2010, by and between Boston Properties Limited Partnership and the Registrant.

EX-10.2 Form of Restricted Stock Unit Agreement under 2009 Stock Incentive Plan.

 

EX-10.3 Supply Agreement, dated June 23, 2010, by and between ConocoPhillips Specialty Products, Inc. and the Registrant.

EX-31.1 CEO Certification pursuant to Section 302 of the Sarbanes-Oxley Act

 

EX-31.2 CFO Certification pursuant to Section 302 of the Sarbanes-Oxley Act

 

EX-32.1 CEO Certification pursuant to Section 906 of the Sarbanes-Oxley Act

 

EX-32.2 CFO Certification pursuant to Section 906 of the Sarbanes-Oxley Act

 

 



Table of Contents

 

Part I. Financial Information

 

Item 1. Financial Statements

 

A123 Systems, Inc.

Condensed Consolidated Balance Sheets

(in thousands, except share and per share data)

(Unaudited)

 

 

 

December 31,

 

June 30,

 

 

 

2009

 

2010

 

 

 

 

 

 

 

ASSETS

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

457,122

 

$

353,326

 

Restricted cash

 

1,742

 

674

 

Accounts receivable, net

 

17,718

 

18,332

 

Inventory

 

37,438

 

41,688

 

Prepaid expenses and other current assets

 

8,895

 

7,648

 

Total current assets

 

522,915

 

421,668

 

 

 

 

 

 

 

Property, plant and equipment, net

 

71,662

 

116,571

 

Goodwill

 

9,581

 

9,581

 

Intangible assets, net

 

1,254

 

730

 

Deposits and other assets

 

11,698

 

22,818

 

Restricted cash

 

980

 

1,987

 

Investment

 

 

20,495

 

Total assets

 

$

618,090

 

$

593,850

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Revolving credit lines

 

$

8,000

 

$

8,000

 

Current portion of long-term debt

 

6,456

 

5,153

 

Current portion of capital lease obligations

 

411

 

766

 

Accounts payable

 

16,475

 

29,595

 

Accrued expenses

 

11,689

 

29,946

 

Other current liabilities

 

1,859

 

1,841

 

Deferred revenue

 

7,543

 

2,059

 

Deferred rent

 

58

 

134

 

Total current liabilities

 

52,491

 

77,494

 

 

 

 

 

 

 

Long-term debt, net of current portion

 

7,438

 

4,797

 

Capital lease obligations, net of current portion

 

193

 

795

 

Deferred revenue, net of current portion

 

26,142

 

25,347

 

Deferred rent, net of current portion

 

630

 

1,210

 

Other long-term liabilities

 

2,866

 

5,022

 

Total liabilities

 

89,760

 

114,665

 

 

 

 

 

 

 

Commitments and contingencies (Note 7)

 

 

 

 

 

 

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

Preferred stock, $0.001 par value—5,000,000 shares authorized; 0 shares issued and outstanding at December 31, 2009 and June 30, 2010

 

 

 

Common stock, $0.001 par value—250,000,000 shares authorized; 102,606,088 and 104,633,868 shares issued and outstanding at December 31, 2009 and June 30, 2010, respectively

 

103

 

105

 

Additional paid-in capital

 

767,694

 

781,681

 

Accumulated deficit

 

(238,668

)

(301,911

)

Accumulated other comprehensive loss

 

(909

)

(654

)

Total A123 Systems, Inc. stockholders’ equity

 

528,220

 

479,221

 

Noncontrolling interest

 

110

 

(36

)

Total stockholders’ equity

 

528,330

 

479,185

 

 

 

 

 

 

 

Total liabilities and stockholders’ equity

 

$

618,090

 

$

593,850

 

 

See notes to unaudited condensed consolidated financial statements.

 

1



Table of Contents

 

A123 Systems, Inc.

Condensed Consolidated Statements of Operations

(in thousands, except per share data)

(Unaudited)

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2009

 

2010

 

2009

 

2010

 

 

 

 

 

 

 

 

 

 

 

Revenue:

 

 

 

 

 

 

 

 

 

Product

 

$

16,517

 

$

15,558

 

$

36,638

 

$

35,332

 

Services

 

3,185

 

7,050

 

6,284

 

11,744

 

Total revenue

 

19,702

 

22,608

 

42,922

 

47,076

 

 

 

 

 

 

 

 

 

 

 

Cost of revenue:

 

 

 

 

 

 

 

 

 

Product

 

19,616

 

18,977

 

39,186

 

41,331

 

Services

 

2,661

 

6,580

 

4,505

 

10,735

 

Total cost of revenue

 

22,277

 

25,557

 

43,691

 

52,066

 

Gross loss

 

(2,575

)

(2,949

)

(769

)

(4,990

)

 

 

 

 

 

 

 

 

 

 

Operating expenses:

 

 

 

 

 

 

 

 

 

Research, development and engineering

 

11,587

 

13,832

 

22,814

 

27,948

 

Sales and marketing

 

2,245

 

3,366

 

4,227

 

6,166

 

General and administrative

 

5,990

 

8,804

 

12,273

 

17,044

 

Production start-up

 

179

 

3,606

 

179

 

5,417

 

Total operating expenses

 

20,001

 

29,608

 

39,493

 

56,575

 

Operating loss

 

(22,576

)

(32,557

)

(40,262

)

(61,565

)

 

 

 

 

 

 

 

 

 

 

Other income (expense):

 

 

 

 

 

 

 

 

 

Interest expense, net

 

(292

)

(372

)

(510

)

(590

)

Gain (loss) on foreign exchange

 

673

 

(1,226

)

(115

)

(981

)

Unrealized loss on preferred stock warrant liability

 

(22

)

 

(70

)

 

Other income (expense), net

 

359

 

(1,598

)

(695

)

(1,571

)

 

 

 

 

 

 

 

 

 

 

Loss from operations, before tax

 

(22,217

)

(34,155

)

(40,957

)

(63,136

)

Provision for income taxes

 

123

 

132

 

267

 

253

 

Net loss

 

(22,340

)

(34,287

)

(41,224

)

(63,389

)

Less: Net loss attributable to the noncontrolling interest

 

427

 

69

 

574

 

146

 

Net loss attributable to A123 Systems, Inc.

 

$

(21,913

)

$

(34,218

)

$

(40,650

)

$

(63,243

)

Accretion to preferred stock

 

(17

)

 

(28

)

 

Net loss attributable to A123 Systems, Inc. common stockholders

 

$

(21,930

)

$

(34,218

)

$

(40,678

)

$

(63,243

)

 

 

 

 

 

 

 

 

 

 

Net loss per share attributable to common stockholders - basic and diluted:

 

$

(2.36

)

$

(0.33

)

$

(4.39

)

$

(0.61

)

Weighted average number of common shares outstanding - basic and diluted

 

9,277

 

104,333

 

9,272

 

103,825

 

 

See notes to unaudited condensed consolidated financial statements.

 

2



Table of Contents

 

A123 Systems, Inc.

Condensed Consolidated Statements of Stockholders’ (Deficit) Equity

(in thousands, except per share data)

(Unaudited)

 

 

 

Series B-1 Convertible
Preferred Stock, $0.001
Par Value

 

Common Stock, $0.001
Par Value

 

Additional
Paid-in

 

Accumulated

 

Accumulated
Other
Comprehensive

 

Total
Stockholders’
(Deficit)

 

Noncontrolling

 

Comprehensive

 

 

 

Shares

 

Amount

 

Shares

 

Amount

 

Capital

 

Deficit

 

Loss

 

Equity

 

Interest

 

Loss

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

BALANCE - January 1, 2009

 

1,493

 

$

1

 

7,662

 

$

8

 

$

19,649

 

$

(152,889

)

$

(197

)

$

(133,428

)

$

871

 

 

 

Accretion of redeemable convertible preferred stock to redemption value

 

 

 

 

 

(28

)

 

 

(28

)

 

 

 

Stock-based compensation

 

 

 

 

 

4,034

 

 

 

4,034

 

 

 

 

Issuance of common stock

 

 

 

35

 

 

24

 

 

 

24

 

 

 

 

Comprehensive loss:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net loss

 

 

 

 

 

 

(40,650

)

 

(40,650

)

(574

)

$

(41,224

)

Foreign currency translation adjustment

 

 

 

 

 

 

 

(271

)

(271

)

48

 

(223

)

Total comprehensive loss

 

 

 

 

 

 

 

 

 

 

$

(41,447

)

BALANCE - June 30, 2009

 

1,493

 

$

1

 

7,697

 

$

8

 

$

23,679

 

$

(193,539

)

$

(468

)

$

(170,319

)

$

345

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

BALANCE - January 1, 2010

 

 

$

 

 

102,606

 

$

103

 

$

767,694

 

$

(238,668

)

$

(909

)

$

528,220

 

$

110

 

 

 

Stock-based compensation

 

 

 

 

 

5,133

 

 

 

5,133

 

 

 

 

Issuance of common stock

 

 

 

2,028

 

2

 

8,854

 

 

 

8,856

 

 

 

 

Comprehensive loss:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net loss

 

 

 

 

 

 

(63,243

)

 

(63,243

)

(146

)

$

(63,389

)

Foreign currency translation adjustment

 

 

 

 

 

 

 

255

 

255

 

 

255

 

Total comprehensive loss

 

 

 

 

 

 

 

 

 

 

$

(63,134

)

BALANCE - June 30, 2010

 

 

$

 

104,634

 

$

105

 

$

781,681

 

$

(301,911

)

$

(654

)

$

479,221

 

$

(36

)

 

 

 

See notes to unaudited condensed consolidated financial statements.

 

3



Table of Contents

 

A123 Systems, Inc.

Condensed Consolidated Statements of Cash Flows

(in thousands)

(Unaudited)

 

 

 

Six Months Ended

 

 

 

June 30,

 

 

 

2009

 

2010

 

 

 

 

 

 

 

Cash flows from operating activities:

 

 

 

 

 

Net loss

 

$

(41,224

)

$

(63,389

)

Adjustments to reconcile net loss to net cash used in operating activities:

 

 

 

 

 

Depreciation and amortization

 

6,304

 

7,758

 

Noncash rent

 

37

 

656

 

Noncash foreign exchange (gain) loss on intercompany loan

 

(20

)

599

 

Impairment of long-lived and intangible assets

 

 

530

 

Unrealized loss on preferred stock warrant liability

 

70

 

 

Loss on disposal of property and equipment

 

9

 

119

 

Amortization of debt issuance costs and noncash interest expense

 

42

 

 

Stock-based compensation

 

4,034

 

5,133

 

Changes in current assets and liabilities:

 

 

 

 

 

Accounts receivable

 

839

 

(2,448

)

Inventory

 

(6,093

)

(4,540

)

Prepaid expenses and other assets

 

2,291

 

(1,735

)

Accounts payable

 

(8,699

)

7,459

 

Accrued expenses

 

677

 

(2,369

)

Deferred revenue

 

(1,030

)

(4,459

)

Other liabilities

 

(11

)

963

 

Net cash used in operating activities

 

(42,774

)

(55,723

)

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

(Increase) decrease in restricted cash

 

(2,245

)

58

 

Purchases of property, plant and equipment

 

(17,220

)

(60,987

)

Proceeds from sale of property and equipment

 

13

 

 

Proceeds from government grant

 

 

26,319

 

Purchase of investment

 

 

(13,000

)

Net cash used in investing activities

 

(19,452

)

(47,610

)

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

Deferred offering costs

 

(756

)

 

Proceeds from government grant

 

3,000

 

1,250

 

Proceeds from exercise of stock options

 

24

 

2,259

 

Proceeds from issuance of long-term debt

 

7,585

 

 

Payments on long-term debt

 

(2,648

)

(3,955

)

Payments on capital lease obligations

 

(278

)

(278

)

Net proceeds from issuance of redeemable convertible preferred stock

 

99,590

 

 

Net cash provided by (used in) financing activities

 

106,517

 

(724

)

 

 

 

 

 

 

Effect of foreign exchange rates on cash and cash equivalents

 

76

 

261

 

Net increase (decrease) in cash and cash equivalents

 

44,367

 

(103,796

)

Cash and cash equivalents at beginning of period

 

70,510

 

457,122

 

Cash and cash equivalents at end of period

 

$

114,877

 

$

353,326

 

Supplemental cash flow information - cash paid for interest

 

$

551

 

$

485

 

Noncash investing and financing activities:

 

 

 

 

 

Issuance of note for consulting services

 

$

830

 

$

 

Purchase of equipment under capital leases

 

$

423

 

$

1,235

 

Equipment purchases included in accounts payable and accrued expenses

 

$

1,423

 

$

28,088

 

Issuance of common stock for investment

 

$

 

$

7,495

 

 

See notes to unaudited condensed consolidated financial statements.

 

4



Table of Contents

 

A123 Systems, Inc.

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

1. Nature of the Business, Basis of Presentation, and Significant Accounting Policies

 

A123 Systems, Inc. (the ‘‘Company’’) was incorporated in Delaware on October 19, 2001 and has its corporate offices in Watertown, Massachusetts. The Company designs, develops, manufactures and sells advanced rechargeable lithium-ion batteries and battery systems and provides services to government agencies and commercial customers.

 

Basis of Presentation —The accompanying condensed consolidated financial statements and the related disclosures as of June 30, 2010 and for the three and six months ended June 30, 2009 and 2010 are unaudited and have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and the applicable rules and regulations of the Securities and Exchange Commission (‘‘SEC’’) for interim financial information. Accordingly, they do not include all of the information and notes required by GAAP for complete financial statements.  These interim condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto contained in the Company’s Annual Report on Form 10-K filed with the SEC on March 15, 2010.  The December 31, 2009 condensed consolidated balance sheet included herein was derived from the audited financial statements as of that date, but does not include all disclosures, including notes, required by GAAP for complete financial statements.

 

The unaudited interim condensed consolidated financial statements have been prepared on the same basis as the audited consolidated financial statements and, in the opinion of management, reflect all adjustments of a normal recurring nature considered necessary to present fairly the Company’s financial position as of June 30, 2010 and results of its operations for the three and six months ended June 30, 2009 and 2010, and its cash flows for the six months ended June 30, 2009 and 2010. The interim results for the three and six months ended June 30, 2010 are not necessarily indicative of the results that may be expected for the year ending December 31, 2010.

 

Principles of Consolidation—The accompanying condensed consolidated financial statements include the accounts of the Company and its subsidiaries. All inter-company balances and transactions have been eliminated in consolidation. The Company’s investment in a variable interest entity (‘‘VIE’’), of which the Company is the primary beneficiary, is consolidated.

 

Use of Estimates—The preparation of condensed consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, expense and related disclosures. The Company bases estimates and assumptions on historical experience and on various other factors that it believes to be reasonable under the circumstances. The Company evaluates its estimates and assumptions on an ongoing basis. The Company’s actual results may differ from these estimates under different assumptions or conditions.

 

Revisions to Amounts Previously Presented—Certain prior period amounts have been reclassified to conform to the current period presentation.  Production start-up expenses for the three and six months ended June 30, 2009, relating to the Company’s facility in Livonia, Michigan,  have been reclassified from general and administrative expenses to production start-up expenses in the condensed consolidated statements of operations.

 

Government Grants—The Company recognizes government grants when there is reasonable assurance that the Company will comply with the conditions attached to the grant arrangement and the grant will be received. Government grants are recognized in the condensed consolidated statements of operations on a systematic basis over the periods in which the Company recognizes the related costs for which the government grant is intended to compensate. Specifically, when government grants are related to reimbursements for cost of revenues or operating expenses, the government grants are recognized as a reduction of the related expense in the condensed consolidated statements of operations. For government grants related to reimbursements of capital expenditures, the government grants are recognized as a reduction of the basis of the asset and recognized in the condensed consolidated statements of operations over the estimated useful life of the depreciable asset as reduced depreciation expense.

 

The Company records government grants receivable in the condensed consolidated balance sheets in prepaid expenses and other current assets or deposits and other assets, depending on when the amounts are expected to be received from the government agency. Proceeds received from government grants prior to expenditures being incurred are recorded as restricted cash and other current liabilities or other long-term liabilities, depending on when the Company expects to use the proceeds.

 

The Company classifies in the condensed consolidated statements of cash flows grant proceeds received in advance of spending for qualified expenditures as a cash flow from financing activities, as the proceeds are used to assist in funding future expenditures. Grant proceeds received as reimbursements for capital expenditures previously incurred are classified in cash flows from investing activities and grant proceeds received as reimbursements for operating expenditures previously incurred are classified in cash flows from operating activities.

 

5



Table of Contents

 

Revenue Recognition—The Company recognizes revenue from the sale of products and delivery of services, including governmental contracts. Revenue is recognized when all of the following criteria are met: persuasive evidence of an arrangement exists, delivery has occurred or services have been provided, the price to the buyer is fixed or determinable, and collectability is reasonably assured. If sales arrangements contain multiple elements, the Company evaluates the agreements to determine if separate units of accounting exist within the arrangement. If separate units of accounting exist within an arrangement, the Company allocates revenue to each element based on the relative selling price of each of the elements.

 

Effective January 1, 2010, the Company early adopted the new accounting standards for revenue recognition related to multiple-deliverable revenue arrangements. Under the new authoritative guidance, each deliverable within a multiple-element revenue arrangement is accounted for as a separate unit of accounting if both of the following criteria are met: (1) the delivered item or items have value to the customer on a standalone basis and (2) for an arrangement that includes a general right of return relative to the delivered item(s), delivery or performance of the undelivered item(s) is considered probable and substantially in the Company’s control. The Company considers a deliverable to have standalone value if the Company sells this item separately or if the item is sold by another vendor or could be resold by the customer. Further, the Company’s revenue arrangements generally do not include a general right of return relative to delivered products. Deliverables not meeting the criteria for being a separate unit of accounting are combined with a deliverable that does meet that criterion. The appropriate allocation of arrangement consideration and recognition of revenue is then determined for the combined unit of accounting.

 

In accordance with the new authoritative guidance, the Company allocates arrangement consideration to each deliverable in an arrangement based on its relative selling price. The Company determines selling price using vendor-specific objective evidence (“VSOE”), if it exists; otherwise, the Company uses third-party evidence (“TPE”). If neither VSOE nor TPE of selling price exists for a unit of accounting, the Company uses estimated selling price (“ESP”).

 

VSOE is generally limited to the price charged when the same or similar product is sold separately. If a product or service is seldom sold separately, it is unlikely that the Company can determine VSOE for the product or service. In most cases, VSOE of selling price is an average price of recent actual transactions that are priced within a reasonable range. TPE is determined based on the prices charged by the Company’s competitors for a similar deliverable when sold separately. It may be difficult for the Company to obtain sufficient information on competitor pricing to substantiate TPE and, therefore, the Company may not always be able to use TPE.

 

If the Company is unable to establish selling price using VSOE or TPE, and the new or materially modified arrangement was entered into after the implementation date of January 1, 2010, the Company will use ESP in the allocation of arrangement consideration. The objective of ESP is to determine the price at which the Company would transact if the product or service were sold on a standalone basis. The Company’s determination of ESP involves a weighting of several factors based on the specific facts and circumstances of the arrangement. Because of the nature of the business and history with providing services and manufacturing products for various applications, the Company performs an initial assessment on the nature of the services that will be provided by estimating the cost to provide those services plus an estimated profit margin. The Company performs the same assessment on new products by estimating the per unit cost to manufacture the product plus an estimated profit margin. The estimated profit margins initially used in the assessment are based on the Company’s profit objectives which will be adjusted based on other considerations such as pricing of similar products and services, characteristics of the specific market, ongoing pricing strategy and policies and value of any enhancements in functionality included in the deliverable.

 

The Company plans to analyze the selling prices used in the allocation of arrangement consideration at a minimum on an annual basis. Selling prices will be analyzed on a more frequent basis if a significant change in the business necessitates a more timely analysis or if the Company experiences significant variances in selling prices.

 

Product Revenue

 

Product revenue is generally recognized upon transfer of title and risk of loss, which is generally upon shipment, unless an acceptance period exists. In general, the Company’s customary shipping terms are FOB shipping point or free carrier. In instances where customer acceptance of a product is required, revenue is either recognized (i) upon shipment when the Company is able to demonstrate that the customer specific objective criteria have been met or (ii) upon the earlier of customer acceptance or expiration of the acceptance period.

 

The Company provides warranties for its products and records the estimated costs as a cost of revenue in the period the revenue is recorded. The Company’s standard warranty period extends one to five years from the date of delivery, depending on the type of product purchased and its application. The warranties provide that the Company’s products will be free from defects in material and workmanship and will, under normal use, conform to the specifications for the product. The warranties further provide that the Company will repair the product or provide replacement parts at no charge to the customer. When the Company is unable to reasonably determine its obligation for warranty of new products, revenue from the sale of the products is deferred until expiration of the warranty period or until such time as the warranty obligation can be reasonably estimated.

 

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Services Revenue

 

Revenue from services is recognized as the services are performed consistent with the performance requirements of the contract using the proportional performance method. Where arrangements include milestones or governmental approval that impact the fees payable to the Company, revenue is limited to those amounts whereby collectability is reasonably assured. The Company recognizes revenue earned under time and materials contracts as services are provided based upon actual costs incurred plus a contractually agreed-upon profit margin. The Company recognizes revenue from fixed-price contracts using the proportional performance method based on the ratio of costs incurred to estimates of total expected project costs in order to determine the amount of revenue earned to date. Project costs are based on the direct salary and associated fringe benefits of the employees on the project plus all direct expenses incurred to complete the project that are not reimbursed by the client. The proportional performance method is used since reasonably dependable estimates of the revenues and costs applicable to various stages of a contract can be made. These estimates are based on historical experience and deliverables identified in the contract and are indicative of the level of benefit provided to the Company’s clients. There are no costs that are deferred and amortized over the contract term.

 

Service revenue includes revenue derived from the execution of contracts awarded by the U.S. federal government, other government agencies and commercial customers. The Company’s research and development arrangements with the federal government or other government agencies typically require the Company to provide pure research, in which the Company investigates design techniques on new battery technologies. The Company’s arrangements with commercial customers consist of arrangements where the Company is paid to enhance or modify an existing product or to develop or jointly develop a new product to meet a customer’s specifications.

 

Pre-production costs related to long-term supply arrangements—Engineering, design and development costs for products sold under long-term supply arrangements are expensed as incurred in research, development and engineering expenses in the condensed consolidated statement of operations, unless the Company has a contractual guarantee for reimbursement from the customer.  Costs that have a contractual guarantee for reimbursement are capitalized and amortized as a cost of sales over the applicable term.  For the three and six months ended June 30, 2010, the Company expensed $0.2 million of pre-production costs related to long-term supply arrangements as research, development and engineering expense.  As of June 30, 2010, the Company capitalized $0.4 million of pre-production costs that have a contractual guarantee for reimbursement.

 

Production start-up—Production start-up expenses consist of salaries and personnel-related costs, site selection costs, including legal and regulatory costs, rent and the cost of operating a production line before it has been qualified for full production, including the cost of raw materials run through the production line during the qualification phase.  The Company expects to continue to incur production start-up expenses related to its facilities in Livonia and Romulus, Michigan. The Livonia facility is expected to begin qualification for production in the second half of 2010. The Romulus facility is expected to begin qualification for production in the first half of 2011.  During the three and six months ended June 30, 2010, the Company recorded production start-up expenses of $3.6 million and $5.4 million, of which $1.6 million related to materials, labor and overhead costs incurred in the qualification of the prismatic cell production line.

 

Fair Value of Financial Instruments—The carrying amount of cash, cash equivalents, restricted cash, accounts receivable, accounts payable and accrued expenses approximates fair value due to the short-term nature of these items. Management believes that the Company’s debt obligations bear interest at rates which approximate prevailing market rates for instruments with similar characteristics and, accordingly, the carrying values for these instruments approximate fair value.

 

Fair value is an exit price, representing the amount that would be received from the sale of an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or liability. As a basis for considering such assumptions, GAAP establishes a three-tier value hierarchy, which prioritizes the inputs used in measuring fair value as follows: (Level 1) observable inputs such as quoted prices in active markets; (Level 2) inputs other than the quoted prices in active markets that are observable either directly or indirectly; and (Level 3) unobservable inputs in which there is little or no market data, which requires the Company to develop its own assumptions. This hierarchy requires the Company to use observable market data, when available, and to minimize the use of unobservable inputs when determining fair value. On a recurring basis, the Company measures certain financial assets and liabilities at fair value, including the Company’s cash equivalents.

 

The Company did not have any material items that are measured at fair value on a non-recurring basis under this requirement as of December 31, 2009 or June 30, 2010.

 

The following tables show assets measured at fair value on a recurring basis and the input categories associated with those assets (in thousands):

 

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As of December 31, 2009

 

 

 

Fair Value at
December 31, 2009

 

Quoted Prices in
Active Markets for
Identical Assets
(Level 1)

 

Significant Other
Observable
Inputs
(Level 2)

 

Significant
Unobservable
Inputs
(Level 3)

 

Asset:

 

 

 

 

 

 

 

 

 

Money market funds

 

$

447,368

 

$

447,368

 

$

 

$

 

 

 

 

 

 

As of June 30, 2010

 

 

 

Fair Value at June
30, 2010

 

Quoted Prices in
Active Markets for
Identical Assets
(Level 1)

 

Significant Other
Observable
Inputs
(Level 2)

 

Significant
Unobservable
Inputs
(Level 3)

 

Asset:

 

 

 

 

 

 

 

 

 

Money market funds

 

$

331,432

 

$

331,432

 

$

 

$

 

 

The Company’s cash equivalents consist of money market funds that approximate their face value.

 

Stock-Based Compensation—The Company accounts for all awards, including employee and director awards, by recognizing compensation expense based on the fair value of share-based transactions in the condensed consolidated financial statements.  The Company recognizes compensation expense over the vesting period using a ratable method (providing the minimum amount of compensation recorded is equal to the vested portion of the award, requiring a ratable method when necessary) and classifies these amounts in the condensed consolidated statements of operations based on the department to which the related employee reports. The Company uses the Black-Scholes valuation model to calculate the fair value of stock options, utilizing various assumptions.

 

The Company records equity instruments issued to non-employees as expense at their fair value over the related service period and periodically revalues the equity instruments as they vest.

 

Net Loss Per Share—Basic net loss per share is computed by dividing net loss by the weighted-average number of common shares outstanding during the relevant period. Diluted net loss per share is computed by dividing net loss by the weighted-average number of dilutive common shares outstanding during the relevant period. Dilutive shares outstanding are calculated by adding to the weighted shares outstanding any potential (unissued) shares of common stock and warrants based on the treasury stock method.

 

The following potentially dilutive securities were excluded from the calculation of diluted net loss per share, as the effect would have been anti-dilutive (in thousands):

 

 

 

June 30,

 

 

 

2009

 

2010

 

Convertible preferred stock upon conversion to common stock

 

61,374

 

 

Warrants to purchase redeemable convertible preferred stock

 

126

 

 

Warrants to purchase common stock

 

45

 

45

 

Options to purchase common stock

 

10,245

 

10,229

 

Unvested restricted stock units

 

 

198

 

 

 

71,790

 

10,472

 

 

New Accounting Pronouncements—In June 2009, the FASB issued new accounting guidance which modifies the existing quantitative guidance used in determining the primary beneficiary of a VIE by requiring entities to qualitatively assess whether an enterprise is a primary beneficiary, based on whether the entity has (i) power over the significant activities of the VIE, and (ii) an obligation to absorb losses or the right to receive benefits that could be potentially significant to the VIE.  This guidance became effective for all new and existing VIE’s on January 1, 2010.  There was no significant impact on the Company’s condensed consolidated financial statements upon adopting this guidance.

 

During the second quarter of 2010, the Company elected to early adopt, as permitted by the guidance, the new accounting standards for revenue recognition for multiple-deliverable revenue arrangements.  The Company has prospectively (retroactive to January 1, 2010) applied the provisions of the new authoritative guidance to all revenue arrangements entered into or materially modified after January 1, 2010.  The adoption had no impact on previously reported amounts for the three months ended March 31, 2010.  This new authoritative guidance amends previously issued guidance to eliminate the residual method of allocation for multiple-deliverable revenue arrangements, and requires that arrangement consideration be allocated at the inception of an arrangement to all deliverables using the relative selling price method. The new authoritative guidance also establishes a selling price hierarchy for

 

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determining the selling price of a deliverable, which includes (1) VSOE, if available, (2) TPE, if vendor-specific objective evidence is not available, and (3) ESP, if neither vendor-specific nor third-party evidence is available. Additionally, it expands the disclosure requirements related to a vendor’s multiple-deliverable revenue arrangements.  Adopting the new standard will allow the Company to allocate the arrangement consideration to multiple deliverables in an arrangement. The Company’s multiple-deliverable revenue arrangements may include any combination of engineering services, research and development services, prototypes, battery packs, battery system components and battery cells.

 

During the six months ended June 30, 2010, the adoption of this guidance had no material impact. The new accounting standards for revenue recognition, if applied in the same manner to the year ended December 31, 2009, would not have had a material impact on total net revenue for that fiscal year.

 

In January 2010, the FASB issued an update to the existing disclosure requirements related to fair value measurements which requires entities to make new disclosures about recurring or nonrecurring fair value measurements including significant transfers into and out of Level 1 and Level 2 fair value measurements and information on purchases, sales, issuances, and settlements on a gross basis in the reconciliation of Level 3 fair value measurements. This update is effective for annual and interim periods beginning after December 15, 2009, except for Level 3 reconciliation disclosures which are effective for annual periods beginning after December 15, 2010.  There was no significant impact on the Company’s condensed consolidated financial statement disclosures for the adoption of this update as it relates to disclosures about recurring or nonrecurring fair value measurements including significant transfers into and out of Level 1 and Level 2.

 

In April 2010, the FASB issued an update to the accounting and reporting guidance for milestone based revenue arrangements.  This update provides guidance on defining a milestone and determining when it may be appropriate to apply the milestone method of revenue recognition for research or development transactions. Research or development arrangements frequently include payment provisions whereby a portion or all of the consideration is contingent upon the achievement of milestone events. An entity may only recognize consideration that is contingent upon the achievement of a milestone in its entirety in the period the milestone is achieved only if the milestone meets certain criteria. This update is effective prospectively for milestones achieved in fiscal years beginning on or after June 15, 2010. While the Company is still evaluating the potential impact of this guidance, the Company does not expect that the adoption of this update will have a material impact on its financial position, results of operations, or cash flows.

 

2.  Government Grants and Incentives

 

Center of Energy and Excellence Grant

 

In February 2009, the State of Michigan awarded the Company a $10.0 million Center of Energy and Excellence grant. Under the agreement, the State of Michigan will provide cost reimbursement for 100% of qualified expenditures incurred through November 30, 2011. Other than certain standard conditions, there are no conditions attached to this award that will require repayment of amounts received if those conditions are not met. The Company received $3.0 million of this grant in March 2009, with the remainder to be paid based on the achievement of certain milestones in the facility development. The Company used $2.2 million of these funds in the year ended December 31, 2009.  The Company used $0 and $0.8 million of these funds during the three and six months ended June 30, 2010, of which $0.7 million and $0.1 million was recorded as an offset to property, plant, and equipment and operating expenses, respectively, for the six months ended June 30, 2010.  In addition, the Company incurred allowable costs of $31,000 and $1.5 million during the three and six months ended June 30, 2010, respectively, which was recorded as a receivable in prepaid expense and other current assets and as an offset to property, plant, and equipment and operating expenses.

 

Michigan Economic Growth Authority

 

In April 2009, Michigan Economic Growth Authority (“MEGA”) offered the Company certain tax incentives, which can be used to offset the Michigan Business Tax owed in a tax year, carried forward for the number of years specified by the agreement, or be paid to the Company in cash at the time claimed to the extent the Company does not owe a tax. The terms and conditions of the High-Tech Credit were established in October 2009 and the Cell Manufacturing Credit in November 2009.

 

High Tech Credit—The High-Tech Credit agreement provides the Company with a 15-year tax credit, beginning with the 2011 fiscal year. The credit will be calculated as qualified wages and benefits, multiplied by the Michigan personal income tax rate beginning in the tax year the credit is sought. The proceeds to be received by the Company will be based on the number of jobs created, qualified wages paid and tax rates in effect over the 15 year period. The tax credit is subject to a repayment provision in the event the Company relocates a substantial portion of the jobs outside the state of Michigan within 15 years from the date the Company first receives the credit. There is no impact to the condensed consolidated financial statements as of June 30, 2010.

 

Cell Manufacturing Credit—The Cell Manufacturing Credit agreement authorizes a credit for the Company equal to 50% of capital investment expenses related to the construction of the Company’s integrated battery cell manufacturing facilities in Michigan, commencing January 1, 2009, up to a maximum of $100.0 million over a four year period. The credit shall not exceed $25.0 million per year and can be submitted for reimbursement beginning in tax year 2012. The Company is required to create 300 jobs no later than

 

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December 31, 2016 for the tax credit to be non-refundable. The tax credit is subject to a repayment provision in the event the Company relocates 51% or more of the 300 jobs outside of the state of Michigan within three years after the last year the tax credit is received. Through June 30, 2010, the Company has incurred $60.4 million in expenses related to the construction of the Livonia and Romulus facilities. When the Company has met the filing requirements for the tax year ending December 31, 2012, the Company expects to receive $30.2 million in refundable tax credits related to these expenses. There is no impact to the condensed consolidated financial statements as of June 30, 2010.  The Company will record the receivable when it is probable that it will comply with the conditions of the grant and receipt of the grant.  At that time, the Company would reduce the basis in the fixed assets acquired under the grant by $26.7 million and record $3.5 as reimbursement for expenses previously incurred.

 

Michigan Economic Growth Authority Loan

 

The State of Michigan also granted the Company a low interest forgivable loan of up to $4.0 million effective August 2009 with the objective of conducting advance vehicle technology operations to promote and enhance job creation within the State of Michigan. To receive advances under the loan, the Company is required to achieve certain key milestones related to the development of the manufacturing facility. The note will accrue interest of 1% per annum from the date of the initial advance, and the Company will have no obligation to pay any principal or interest until August 2012. If the Company creates 350 full time jobs by August 2012 and maintains the jobs in the State of Michigan for three years after the end of the loan, the entire debt will be forgiven. The Company has not yet met the first milestone required to receive the initial advance from the loan, and as such, there is no impact to the condensed consolidated financial statements as of June 30, 2010.

 

U.S. Department of Energy Battery Initiative

 

In December 2009, the Company entered into an agreement establishing the terms and conditions of a $249.1 million grant awarded under the Department of Energy (“DOE”) Battery Initiative to support manufacturing expansion of new lithium-ion battery manufacturing facilities in Michigan. Under the agreement, the DOE will provide cost reimbursement for 50% of qualified expenditures incurred from December 1, 2009 to November 30, 2012. The agreement also provides for reimbursement of pre-award costs incurred from June 1, 2009 to November 30, 2009. Other than certain standard conditions, there are no conditions attached to this award that will require repayment of amounts received if those conditions are not met. For the three and six months ended June 30, 2010, the Company received $0 million and $6.1 in reimbursement, respectively, for costs incurred in 2009, of which $5.7 million related to offsets to property, plant and equipment and $0.4 million related to offsets to operating expenses. For the three and six months ended June 30, 2010, the Company received $22.3 million in reimbursement for costs incurred in 2010, of which $20.6 million related to offsets to property, plant and equipment and $1.7 million related to operating expenses.  The Company has incurred additional allowable costs in the six months ended June 30, 2010, entitling the Company to receive $1.7 million in reimbursement.  The Company recorded the $1.7 million receivable in prepaid expenses and other current assets in the consolidated balance sheets of which $1.2 million is an offset to deposits for purchases of equipment, included in other long-term assets in the condensed consolidated balance sheets, and the remaining $0.5 million as an offset to operating expenses in the condensed consolidated statements of operations.

 

Department of Energy, Labor and Economic Growth (“DELEG”)

 

In December 2009, the State of Michigan awarded the Company $2.0 million to assist in funding the Company’s smart grid stabilization project, the purpose of which is to develop and improve the quality of application of energy efficient technologies and to create or expand the market for such technologies. The Company received the initial advance of $0.9 million in December 2009, and through June 30, 2010, the Company incurred $0.3 million in allowable costs which was recorded as an offset to operating expenses.  The Company will receive the remainder of the grant upon expending 90% of the initial advance.  As of June 30, 2010, $0.6 million is included in short-term restricted cash and other current liabilities.

 

City of Livonia Personal Property Tax Exemption

 

The Company entered into an agreement with the City of Livonia allowing 100% exemption from personal property taxes by Livonia on all new personal property during the exemption period commencing on December 31, 2009 and continuing for fourteen years through December 31, 2023. The Company is required to invest at least $24.0 million in personal property and create or locate 350 new jobs in the eligible district to receive the exemption. If the Company relocates operations, jobs or activities outside the City of Livonia on or before May 31, 2016 such that employment is 175 jobs or less, the Company is required to repay all or a portion of the property taxes exempted. There is no impact to the condensed consolidated financial statements as of June 30, 2010 as a result of this agreement.

 

Michigan Strategic Fund Renaissance Zone Development

 

In May 2010, the Company entered into a Renaissance Zone Development agreement with the Michigan Strategic Fund and the property owners for the site leased by the Company in Romulus, Michigan.  Under the terms of the agreement, the Company may receive exemptions, deductions, credits or other benefits if it invests a certain amount of capital, creates a certain number of jobs and

 

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complies with other standard conditions related to its facility in Romulus, Michigan.  As of June 30, 2010, the Company has not yet met the conditions to be eligible to receive any of the Renaissance Zone benefits.  There is no impact to the condensed consolidated financial statements as of June 30, 2010 as a result of this agreement.

 

3.  Inventory

 

Inventory consists of the following (in thousands):

 

 

 

December 31, 2009

 

June 30, 2010

 

Raw materials

 

$

7,726

 

$

9,837

 

Work-in-process

 

25,139

 

31,230

 

Finished goods

 

4,573

 

621

 

 

 

$

37,438

 

$

41,688

 

 

4.  Property, Plant and Equipment

 

For government grants related to capital expenditures, the Company recognizes the reimbursement as a reduction of the basis of the asset and a reduction to depreciation expense over the useful life of the asset.   Property, plant and equipment consists of the following (in thousands):

 

 

 

December 31, 2009

 

June 30, 2010

 

Computer equipment and software

 

$

7,005

 

$

9,608

 

Furniture and fixtures

 

1,585

 

2,791

 

Automobiles

 

385

 

400

 

Machinery and equipment

 

66,934

 

71,578

 

Buildings

 

6,900

 

7,039

 

Leasehold improvements

 

9,224

 

18,021

 

Assets in progress

 

9,126

 

60,105

 

Property, plant and equipment, basis

 

101,159

 

169,542

 

Less reduction for costs reimbursed under government grants

 

1,100

 

19,080

 

Property, plant and equipment, carrying value

 

100,059

 

150,462

 

Less net accumulated depreciation and amortization

 

28,397

 

33,891

 

Property, plant and equipment, net

 

$

71,662

 

$

116,571

 

 

The Company has deposits for equipment not yet received of $17.0 million and $34.1 million at December 31, 2009 and June 30, 2010, respectively, included within deposits and other assets in the condensed consolidated balance sheets.  These deposits are reported net of contra deposit balances related to reimbursements under government grants of $6.7 million and $12.7 million at December 31, 2009 and June 30, 2010, respectively.

 

Computer equipment under capital lease consists of the following (in thousands):

 

 

 

December 31, 2009

 

June 30, 2010

 

Computer equipment and software, at cost

 

$

1,624

 

$

2,547

 

Less accumulated depreciation

 

(855

)

(936

)

Computer equipment and software, net

 

$

769

 

$

1,611

 

 

Net depreciation expense for the three months ended June 30, 2009 and 2010 and for the six months ended June 30, 2009 and 2010 was $2.9 million, $3.9 million, $5.3 million and $7.5 million, respectively.  For the three and six months ended June 30, 2010, the Company recorded $0.1 million as a reduction to depreciation expense related to reduced carrying value due to government grant reimbursements.  There was no reduction to depreciation expense recorded for either the three or six months ended June 30, 2009.

 

5.  Intangible Assets

 

Intangible assets consist of the following (in thousands):

 

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December 31, 2009

 

June 30, 2010

 

 

 

Useful Life

 

 

 

Accumulated

 

 

 

 

 

Accumulated

 

 

 

Intangible Asset Class

 

(Years)

 

Gross

 

Amortization

 

Net

 

Gross

 

Amortization

 

Net

 

Contractual backlogs

 

1-3

 

$

497

 

$

497

 

$

 

$

497

 

$

497

 

$

 

Customer relationships

 

5-17

 

640

 

394

 

246

 

629

 

396

 

233

 

Patented technology

 

4-5

 

2,473

 

1,855

 

618

 

2,394

 

2,008

 

386

 

Specialty-trained workforce

 

4

 

60

 

44

 

16

 

60

 

51

 

9

 

Trademarks and trade names

 

Indefinite

 

374

 

 

374

 

102

 

 

102

 

 

 

 

 

$

4,044

 

$

2,790

 

$

1,254

 

$

3,682

 

$

2,952

 

$

730

 

 

Amortization expense for intangible assets for the three months ended June 30, 2009 and 2010 and for the six months ended June 30, 2009 and 2010 was $0.2 million, $0.1 million, $0.4 million, and $0.2 million, respectively. The remaining net book value of the intangible assets will be amortized over a weighted-average period of approximately 2.97 years as of December 31, 2009.

 

6.  Investment

 

In January 2010, the Company entered into an agreement to purchase preferred stock of a maker of plug-in hybrid electric vehicles in the United States (the “Automaker”).  The Company agreed to invest cash of $13.0 million and shares of the Company’s common stock, which, when transferred to the Automaker, had a fair market value of $7.5 million.  As of June 30, 2010, all cash and stock consideration had been transferred to the Automaker in return for preferred stock of the Automaker.  The Company is accounting for its investment under the cost method.

 

In conjunction with the investment, the Company entered into a supply agreement with the Automaker to supply battery systems for its plug-in hybrid electric vehicle programs. Through June 30, 2010, the Company has recorded $0.3 million of revenue related to shipments of products to the Automaker.  The balance due from the Automaker as of June 30, 2010, of $0.3 million, is included within accounts receivable on the Company’s condensed consolidated balance sheet.

 

The Company recognizes revenue on product shipments to the Automaker, within the condensed consolidated statements of operations, when all revenue recognition criteria are met.

 

7.  Commitments and Contingencies

 

In June 2010, the Company entered into a supply agreement for a raw material component which included commitments to purchase minimum product volumes for each of the years ending December 31, 2010 through December 31, 2013.  If the Company’s purchase volumes during any year fail to meet the minimum purchase commitments, it is required to pay the seller a variance payment for the difference between the amount actually purchased in that calendar year and the annual minimum purchase commitment for that calendar year.  The Company will receive a credit for the amount of the variance payment to be applied to purchases in the following year and will have until April 1, 2015 to reclaim any variance payments resulting from the minimum purchase commitments for calendar years 2012 or 2013.  This arrangement qualifies as a normal purchase and normal sales contract.  For the three and six months ended June 30, 2010, the Company has purchased $1.7 million and $2.1 million under this supply agreement.  The amounts of purchase commitments by year are as follows (in thousands):

 

 

 

Purchase
Commitment

 

 

 

 

 

Remaining portion of 2010

 

$

4,584

 

2011

 

12,950

 

2012

 

18,500

 

2013

 

18,500

 

 

 

 

 

Total future purchase commitments

 

$

54,534

 

 

In May 2010, the Company entered into a Lease Agreement (the “Waltham Lease”) for approximately 97,000 square feet of office, research, lab and light manufacturing space in Waltham, Massachusetts for an initial term of ten years, expected to commence on April 1, 2011, with the option to extend for an additional five years.  The total cash obligation for base rent over the initial term of the Waltham Lease is $25.3 million.  In addition to base rent, the Company is also responsible for its share of electricity cost and its pro rata share of increases in operating expenses.  The landlord has agreed to provide the Company with an allowance for certain construction costs incurred. In connection with the Waltham Lease, the Company provided the landlord a security deposit of $1.0 million in the form of an irrevocable letter of credit.

 

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Litigation—In November 2005, the Company received a letter asserting that it was infringing upon certain U.S. patents. In April 2006, the Company commenced an action in the United States District Court for the District of Massachusetts seeking a declaratory judgment that the patents in question were not infringed by the Company’s products and that the patents claiming to be infringed upon are invalid. On September 11, 2006, a countersuit was filed against the Company and two of its business partners in the United States District Court for the Northern District of Texas alleging infringement of these patents. In October 2006 and January 2007, the U.S. Patent and Trademark Office (“PTO”) granted the Company’s request for reexamination of the two patents. In January and February 2007, the two suits were stayed pending the reexamination. The reexaminations of the two patents were concluded on April 15, 2008 and May 12, 2009, respectively. The Company filed a motion to re-open the litigation in the United States District Court for the District of Massachusetts on June 11, 2009. On September 28, 2009, the Massachusetts court entered an order denying that motion, which the Company appealed on October 27, 2009 to the United States Court of Appeals for the Federal Circuit.  On July 22, 2009, the Company was sent a proposed Second Amended Complaint which the complainants intend to seek leave to file with the Texas court in light of the PTO’s reexaminations.  On August 27, 2009, Hydro-Quebec and UT filed a Motion for Leave to File Second Amended Complaint and Jury Demand in the United States District Court for the Northern District of Texas and the Company was granted several unopposed extensions to file its response.  Hydro-Quebec and UT filed for leave to file an Amended Motion for Leave to File Second Amended Complaint and Jury Demand on April 1, 2010 and the Company filed its opposition to this application on April 22, 2010.  The judge held a status hearing with the parties on May 14, 2010 and has entered a schedule for the case leading to a claim construction hearing in December 2010.  The Company has agreed to defend and indemnify the other named business partner for its legal costs in defending this litigation and any damages that may be awarded. The Company is unable to predict the outcome of this matter, and therefore no accrual has been established for this contingency.

 

On February 3, 2010, the Company received notice that LG Chem, Ltd., or LG Chem, filed applications in the 50th division of Seoul District Court for preliminary injunctions against six former employees who are now employed either by the Company or its Enerland subsidiary. The applications allege that these former employees violated the two-year non-competition clause in their employment contracts with LG Chem and that there is a likelihood that they are infringing LG Chem’s trade secrets by working for a competitor.  An initial court hearing was held on February 19, 2010 and a second hearing was held on March 19, 2010.  The court rendered a decision on this application on June 9, 2010, which reduced the post-termination non-competition term from two years to eighteen months and prohibited four of the six defendants from working at Enerland during the applicable balance of their respective non-compete terms, ranging from four months to eleven months.  The six defendants were also prohibited from using the alleged trade secrets that LG Chem submitted to the court.  LG Chem has not commenced any additional legal action against these former employees, the Company or Enerland; however, should they do so, such legal action could result in significant legal expenses and diversion of time by the Company’s technical and management personnel.

 

8.  Income Taxes

 

The Company provides for income taxes at the end of each interim period based on the estimated effective tax rate for the full fiscal year. Cumulative adjustments to the Company’s estimate are recorded in the interim period in which a change in the estimated annual effective rate is determined.  The Company’s provision for income taxes consists primarily of foreign taxes.

 

As of December 31, 2009, the Company has provided a liability of $0.6 million for uncertain tax positions related to various foreign income tax matters which are classified as other long-term liabilities in the Company’s condensed consolidated balance sheets. The uncertain tax positions as of December 31, 2009 exclude interest and penalties of $0.2 million which are classified as other long-term liabilities on the Company’s condensed consolidated balance sheets. These uncertain tax positions would impact the Company’s effective tax rate, if recognized. The Company does not expect that the amounts of uncertain tax positions will change significantly within the next 12 months.

 

The Company recognizes interest and penalties accrued related to uncertain tax positions in the provision for income taxes. During the three months ended June 30, 2009 and 2010 and the six months ended June 30, 2009 and 2010, the Company recognized approximately $0, $14,000, $14,000 and $27,000 in penalties and interest, respectively. The Company had approximately $0.2 million for the payment of penalties and interest accrued at June 30, 2010.

 

9.  Financing Arrangements

 

Long-Term Debt—Long-term debt consists of the following (in thousands):

 

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Table of Contents

 

 

 

December 31, 2009

 

June 30, 2010

 

Term loan

 

$

12,069

 

$

9,569

 

Enerland debt

 

 

 

 

 

Term loan 2

 

1,289

 

 

Technology funds loan

 

107

 

69

 

Korean government loans

 

429

 

312

 

Total

 

13,894

 

9,950

 

Less amounts classified as current

 

6,456

 

5,153

 

Long-term debt

 

$

7,438

 

$

4,797

 

 

Term Loan—The Company has a term loan agreement with a financial institution that is also a common shareholder. The Company has a term loan facility under the term loan agreement for $15.0 million.  The term loan facility is repayable over a 36-month period and accrues interest at prime plus 0.75%.

 

The term loan agreement requires the Company to comply with certain financial covenants, which include a minimum liquidity ratio calculation. The term loan agreement is collateralized by substantially all assets of the Company, excluding intellectual property, property and equipment owned as of December 31, 2005 and certain equipment located in China.

 

Enerland debt—The Company has the following outstanding obligations for its Enerland subsidiary:

 

· Term loan 2—On March 5, 2008, the Company entered into two loan agreements with a financial institution in the amounts of $1.3 million and $0.3 million which matured in 2010. The loans had a variable interest rate.  Term loan 2 was paid off during February 2010.

 

· Technology funds loan—The Company has a technology funds loan agreement amounting to $0.1 million with a variable interest rate. The weighted average interest rate for the loan as of June 30, 2010 was 4.86%. The loan matures in August 2011.

 

· Korean government loans—As a part of the Korean government’s initiative to promote and encourage the development of start-up companies in certain high technology industries, high technology start-up companies with industry leading technology or products are eligible for government loans.

 

Revolving Credit Facilities—The Company entered into a line of credit (“LOC”) for $8.0 million with a financial institution that is also a common stockholder. The line of credit accrues interest at prime (3.25% at December 31, 2009 and June 30, 2010).  The outstanding balance at December 31, 2009 and June 30, 2010 was $8.0 million. The LOC has a maturity date of September 24, 2010, and the Company is required to comply with the same financial covenants required under the Term Loan mentioned above.

 

10.  Stock-Based Compensation

 

Stock Incentive Plans and Stock-Based Compensation—During 2009, the Company’s Board of Directors approved the 2009 Stock Incentive Plan (the “2009 Plan”) which became effective on the closing of the Company’s initial public offering (“IPO”) on September 24, 2009.  The 2009 Plan originally provided for the grant of qualified incentive stock options, nonqualified stock options, stock appreciation rights, restricted stock, restricted stock units, and other stock-based awards for the purchase of shares of the Company’s common stock to the Company’s employees, officers, directors, and outside consultants.  Up to an aggregate of 3,000,000 shares of Company’s common stock, subject to increase on an annual basis, are reserved for future issuance under the 2009 Plan.  Shares of common stock reserved for issuance under the Company’s 2001 Stock Incentive Plan (the “2001 Plan”) that remained available for issuance immediately prior to closing of the IPO and any shares of common stock subject to awards under the 2001 Plan that expired, terminated, or were otherwise forfeited, canceled or repurchased by the Company prior to being fully exercised were added to the number of shares available under the 2009 Plan, up to a maximum of 500,000 shares.  During the year ended December 31, 2009, and the six months ended June 30, 2010, 378,792 and 121,208 shares from the 2001 Plan were added to the number of shares available under the 2009 Plan, respectively.  No additional shares from the 2001 Plan will be added to the 2009 Plan.  On January 1, 2010, 5,000,000 shares were added to the 2009 Plan in connection with the annual increase.  At June 30, 2010, stock awards outstanding under the 2009 Plan included stock options and restricted stock units.  As of June 30, 2010, the Company had 6,480,971 stock-based awards available for future grant under the 2009 Plan and no stock-based awards available for future grant under the 2001 Plan.

 

Stock-based compensation cost is measured at the grant date, based on the calculated fair value of the award, and is recognized as an expense over the service period (generally the vesting period of the equity grant). The following table presents stock-based compensation expense included in the Company’s condensed consolidated statements of operations (in thousands):

 

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Three Months Ended

 

Six Months Ended

 

 

 

June 30,

 

June 30,

 

 

 

2009

 

2010

 

2009

 

2010

 

 

 

 

 

 

 

 

 

 

 

Cost of revenue

 

$

581

 

$

478

 

$

747

 

$

893

 

Research, development and engineering

 

1,339

 

1,110

 

1,940

 

2,072

 

Sales and marketing

 

229

 

97

 

344

 

395

 

General and administrative

 

676

 

961

 

1,003

 

1,773

 

Total

 

$

2,825

 

$

2,646

 

$

4,034

 

$

5,133

 

 

The Company has capitalized an immaterial amount of stock-based compensation as a component of inventory.

 

As of June 30, 2010, there was approximately $35.5 million of total unrecognized compensation cost related to non-vested stock-based compensation arrangements granted under the plans, which is expected to be recognized over a weighted-average period of 2.71 years.

 

Stock Options—Stock options generally vest over a four-year period and expire 10 years from the date of grant. Upon option exercise, the Company issues shares of common stock.

 

The following table summarizes stock option activity for the six months ended June 30, 2010:

 

 

 

Shares

 

Weighted
Average
Exercise
Price

 

Weighted
Average
Remaining
Contractual
Term

 

Aggregate
Intrinsic
Value

 

 

 

(In thousands)

 

 

 

 

 

(In thousands)

 

Outstanding - January 1, 2010

 

10,640

 

$

5.98

 

7.40

 

$

175,122

 

Granted

 

1,513

 

10.57

 

 

 

 

 

Exercised

 

(1,596

)

1.48

 

 

 

 

 

Forfeited

 

(328

)

8.39

 

 

 

 

 

Outstanding - June 30, 2010

 

10,229

 

$

7.29

 

7.70

 

$

29,633

 

Vested or expected to vest - June 30, 2010

 

9,824

 

$

7.14

 

7.64

 

$

29,456

 

Options exercisable - June 30, 2010

 

5,038

 

$

4.75

 

6.63

 

$

24,662

 

 

The Company estimates the fair value of stock options granted using the Black-Scholes option-pricing model and assumptions as to the fair value of the common stock on the grant date, expected term, expected volatility, risk-free rate of interest and an assumed dividend yield.  Options are granted with an exercise price equal to the fair value of the common stock as of the date of grant.  Prior to the Company’s IPO, fair value was determined by the Board of Directors.  For awards granted subsequent to the Company’s IPO, the fair value of the common stock is generally determined based on the closing price of the stock on the Nasdaq Global Market on the grant date.  In addition, due to the Company’s limited historical data, the Company estimated the expected volatility of its common stock at the date of grant based on the historical volatility of comparable public companies over the option’s expected term. The Company calculated the expected life of options using the simplified method as prescribed by the Stock Compensation Subtopic of the FASB Codification, due to the Company’s limited historical data.  The assumed dividend yield is based upon the Company’s expectation of not paying dividends in the foreseeable future. The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant for maturities similar to the expected term. Compensation expense is amortized on a straight-line basis over the requisite service period of the options, which is generally four years.

 

The Black-Scholes model assumptions for the periods set forth below are as follows:

 

 

 

Three Months Ended

 

Six Months Ended

 

 

 

June 30,

 

June 30,

 

 

 

2009

 

2010

 

2009

 

2010

 

Risk-free interest rate

 

2.7 - 3.2

%

2.8 - 3.3

%

2.7 - 3.2

%

2.8 - 3.3

%

Expected life

 

6.25 years

 

6.25 years

 

6.25 years

 

6.25 years

 

Expected volatility

 

73

%

74

%

73

%

74

%

Expected dividends

 

0

%

0

%

0

%

0

%

 

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The weighted average grant date fair value of options granted during the three months ended June 30, 2009 and 2010 and during the six months ended June 30, 2009 and 2010 was $6.37, $6.94,  $9.48, and $7.14, respectively. The intrinsic value of options exercised during the three months ended June 30, 2009 and 2010 and during the six months ended June 30, 2009 and 2010 was $0.1 million, $5.6 million, $4.7 million, and $22.8 million, respectively.

 

The Company received $13,000 and $1.8 million in cash from option exercises during the three months ended June 30, 2009 and 2010, respectively and $24,000 and $2.3 million in cash from option exercises during the six months ended June 30, 2009 and 2010, respectively.

 

Restricted Stock Units—During the three months ended June 30, 2010, the Company granted restricted stock unit awards to certain executives.  The restricted stock unit awards generally vest over a four-year period and upon vesting the Company issues shares of common stock.  The following table summarizes the Company’s restricted stock unit award activity for the six months ended June 30, 2010:

 

 

 

Shares

 

Weighted
Average Fair
Value

 

 

 

(In thousands)

 

 

 

Non-vested - January 1, 2010

 

 

$

 

Granted

 

198

 

10.11

 

Vested

 

 

 

Forfeited

 

 

 

Non-vested - June 30, 2010

 

198

 

$

10.11

 

 

The fair value of restricted stock unit awards is determined based on the closing price of the Company’s common stock on the Nasdaq Global Market on the grant date.

 

11.  Subsequent Events

 

In July 2010, the Company entered into a Lease Agreement (the “Lease”) for approximately 67,000 square feet of office, research and development, assembly, fabrication and warehouse space in Westborough, Massachusetts.  The lease term is from July 2010 through January 2021, and provides for the option to extend for one additional term of five years and the option for the Company to terminate the Lease in February 2016.  The total cash obligation for the base rent over the initial term of the Lease is approximately $4.4 million.  In addition to the base rent, the Company is also responsible for its share of operating expenses and taxes, including, but not limited to, insurance, real estate taxes, and common area maintenance costs.  In connection with the Lease, the Company provided a security deposit of approximately $156,000 to the landlord in the form of an irrevocable, unconditional, negotiable letter of credit.  The landlord has agreed to provide the Company with allowances totaling approximately $0.6 million for certain upgrades and repairs to be made by the Company.

 

The Company has evaluated the period from June 30, 2010, the date of the financial statements, to the date of the issuance and filing, and has determined that no material subsequent events have occurred, other than the event described above, that would affect the information presented in these financial statements or require additional disclosure.

 

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

 

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the unaudited condensed consolidated financial statements and the related notes thereto included elsewhere in this Quarterly Report on Form 10-Q and the audited consolidated financial statements and notes thereto and management’s discussion and analysis of financial condition and results of operations for the year ended December 31, 2009 included in our Annual Report on Form 10-K filed with the Securities and Exchange Commission, or SEC, on March 15, 2010. This Quarterly Report on Form 10-Q contains “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act. These statements are often identified by the use of words such as “may,” “will,” “expect,” “believe,” “anticipate,” “intend,” “could,” “estimate,” or “continue,” and similar expressions or variations. Such forward-looking statements are subject to risks, uncertainties and other factors that could cause actual results and the timing of certain events to differ materially from future results expressed or implied by such forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in the section titled “Risk Factors,” set forth in Part II, Item 1A of this Quarterly Report on Form 10-Q and set forth in Part I, Item 1A of our Annual Report on Form 10-K filed with the SEC on March 15, 2010 and elsewhere in this Quarterly Report. The forward-looking statements in this Quarterly Report on Form 10-Q represent our views as of the date of this Quarterly Report on Form 10-Q. We anticipate that subsequent events and developments will cause our views to change. However, while we may elect to update these forward-looking statements at some point in the future, we have no current intention of doing so except to the extent required by applicable law. You should, therefore, not rely on these forward-looking statements as representing our views as of any date subsequent to the date of this Quarterly Report on Form 10-Q.

 

Overview

 

We design, develop, manufacture and sell advanced, rechargeable lithium-ion batteries and battery systems. Our target markets are the transportation, electric grid services and commercial markets.

 

We market and sell our products primarily through a direct sales force. In the transportation market, we are focusing sales of our batteries and battery systems to automotive and heavy duty vehicle manufacturers either directly or through tier 1 suppliers. We work with automotive and heavy duty vehicle manufacturers directly to educate and inform them about the benefits of our technology for use in hybrid electric vehicles, or HEVs, plug-in hybrid electric vehicles, or PHEVs and electric vehicles, or EVs, and are engaged in design and development efforts with several automotive and heavy duty vehicle manufacturers and tier 1 suppliers. At the same time, we work with tier 1 suppliers who are developing integrated solutions using our batteries. In the electric grid services market, our agreements were initiated directly by our sales force. In the commercial market, our sales are made both directly and indirectly through distributors with key accounts managed by our sales personnel. We have entered into an exclusive agreement to license certain of our technology in the field of commercial electronic devices (excluding power tools and certain other consumer products) and expect to receive royalty fees on net sales of licensed products that include our technology. We expect to continue to expand our sales presence in Europe and Asia as our business in those regions continues to grow. We expect international markets to provide increased opportunities for our products.

 

Our sales cycles vary by product and market segment. Most of our batteries and battery systems typically undergo a lengthy development and qualification period prior to commercial production. We expect that the total time from customer introduction to commercial production will range up to five years depending on the specific product and market served. Our long and unpredictable sales cycles and the potential large size of battery supply and development contracts cause our period-to-period financial results to be susceptible to significant variability. Since most of our operating and capital expenses are incurred up-front based on the anticipated timing of estimated design wins and customer orders, the loss or delay of any such orders could have a material adverse effect on our results of operations for any particular period. The variability in our period-to-period results will also be driven by likely period-to-period variations in product mix and by the seasonality experienced by some of the end markets into which we sell our products.  In the electric grid market, revenue recognition will be volatile due to the timing of deployment, delivery, and system testing.  As such, the timing of these events will significantly affect the comparison of period-to-period revenues.

 

We have been expanding our manufacturing capacity since inception, including the current expansion of our Livonia and Romulus, Michigan facilities, and we intend to further expand our manufacturing capacity by constructing more manufacturing lines primarily in Michigan.  We are currently in transition as we are expanding capacity in anticipation of increased demand for our prismatic cells as we expect transportation product revenues to increase in future periods.  We intend to further accelerate the expansion of our manufacturing capacity subject to actual and anticipated future demand for our products and the receipt of stimulus funds from the U.S. and state governments.  In the first quarter of 2010, we began making investments against plans to further expand the final assembly capacity of our Michigan facilities.  Based on new design wins and our demand estimates, we have approved plans to increase our capacity in Michigan, resulting in a worldwide capacity of over 760MWh.  We believe that increases in production capacity have had, and will continue to have, a significant effect on our financial condition and results of operations. We have made and continue to make significant up-front investments in our manufacturing capacity, which negatively impact earnings and cash balances, but we expect these investments will increase our revenue in the long term.

 

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Our research and development efforts are focused on developing new products and improving the performance of existing products. We fund our research and development initiatives both from internal and external sources. As part of our development strategy, certain customers fund or partially fund research and development efforts to design and customize batteries and battery systems for their specific application.

 

We have continued to experience significant losses since inception, as we have continued to invest significantly to support the anticipated growth in our business. In particular, we have invested in product development and sales and marketing in order to meet product requirements of our target markets and to secure design wins that may lead to strong revenue growth and general and administrative overhead to develop the infrastructure to support the business. We have also invested in the expansion of our manufacturing capacity to meet anticipated demand and our battery systems capabilities to provide battery systems solutions to our customers. As our business grows, the key factors to improving our financial performance will be revenue growth and revenue diversification into the transportation and electric grid services markets. Our revenue growth and revenue diversification will depend on our ability to secure design wins in the transportation and electric grid services markets. Higher revenue will also increase gross profit, as higher production volumes will provide for increased absorption of manufacturing overhead and will reduce, on a percentage basis, the costs associated with increasing our production capacity.

 

In December 2009, we executed an agreement with the DOE regarding the terms and conditions of the $249.1 million grant awarded under the DOE’s Battery Initiative to fund the construction of new lithium-ion battery manufacturing facilities in Michigan. Under the DOE Battery Initiative, we are required to spend up to one dollar of our funds for every incentive dollar received. We are also negotiating a loan under the Advanced Technology Vehicles Manufacturing Loan Program, or the ATVM Program, to support this manufacturing expansion. Based on the amount of our grant award under the DOE Battery Initiative and the guidelines associated with the ATVM Program, we believe we will be permitted to borrow up to $233 million under the ATVM Program. We expect we will be required to spend one dollar of our own funds for every four dollars we borrow under the ATVM Program. The timing and the amount of any loan we may receive under the ATVM Program are currently not known by us, and, once disclosed to us, are subject to change and negotiation with the federal government.

 

In October 2009, we entered into a High-Tech Credit agreement with the Michigan Economic Growth Authority, or MEGA, pursuant to which we are eligible for a 15-year tax credit, beginning with the 2011 fiscal year. This credit has an estimated value of up to $25.3 million, depending on the number of jobs we create in Michigan. In November 2009, we entered into a Cell Manufacturing Credit agreement with MEGA pursuant to which we are eligible for a credit equal to 50% of our capital investment expenses commencing January 2009, up to a maximum of $100 million over a four-year period related to the construction of our integrated battery cell manufacturing plant. The credit shall not exceed $25 million per year beginning with the tax year of 2012. We are required to create 300 jobs no later than December 31, 2016 in order to receive the refundable tax credit. The tax credit is subject to a repayment provision in the event we relocate 51% or more of the 300 jobs outside of the State of Michigan within three years after the last year we received the tax credit. Through June 30, 2010 we have incurred expenses of $60.4 million related to the construction of our facilities, and we are expecting to receive approximately $30.2 million in refundable tax credits related to these expenses.  We will record the receivable when it is probable that we will comply with the conditions of the grant and the receipt of the grant.  At that time, we would reduce the basis in the assets acquired under the grant by $26.7 million and record $3.5 million as reimbursement for expenses previously incurred.

 

Financial Operations Overview

 

Revenue

 

We derive revenue from product sales and providing services.

 

Product Revenue.  Product revenue is derived from the sale of our batteries and battery systems. For the six months ended June 30, 2009 and 2010, product revenue represented 85% and 75% of our total revenue, respectively.

 

A significant portion of our revenue is generated from a limited number of customers. Our two largest customers (BAE Systems and AES Energy Storage, LLC) accounted for approximately 37% and 43% of our total revenue during the six months ended June 30, 2009 and 2010, respectively, and we expect that most of our revenue will continue to come from a relatively small number of customers for the foreseeable future. As we increase our focus on the transportation and electric grid markets, BAE Systems and AES Energy Storage will continue to represent a significant portion of our 2010 revenue, and the loss of BAE Systems or AES Energy as a customer could have a material adverse effect on our short-term revenue. Black & Decker has historically represented a significant portion of our revenue; however, we expect revenue from Black & Decker to continue to decline in future periods as we increase our focus on the transportation and electric grid markets and Black & Decker engages additional suppliers for its battery requirements. We expect the transportation market to be the largest portion of our revenue in the near and long term.

 

Services Revenue.  Services revenue is primarily derived from contracts awarded by the U.S. federal government, other government agencies and commercial customers. These activities range from pure research, in which we investigate design techniques on new battery technologies at the request of a government agency or commercial customer, to custom development projects in which

 

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we are paid to enhance or modify an existing product or develop a new product to meet a customer’s specifications. We expect to continue to perform funded research and development work and to use the technology developed to advance our new product development efforts. We expect that revenue from services will vary period-to-period depending on the timing of cash payments received and, if applicable, the achievement of milestones. We expect that services revenue will decrease as a percentage of our total revenue due to the expected increase in product revenue over the long-term.

 

Deferred Revenue.  We record deferred revenue for product sales and services in several different circumstances. These circumstances include (i) the products have been delivered or services have been performed but other revenue recognition criteria have not been satisfied (ii) payments have been received in advance of products being delivered or services being performed and (iii) when all other revenue recognition criteria have been met, but we are not able to reasonably estimate the warranty expense. Deferred revenue includes customer deposits and up-front fees associated with service arrangements. Deferred revenue expected to be recognized as revenue more than one year subsequent to the balance sheet date is classified as long-term deferred revenue. Deferred revenue will vary depending on the timing and amount of cash receipts from customers and can vary significantly depending on specific contractual terms. As a result, deferred revenue is likely to fluctuate from period-to-period. During 2008, we received and recorded as deferred revenue a $25.0 million up-front payment in connection with our license agreement with Gillette. Under our exclusive license agreement with Gillette, Gillette paid us an up-front fee of $22.5 million and a support fee of $2.5 million. Gillette will also be required to pay us an additional license fee following the completion of a support period. In addition, the agreement requires Gillette to pay us royalty fees on net sales of products that include our technology. We have agreed with Gillette that if, during a certain period following execution of the license agreement, we enter into an agreement with a third party that materially restricts Gillette’s license rights under the license agreement, then we may be required to refund to Gillette all license and support fees paid to us by Gillette under the license agreement, plus, in certain cases, an additional amount to cover Gillette’s capital and other expenses paid and/or committed by Gillette in reliance upon its rights under the license agreement. Revenue recognition is expected to commence two years from the date of the agreement, upon successful transfer of technology know how to Gillette. The license and support fee will be recognized on a straight-line basis over the longer of the patent term or the expected customer relationship.

 

Factors that May Affect Comparability

 

Public Company Expenses. In September 2009, we completed an initial public offering of shares of our common stock.  As a result, we are subject to laws, regulations, and requirements that we were not required to comply with as a private company, including the Sarbanes-Oxley Act of 2002, other SEC regulations and the requirements of the NASDAQ Global Market.  Compliance with these requirements requires us to increase our general and administrative expenses in order to pay consultants, legal counsel and independent registered public accountants to assist us in, among other things, instituting and monitoring a more comprehensive compliance and board governance function, establishing and maintaining internal control over financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act of 2002 and preparing and distributing periodic public reports in compliance with our obligations under the federal securities laws.  In addition, as a public company, it is more expensive for us to obtain and maintain directors’ and officers’ liability insurance.

 

Cost of Revenue and Gross Profit

 

Cost of product revenue includes the cost of raw materials, labor and components that are required for the production of our products, as well as manufacturing overhead costs (including depreciation), inventory obsolescence charges, and warranty costs.  Raw material costs, which are our most significant cost item over the past two years, have historically been stable, but increasing energy costs for some of our materials are expected to increase this cost. This increase may be partially offset by process innovation, dual sourcing of materials and increased volume if we achieve better economies of scale. We incur costs associated with unabsorbed manufacturing expenses prior to a factory operating at normal operating capacity. We expect these unabsorbed manufacturing costs, which include certain personnel, rent, utilities, materials, testing and depreciation costs, to increase in absolute dollars and as a percentage of revenue in the near term.

 

Cost of services revenue includes the direct labor costs of engineering resources committed to funded service contracts, as well as third-party consulting, and associated direct material and equipment costs. Additionally, we include overhead expenses such as occupancy costs associated with the project resources, engineering tools and supplies and program management expense.

 

Our gross profit/(loss) is affected by a number of factors, including the mix of products sold, customer diversification, the mix between product revenue and services revenue, average selling prices, foreign exchange rates, our actual manufacturing costs and costs associated with increasing production capacity until full production is achieved. As we continue to grow and build out our manufacturing capacity, and as new product designs come into production, our gross profit will continue to fluctuate from period-to-period.

 

Operating Expenses

 

Operating expenses consist of research, development and engineering, sales and marketing, general and administrative and production start-up expenses. Personnel-related expenses comprise the most significant component of these expenses. We expect to

 

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hire a significant number of new employees in order to support our anticipated growth. In any particular period, the timing of additional hires could materially affect our operating expenses, both in absolute dollars and as a percentage of revenue.

 

Research, Development and Engineering Expenses.  Research, development and engineering expenses consist primarily of expenses for personnel engaged in the development of new products and the enhancement of existing products, as well as lab materials, quality assurance activities and facilities costs and other related overhead.  These expenses also include pre-production costs related to long-term supply agreements unless reimbursement from the customer is contractually guaranteed.  Pre-production costs consist of engineering, design and development costs for products sold under long-term supply arrangements.  We expense all of our research, development and engineering costs as they are incurred. In the near term, we expect research, development and engineering expenses to increase in large part due to personnel-related expenses as we seek to hire additional employees, as well as contract-related expenses as we continue to invest in the development of our products.  Research, development and engineering expense is reported net of any funding received under contracts with governmental agencies and commercial customers that are considered to be cost sharing arrangements with no contractually committed deliverable. Accordingly, we expect that our research, development and engineering expenses will continue to increase in absolute dollars but decrease as a percentage of revenue in the long term.

 

Sales and Marketing Expenses.  Sales and marketing expenses consist primarily of personnel-related expenses, travel and other out-of-pocket expenses for marketing programs, such as trade shows, industry conferences, marketing materials and corporate communications, and facilities costs and other related overhead. We intend to hire additional sales personnel, initiate additional marketing programs and build additional relationships with resellers, systems integrators and strategic partners on a global basis. Accordingly, we expect that our sales and marketing expenses will continue to increase in absolute dollars but decrease as a percentage of revenue in the long term.

 

General and Administrative Expenses.  General and administrative expenses consist primarily of personnel-related expenses related to our executive, legal, finance, human resource and information technology functions, as well as fees for professional services and allocated facility overhead expenses. Professional services consist principally of external legal, accounting, tax, audit and other consulting services. We expect general and administrative expenses to increase as we incur additional costs related to operating as a publicly-traded company, including increased audit and legal fees, costs of compliance with securities, corporate governance and other regulations, investor relations expenses and higher insurance premiums, particularly those related to director and officer insurance. In addition, we expect to incur additional costs as we hire personnel and enhance our infrastructure to support the anticipated growth of our business. Accordingly, we expect that our general and administrative expenses will continue to increase in absolute dollars but decrease as a percentage of revenue in the long term.

 

Production Start-up Expenses.  Production start-up expenses consist of salaries and personnel-related costs, site selection costs, including legal and regulatory costs, rent and the cost of operating a production line before it has been qualified for full production, including the cost of raw materials run through the production line during the qualification phase.  We expect to incur additional production start-up expenses related to our facilities in Livonia and Romulus, Michigan in the near term. The Livonia facility is expected to begin qualification for production in the second half of 2010. The Romulus facility is expected to begin qualification for production in the first half of 2011.

 

Other Income (Expense), Net.  Other income (expense), net consists primarily of interest income on cash balances, interest expense on borrowings, change in fair value of preferred stock warrants and foreign currency-related gains and losses. We have historically invested our cash in money market investments. Our interest income will vary each reporting period depending on our average cash balances during the period and the current level of interest rates. Similarly, our foreign currency-related gains and losses will also vary depending upon movements in underlying exchange rates. Upon the closing of our IPO, all preferred stock warrants were converted to common stock warrants and we do not expect any gains or losses related to the change in the fair value of preferred stock warrants going forward.

 

Provision for Income Taxes.  Through June 30, 2010, we incurred net losses since inception and have not recorded provisions for U.S. federal income taxes since the tax benefits of our net losses have been offset by valuation allowances.

 

We have recorded a tax provision for foreign taxes associated with our foreign subsidiaries and state income taxes where our net operating loss deductions are limited by statutes.

 

Watt Hours Operating Metric

 

We measure our product shipments in watt hours, or Wh, which refers to the aggregate amount of energy that could be delivered in a single complete discharge by a battery. We calculate Wh for each of our battery models by multiplying the battery’s amp hour, or Ah, storage capacity by the battery’s voltage rating. For example, our 26650 battery is a 2.3 Ah battery that operates at 3.3 V, resulting in a 7.6 Wh rating. We determine a battery’s Ah storage capacity at a specific discharge rate and a specific depth of discharge. We do this by charging the battery to its top voltage and by discharging it to zero capacity (2 volt charge level). The Wh metric allows us and our investors to measure our manufacturing capacity and shipments, regardless of battery voltages and Ah specifications, utilizing a

 

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uniform and consistent metric.

 

Certain Trends and Uncertainties

 

The following represents a summary of certain trends and uncertainties, which could have a significant impact on our financial condition and results of operations. This summary is not intended to be a complete list of potential trends and uncertainties that could impact our business in the long or short term. The summary, however, should be considered along with the factors identified in the section titled “Risk Factors” set forth in Part II, Item 1A of this Quarterly Report on Form 10-Q, and elsewhere in this report.

 

·                We believe that our future revenues depend on our ability to develop, manufacture and market products that improve upon existing battery technology and gain market acceptance. If our battery technology is not adopted by our customers, or if our battery technology does not meet industry requirements for power and energy storage capacity in an efficient and safe design, our batteries will not gain market acceptance.

 

·                We build our manufacturing capacity based on our projection of future development and supply agreement wins. Increases in production capacity, have had, and will continue to have, an effect on our financial condition and results of operations. Our business revenues and profits will depend upon our ability to enter into and complete development and supply agreements, successfully complete these capacity expansion projects, achieve competitive manufacturing yields and drive volume sales consistent with our demand expectations.

 

·                Our revenues are expected to continue to come from a relatively small number of customers for the foreseeable future. The loss of one of our two most significant customers or several of our smaller customers, could materially harm our business.

 

Critical Accounting Policies

 

Our financial statements are prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of our financial statements and related disclosures requires us to make estimates, assumptions and judgments that affect the reported amount of assets, liabilities, revenue, costs and expenses, and related disclosures. We base our estimates and assumptions on historical experience and other factors that we believe to be reasonable under the circumstances. We evaluate our estimates and assumptions on an ongoing basis. Our actual results may differ from these estimates under different assumptions and conditions. Our most critical accounting policies are listed below.

 

·        Revenue recognition;

 

·        Product warranty obligations;

 

·        Inventory;

 

·        Impairment of goodwill and acquired intangible assets;

 

·        Impairment of long-lived assets;

 

·        Government grants;

 

·        Stock-based compensation;

 

·        Income taxes;

 

·        Investments in non-public companies.

 

We updated our critical accounting policies during the three months ended June 30, 2010 as follows:

 

Grants to Non-Employees.  Accounting for grants to non-employees is no longer considered a critical accounting policy as non-employee stock-based compensation expense does not currently have a material impact on our condensed consolidated financial statements.

 

Investments in Non-Public Companies.   Our investments held in non-public companies expose us to equity price risk. As of June 30, 2010, non-publicly traded investments of $20.5 million are accounted for using the cost method.  Strategic investments in third parties are subject to risk of changes in market value, which if determined to be other-than-temporary, could result in realized impairment losses, which could be material. We generally do not attempt to reduce or eliminate our market exposure in cost or equity

 

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method investments. We regularly monitor these non-publicly traded investments for impairment and record reductions in the carrying values when necessary. Circumstances that indicate an other-than-temporary decline include valuation ascribed to the issuing company in subsequent financing rounds, decreases in quoted market price and declines in operations of the issuer. There can be no assurance that cost or equity method investments will not face risks of loss.

 

During the three and six months ended June 30, 2010, there were no other significant changes in our critical accounting policies or estimates. See our Annual Report on Form 10-K for the year ended December 31, 2009, filed with the SEC on March 15, 2010, for additional information about our critical accounting policies, as well as a description of our other significant accounting policies.

 

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Results of Consolidated Operations

 

The following table sets forth selected condensed consolidated statements of operations data for each of the periods (in thousands):

 

 

 

Three Months Ended

 

Six Months Ended

 

 

 

June 30,

 

June 30,

 

 

 

2009

 

2010

 

2009

 

2010

 

 

 

 

 

 

 

 

 

 

 

Revenue:

 

 

 

 

 

 

 

 

 

Product

 

$

16,517

 

$

15,558

 

$

36,638

 

$

35,332

 

Services

 

3,185

 

7,050

 

6,284

 

11,744

 

 

 

 

 

 

 

 

 

 

 

Total revenue

 

19,702

 

22,608

 

42,922

 

47,076

 

 

 

 

 

 

 

 

 

 

 

Cost of revenue:

 

 

 

 

 

 

 

 

 

Product

 

19,616

 

18,977

 

39,186

 

41,331

 

Services

 

2,661

 

6,580

 

4,505

 

10,735

 

 

 

 

 

 

 

 

 

 

 

Total cost of revenue

 

22,277

 

25,557

 

43,691

 

52,066

 

 

 

 

 

 

 

 

 

 

 

Gross loss

 

(2,575

)

(2,949

)

(769

)

(4,990

)

 

 

 

 

 

 

 

 

 

 

Operating expenses:

 

 

 

 

 

 

 

 

 

Research, development and engineering

 

11,587

 

13,832

 

22,814

 

27,948

 

Sales and marketing

 

2,245

 

3,366

 

4,227

 

6,166

 

General and administrative

 

5,990

 

8,804

 

12,273

 

17,044

 

Production start-up

 

179

 

3,606

 

179

 

5,417

 

 

 

 

 

 

 

 

 

 

 

Total operating expenses

 

20,001

 

29,608

 

39,493

 

56,575

 

 

 

 

 

 

 

 

 

 

 

Operating loss

 

(22,576

)

(32,557

)

(40,262

)

(61,565

)

 

 

 

 

 

 

 

 

 

 

Other income (expense):

 

 

 

 

 

 

 

 

 

Interest expense, net

 

(292

)

(372

)

(510

)

(590

)

Gain (loss) on foreign exchange

 

673

 

(1,226

)

(115

)

(981

)

Unrealized loss on preferred stock warrant liability

 

(22

)

 

(70

)

 

 

 

 

 

 

 

 

 

 

 

Other income (expense), net

 

359

 

(1,598

)

(695

)

(1,571

)

 

 

 

 

 

 

 

 

 

 

Loss from operations, before tax

 

(22,217

)

(34,155

)

(40,957

)

(63,136

)

 

 

 

 

 

 

 

 

 

 

Provision for income taxes

 

123

 

132

 

267

 

253

 

 

 

 

 

 

 

 

 

 

 

Net loss

 

(22,340

)

(34,287

)

(41,224

)

(63,389

)

Less: Net loss attributable to the noncontrolling interest

 

427

 

69

 

574

 

146

 

 

 

 

 

 

 

 

 

 

 

Net loss attributable to A123 Systems, Inc.

 

(21,913

)

(34,218

)

(40,650

)

(63,243

)

 

 

 

 

 

 

 

 

 

 

Accretion to preferred stock

 

(17

)

 

(28

)

 

 

 

 

 

 

 

 

 

 

 

Net loss attributable A123 Systems, Inc. common stockholders

 

$

(21,930

)

$

(34,218

)

$

(40,678

)

$

(63,243

)

 

 

 

 

 

 

 

 

 

 

Other Operating Data:

 

 

 

 

 

 

 

 

 

Shipments (in watt hours, or Wh) (in thousands)

 

17,028

 

14,563

 

27,663

 

30,815

 

 

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Three Months Ended June 30, 2009 and 2010

 

Revenue

 

 

 

Three Months Ended June 30,

 

 

 

 

 

 

 

2009

 

2010

 

$ Change

 

% Change

 

 

 

(Dollars in thousands)

 

Revenue

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Product

 

 

 

 

 

 

 

 

 

Transportation

 

$

12,594

 

$

10,457

 

$

(2,137

)

-17.0

%

Commercial

 

3,923

 

5,085

 

1,162

 

29.6

%

Electric grid

 

 

16

 

16

 

100.0

%

 

 

 

 

 

 

 

 

 

 

Total product

 

16,517

 

15,558

 

(959

)

-5.8

%

Services

 

3,185

 

7,050

 

3,865

 

121.4

%

 

 

 

 

 

 

 

 

 

 

Total revenue

 

$

19,702

 

$

22,608

 

$

2,906

 

14.7

%

 

Product Revenue. The decrease in sales to customers in the transportation industry of $2.1 million for the three months ended June 30, 2010 compared to the three months ended June 30, 2009 was primarily due to a decrease in sales to BAE Systems of $2.4 million and a decrease in sales to Mercedes-Benz HighPerformanceEngines of $2.2 million due to the cancellation of the Mercedes-Benz program in 2009.  These decreases were partially offset by an increase of $2.5 million, primarily due to sales to new transportation customers.  Sales to customers in the commercial industry increased by $1.2 million.  In the commercial industry sales to Black & Decker and its affiliates decreased by $0.4 million and sales generated by our Enerland subsidiary decreased by $0.4 million.  Sales to other customers in the commercial industry increased by $2.0 million.

 

Services Revenue. The increase in services revenue was related to the increase in revenue from government agency research contracts, which was primarily due to a new project award granted.

 

Cost of Revenue and Gross Profit (Loss)

 

 

 

Three Months Ended June 30,

 

 

 

 

 

 

 

2009

 

2010

 

$ Change

 

% Change

 

 

 

(Dollars in thousands)

 

Cost of revenue

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Product

 

$

19,616

 

$

18,977

 

$

(639

)

-3.3

%

Services

 

2,661

 

6,580

 

3,919

 

147.3

%

 

 

 

 

 

 

 

 

 

 

Total cost of revenue

 

$

22,277

 

$

25,557

 

$

3,280

 

14.7

%

 

 

 

 

 

 

 

 

 

 

Gross profit (loss)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Product

 

$

(3,099

)

$

(3,419

)

$

(320

)

10.3

%

Services

 

524

 

470

 

(54

)

-10.3

%

 

 

 

 

 

 

 

 

 

 

Total gross profit (loss)