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Table of Contents

 

 

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

(Mark One)

 

 

 

x

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

 

 

 

For the quarterly period ended March 31, 2011

 

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.
200 West Street
Waltham, Massachusetts

 

02451

(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 x  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 x

 

Accelerated filer o

 

 

 

Non-accelerated filer o

 

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 May 5, 2011, there were 125,960,259 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 March 31, 2011

 

INDEX

 

 

PAGE

 

NUMBER

PART I. FINANCIAL INFORMATION

1

ITEM 1: Financial Statements

1

Condensed Consolidated Balance Sheets

1

Condensed Consolidated Statements of Operations

2

Condensed Consolidated Statements of Stockholders’ 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

27

ITEM 4: Controls and Procedures

27

 

 

PART II. OTHER INFORMATION

28

ITEM 1: Legal Proceedings

28

ITEM 1A: Risk Factors

29

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

50

ITEM 6: Exhibits

50

 

 

Signatures

51

 

 

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

 

EX-101.INS - XBRL Instance Document

 

EX-101.SCH - XBRL Taxonomy Extension Schema Document

 

EX-101.CAL - XBRL Taxonomy Extension Calculation Linkbase Document

 

EX-101.LAB - XBRL Taxonomy Extension Label Linkbase Document

 

EX-101.PRE - XBRL Taxonomy Extension Presentation Linkbase Document

 

EX-101.DEF - XTRL Taxonomy Extension Definition

 

 



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)

 

 

 

December 31,

 

March 31,

 

 

 

2010

 

2011

 

 

 

 

 

 

 

ASSETS

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

216,841

 

$

136,805

 

Restricted cash and cash equivalents

 

9,367

 

10,086

 

Accounts receivable, net

 

28,106

 

26,383

 

Inventory

 

48,787

 

63,892

 

Prepaid expenses and other current assets

 

8,006

 

10,589

 

 

 

 

 

 

 

Total current assets

 

311,107

 

247,755

 

 

 

 

 

 

 

Property, plant and equipment, net

 

143,998

 

171,270

 

Goodwill

 

9,581

 

9,581

 

Intangible assets, net

 

413

 

361

 

Long-term grant receivable

 

75,790

 

79,714

 

Deposits and other assets

 

11,768

 

10,703

 

Restricted cash and cash equivalents, net of current portion

 

1,993

 

2,001

 

Investments

 

21,508

 

22,684

 

 

 

 

 

 

 

Total assets

 

$

576,158

 

$

544,069

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Revolving credit lines

 

$

8,000

 

$

8,000

 

Current portion of long-term debt

 

5,379

 

5,088

 

Current portion of capital lease obligations

 

1,571

 

1,849

 

Accounts payable

 

43,523

 

69,644

 

Accrued expenses

 

48,179

 

38,860

 

Other current liabilities

 

1,322

 

2,191

 

Deferred revenue

 

11,109

 

11,156

 

Deferred rent

 

132

 

194

 

 

 

 

 

 

 

Total current liabilities

 

119,215

 

136,982

 

 

 

 

 

 

 

Long-term debt, net of current portion

 

4,603

 

3,600

 

Capital lease obligations, net of current portion

 

18,655

 

18,513

 

Deferred revenue, net of current portion

 

29,836

 

29,639

 

Deferred rent, net of current portion

 

1,452

 

1,338

 

Other long-term liabilities

 

3,865

 

4,676

 

 

 

 

 

 

 

Total liabilities

 

177,626

 

194,748

 

 

 

 

 

 

 

Commitments and contingencies (Note 6)

 

 

 

 

 

 

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

Preferred stock, $0.001 par value—5,000,000 shares authorized; 0 shares issued and outstanding at December 31, 2010 and March 31, 2011

 

 

 

Common stock, $0.001 par value—250,000,000 shares authorized; 105,194,073 and 105,755,929 shares issued and outstanding at December 31, 2010 and March 31, 2011, respectively

 

105

 

106

 

Additional paid-in capital

 

790,256

 

795,425

 

Accumulated deficit

 

(391,228

)

(444,874

)

Accumulated other comprehensive loss

 

(935

)

(1,336

)

 

 

 

 

 

 

Total A123 Systems, Inc. stockholders’ equity

 

398,198

 

349,321

 

Noncontrolling interest

 

334

 

 

 

 

 

 

 

 

Total stockholders’ equity

 

398,532

 

349,321

 

 

 

 

 

 

 

Total liabilities and stockholders’ equity

 

$

576,158

 

$

544,069

 

 

See notes to condensed consolidated financial statements.

 

1



Table of Contents

 

A123 Systems, Inc.
Condensed Consolidated Statements of Operations

(in thousands, except per share data)

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2010

 

2011

 

 

 

 

 

 

 

Revenue:

 

 

 

 

 

Product

 

$

19,774

 

$

15,458

 

Services

 

4,694

 

2,639

 

 

 

 

 

 

 

Total revenue

 

24,468

 

18,097

 

 

 

 

 

 

 

Cost of revenue:

 

 

 

 

 

Product

 

22,354

 

31,096

 

Services

 

4,155

 

2,478

 

 

 

 

 

 

 

Total cost of revenue

 

26,509

 

33,574

 

 

 

 

 

 

 

Gross loss

 

(2,041

)

(15,477

)

 

 

 

 

 

 

Operating expenses:

 

 

 

 

 

Research, development and engineering

 

14,116

 

20,359

 

Sales and marketing

 

2,800

 

4,082

 

General and administrative

 

8,240

 

9,111

 

Production start-up

 

1,811

 

4,621

 

 

 

 

 

 

 

Total operating expenses

 

26,967

 

38,173

 

 

 

 

 

 

 

Operating loss

 

(29,008

)

(53,650

)

 

 

 

 

 

 

Other income (expense):

 

 

 

 

 

Interest, net

 

(218

)

(641

)

Gain on foreign exchange

 

245

 

2

 

Other income, net

 

 

1,026

 

 

 

 

 

 

 

Total other income, net

 

27

 

387

 

 

 

 

 

 

 

Loss from operations, before tax

 

(28,981

)

(53,263

)

 

 

 

 

 

 

Provision for income taxes

 

121

 

410

 

 

 

 

 

 

 

Net loss

 

(29,102

)

(53,673

)

 

 

 

 

 

 

Less: Net loss attributable to the noncontrolling interest

 

77

 

27

 

 

 

 

 

 

 

Net loss attributable to A123 Systems, Inc.

 

$

(29,025

)

$

(53,646

)

 

 

 

 

 

 

Net loss per share attributable to A123 Systems, Inc. - basic and diluted:

 

$

(0.28

)

$

(0.51

)

 

 

 

 

 

 

Weighted average number of common shares outstanding - basic and diluted

 

103,312

 

105,515

 

 

See notes to condensed consolidated financial statements.

 

2



Table of Contents

 

A123 Systems, Inc.

Condensed Consolidated Statements of Stockholders’ Equity

(in thousands, except per share data)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Common Stock, $0.001
Par Value

 

Additional
Paid-in

 

Accumulated

 

Accumulated
Other
Comprehensive

 

Total
Stockholders’

 

Noncontrolling

 

Comprehensive

 

 

 

Shares

 

Amount

 

Capital

 

Deficit

 

Loss

 

Equity

 

Interest

 

Loss

 

BALANCE - January 1, 2010

 

$

102,606

 

$

103

 

$

767,694

 

$

(238,668

)

$

(909

)

$

528,220

 

$

110

 

 

 

Stock-based compensation

 

 

 

2,487

 

 

 

2,487

 

 

 

 

Issuance of common stock

 

1,218

 

1

 

5,907

 

 

 

5,908

 

 

 

 

Comprehensive loss:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net loss

 

 

 

 

(29,025

)

 

(29,025

)

(77

)

$

(29,102

)

Foreign currency translation adjustment

 

 

 

 

 

(148

)

(148

)

 

(148

)

Total comprehensive loss

 

 

 

 

 

 

 

 

$

(29,250

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

BALANCE - March 31, 2010

 

103,824

 

$

104

 

$

776,088

 

$

(267,693

)

$

(1,057

)

$

507,442

 

$

33

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

BALANCE - January 1, 2011

 

$

105,194

 

$

105

 

$

790,256

 

$

(391,228

)

$

(935

)

$

398,198

 

$

334

 

 

 

Stock-based compensation

 

 

 

3,299

 

 

 

3,299

 

 

 

 

Exercise of stock options

 

562

 

1

 

1,870

 

 

 

1,871

 

 

 

 

Purchase of subsidiary shares by noncontrolling interest holder

 

 

 

 

 

 

 

600

 

 

 

Deconsolidation of subsidiary

 

 

 

 

 

 

 

(907

)

 

 

Comprehensive loss:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net loss

 

 

 

 

(53,646

)

 

(53,646

)

(27

)

$

(53,673

)

Foreign currency translation adjustment

 

 

 

 

 

(401

)

(401

)

 

(401

)

Total comprehensive loss

 

 

 

 

 

 

 

 

$

(54,074

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

BALANCE - March 31, 2011

 

105,756

 

$

106

 

$

795,425

 

$

(444,874

)

$

(1,336

)

$

349,321

 

$

 

 

 

 

See notes to condensed consolidated financial statements.

 

3



Table of Contents

 

A123 Systems, Inc.

Condensed Consolidated Statements of Cash Flows

(in thousands)

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2010

 

2011

 

 

 

 

 

 

 

Cash flows from operating activities:

 

 

 

 

 

Net loss

 

$

(29,102

)

(53,673

)

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

 

 

 

 

 

Depreciation and amortization

 

3,749

 

4,923

 

Noncash rent

 

371

 

(52

)

Noncash foreign exchange gain on intercompany loan

 

(335

)

(354

)

Noncash loss on equity investments

 

 

220

 

Impairment of long-lived and intangible assets

 

530

 

 

Gain on asset transfer and subsequent deconsolidation of Variable Interest Entity

 

 

(1,255

)

Loss on disposal of property and equipment

 

 

28

 

Amortization of debt issuance costs and noncash interest expense

 

 

437

 

Stock-based compensation

 

2,487

 

3,299

 

Changes in current assets and liabilities, excluding the effect of deconsolidation of Variable Interest Entity:

 

 

 

 

 

Accounts receivable

 

178

 

1,328

 

Inventory

 

3,684

 

(15,285

)

Prepaid expenses and other assets

 

42

 

(4,720

)

Accounts payable

 

(1,987

)

18,744

 

Accrued expenses

 

(417

)

(3,123

)

Deferred revenue

 

(4,109

)

301

 

Other liabilities

 

944

 

704

 

Net cash used in operating activities

 

(23,965

)

(48,478

)

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Increase in restricted cash

 

(336

)

(724

)

Purchases of and deposits on property, plant and equipment

 

(13,885

)

(42,743

)

Proceeds from government grant

 

5,693

 

12,154

 

Purchases of investments

 

(13,000

)

(1,891

)

Net cash used in investing activities

 

(21,528

)

(33,204

)

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

Deferred offering costs

 

 

(113

)

Proceeds from government grant

 

1,250

 

900

 

Proceeds from exercise of stock options

 

503

 

1,876

 

Payments on long-term debt

 

(2,691

)

(1,303

)

Payments on capital lease obligations

 

(154

)

(301

)

Contributions from noncontrolling interest

 

 

 

600

 

Net cash (used in) provided by financing activities

 

(1,092

)

1,659

 

 

 

 

 

 

 

Effect of foreign exchange rates on cash and cash equivalents

 

(20

)

(13

)

 

 

 

 

 

 

Net decrease in cash and cash equivalents

 

(46,605

)

(80,036

)

Cash and cash equivalents at beginning of period

 

457,122

 

216,841

 

 

 

 

 

 

 

Cash and cash equivalents at end of period

 

$

410,517

 

$

136,805

 

 

 

 

 

 

 

Supplemental cash flow information - cash paid for interest

 

$

253

 

$

224

 

 

 

 

 

 

 

Noncash investing and financing activities:

 

 

 

 

 

Purchase of equipment under capital leases

 

$

560

 

$

 

Equipment purchases included in accounts payable and accrued expenses

 

$

7,556

 

$

54,505

 

Deferred offering costs included in accounts payable and accrued expenses

 

$

 

$

1,134

 

Issuance of common stock for investment

 

$

5,553

 

$

 

Fulfillment of government grants with advance proceeds

 

$

 

$

226

 

 

See notes to condensed consolidated financial statements.

 

4



Table of Contents

 

A123 Systems, Inc.

Notes to Condensed Consolidated Financial Statements

 

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 Waltham, Massachusetts. The Company designs, develops, manufactures and sells advanced rechargeable lithium-ion batteries and battery systems and provides research and development services to government agencies and commercial customers.

 

Management Plan Note —In April 2011, the Company raised a total of $253.9 million of net proceeds from the issuance of convertible subordinated notes and shares of the Company’s common stock to fund the Company’s growth and expansion plans, including funding anticipated future losses, purchase commitments and capital expenditures.  See Note 10 for additional details.

 

Basis of Presentation —The accompanying condensed consolidated financial statements and the related disclosures as of March 31, 2011 and for the three months ended March 31, 2010 and 2011 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 11, 2011.  The December 31, 2010 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 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 March 31, 2011 and results of its operations for the three months ended March 31, 2010 and 2011, and its cash flows for the three months ended March 31, 2010 and 2011. The interim results for the three months ended March 31, 2011 are not necessarily indicative of the results that may be expected for the year ending December 31, 2011.

 

Principles of Consolidation—The accompanying condensed consolidated financial statements include the accounts of the Company and its subsidiaries. All intercompany balances and transactions have been eliminated in consolidation.  In February 2011, the Company entered into an agreement to transfer certain of its assets held by its wholly owned Korean subsidiary to its joint venture with a quasi governmental entity in the Peoples’ Republic of China.  For the three months ended March 31, 2010 and as of December 31, 2010, the joint venture was consolidated as a variable-interest entity, but did not have a material impact on the Company’s consolidated financial operations and did not represent a material portion of the Company’s total consolidated assets.  Subsequent to the transfer in February 2011, the Company no longer is significantly involved in the operations of the joint venture and therefore no longer consolidates the joint venture; however, the Company retains a minority ownership stake in the entity which is accounted for as a cost method investment as of March 31, 2011.  The asset transfer and subsequent deconsolidation of the joint venture resulted in a $1.2 million gain recognized in other income for the three months ended March 31, 2011.

 

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.

 

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 long-term grant receivable, depending on when the amounts are expected to be received from the government agency.  The Company does not discount long-term grant receivables.  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.

 

5



Table of Contents

 

A123 Systems, Inc.

Notes to Condensed Consolidated Financial Statements

 

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.

 

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.

 

The Company’s multiple element arrangements typically include prototypes, production units and/or engineering and design work. Generally, provided all other revenue recognition criteria have been met, the Company recognizes revenue from prototype and production units upon shipment to the customer and revenue from engineering and design work upon the completion of milestones based on the proportional performance method or based on the completed contract method if the Company does not have the ability to reasonably estimate contract costs or progress toward completion of the contract. The Company’s customers may generally cancel orders at any time prior to product shipment.

 

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, if the item is sold by another vendor, or if the item 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.

 

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 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.

 

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Table of Contents

 

A123 Systems, Inc.

Notes to Condensed Consolidated Financial Statements

 

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 eight 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. The Company’s warranty liability is based on projected product failure rates and estimated costs of fulfilling warranty claims. Projections are based on the Company’s actual warranty experience and other known factors. The Company monitors its warranty liability and adjusts the amounts as necessary. 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.

 

In instances where the Company has deferred revenue under various arrangements, the Company also defers the associated costs of revenue until such time that it is able to recognize the revenue. Deferred costs of revenue are classified in the condensed consolidated balance sheets in inventory as all deferred costs are expected to be recognized as cost of revenue in the condensed consolidated statement of operations within one year. As of December 31, 2010 and March 31, 2011, the Company had deferred cost of revenue, primarily related to finished goods inventory, of $1.3 million and $1.7 million, respectively.

 

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 if the Company is able to reasonably estimate the contract cost and progress toward completion of the contract. 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 if reasonably dependable estimates of the revenues and costs applicable to various stages of a contract can be made. Estimates made 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. 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 including sub-contractual and equipment costs where the Company is the principal in the arrangement. Under the proportional performance method, there are no costs that are deferred and amortized over the contract term.  If the Company does not have the ability to reasonably estimate contract costs or progress toward completion of the contract, the Company defers the related revenue and costs and recognizes the revenues and costs based on the completed contract method.

 

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.

 

Production start-up— Production start-up expenses consist of manufacturing 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 production, including the cost of raw materials run through the production line during the qualification phase. During the three months ended March 31, 2010 and 2011, the Company incurred production start-up expenses related to its facility in Romulus, Michigan.  During the three months ended March 31, 2010, the Company also incurred production start-up expenses related to its facility in Livonia, Michigan. The Livonia facility began qualification for production in the third quarter of 2010 and the first production line was qualified in December 2010. Since qualification, expenses related to the first production line in the Livonia facility are no longer included in production start-up expenses. The Romulus facility began qualification for production in the first quarter of 2011 and the Company expects to continue to incur production start-up expenses related to the Romulus facility and costs to qualify the second production line in Livonia in the near term. A portion of production start-up expenses was offset primarily by government grant

 

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Table of Contents

 

A123 Systems, Inc.

Notes to Condensed Consolidated Financial Statements

 

funding. The following table presents production start-up expenditures included in the Company’s condensed consolidated statements of operations (in thousands):

 

 

 

Three Months Ended March 31,

 

 

 

2010

 

2011

 

 

 

 

 

 

 

Aggregated production start-up expenditures

 

$

2,105

 

$

6,997

 

Production start-up reimbursements

 

(294

)

(2,376

)

 

 

 

 

 

 

Production start-up expenses

 

$

1,811

 

$

4,621

 

 

Fair Value of Financial Instruments—The carrying amount of cash, cash equivalents, restricted cash and cash equivalents, 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 and the Company’s capital lease obligations accrue interest at rates which approximate prevailing market rates for instruments with similar characteristics and, accordingly, the carrying values for these instruments approximate fair value.  Investments are accounted for using the cost or equity method.

 

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, 2010 or March 31, 2011.

 

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

 

 

 

 

 

As of December 31, 2010

 

 

 

Fair Value at
December 31, 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

 

$

174,603

 

$

174,603

 

$

 

$

 

U.S. Treasury and government agency securities

 

17,333

 

 

17,333

 

 

 

 

 

 

 

 

As of March 31, 2011

 

 

 

Fair Value at
March 31, 2011

 

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

 

Significant Other
Observable
Inputs
(Level 2)

 

Significant
Unobservable
Inputs
(Level 3)

 

 

 

 

 

 

 

 

 

 

 

Assets:

 

 

 

 

 

 

 

 

 

Money market funds

 

$

110,614

 

$

110,614

 

$

 

$

 

U.S. Treasury and government agency securities

 

8,334

 

 

8,334

 

 

 

The Company’s holds money market fund investments that are classified as cash equivalents and are measured at fair value on a recurring basis based on quoted prices in active markets for identical assets. The Company holds investments in U.S. Treasury and government agency securities that are classified as either cash equivalents or restricted cash equivalents and are measured at fair value based on inputs (other than quoted prices) that are observable for securities, either directly or indirectly.

 

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

 

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Table of Contents

 

A123 Systems, Inc.

Notes to Condensed Consolidated Financial Statements

 

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.

 

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 fiscal year. Diluted net loss per share is computed by dividing net loss by the weighted-average number of dilutive common shares outstanding during the fiscal year. 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):

 

 

 

March 31,

 

 

 

2010

 

2011

 

 

 

 

 

 

 

Warrants to purchase common stock

 

45

 

45

 

Options to purchase common stock

 

9,465

 

10,258

 

Unvested restricted stock units

 

 

183

 

 

 

 

 

 

 

 

 

9,510

 

10,486

 

 

New Accounting Pronouncements— In April 2010, an update was issued 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. Consideration that is contingent on achievement of a milestone in its entirety may be recognized as revenue in the period in which the milestone is achieved only if the milestone is judged to meet certain criteria to be considered substantive. Milestones should be considered substantive in their entirety and may not be bifurcated. An arrangement may contain both substantive and non-substantive milestones, and each milestone should be evaluated individually to determine if it is substantive. This update is effective prospectively for milestones achieved in fiscal years beginning on or after June 15, 2010. The adoption of this update did not have a material impact on the Company’s financial position, results of operations or cash flows.

 

2.  Government Grants

 

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. There are no substantive 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 and $6.0 million of this grant in July 2010, with additional payments to be made based on the achievement of certain milestones in the facility development. Through March 31, 2011, the Company has used $8.3 million of these funds, of which $7.9 million and $0.4 million was recorded as an offset to property, plant and equipment and operating expenses, respectively.  For both the three months ended March 31, 2010 and 2011, $0.1 million was recorded as an offset to operating expenses in the condensed consolidated statements of operations.  As of December 31, 2010 and March 31, 2011, $0.8 million and $0.7 million of these funds are recorded in short-term restricted cash and other current liabilities on the condensed consolidated balance sheets, respectively.

 

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, based on qualified wages and benefits multiplied by the Michigan personal income tax rate beginning with payments made for the 2011 fiscal year. The tax credit has an estimated value of up to $25.3 million, depending on the number of jobs created in Michigan. 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

 

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Table of Contents

 

A123 Systems, Inc.

Notes to Condensed Consolidated Financial Statements

 

the state of Michigan on or before December 31, 2026.  For the three months ended March 31, 2011, $0.3 million was recorded as a receivable in long-term grant receivable with an offsetting balance in other long-term liabilities in the condensed consolidated balance sheet at March 31, 2011.  The balance will be recognized in the condensed consolidated statements of operations over the term that the Company is required to maintain the required number of jobs in Michigan.

 

Cell Manufacturing Credit—The Cell Manufacturing Credit agreement authorizes a tax credit or cash 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 with costs incurred from January 1, 2009, up to a maximum of $100.0 million over a four year period. The tax 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 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 March 31, 2011, the Company has incurred $158.8 million in qualified 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 begin receiving $79.4 million in proceeds related to these expenses. As of December 31, 2010 and March 31, 2011, the Company has recorded undiscounted receivables of $75.8 million and $79.4 million, as it is reasonably assured that the Company will comply with the conditions of the tax credit and will receive the proceeds. Upon recording the receivables, the Company reduced the basis in the fixed assets acquired in accordance with the tax credit and this will be recognized in the condensed consolidated statements of operations over their estimated useful lives of the depreciable asset as reduced depreciation expense.

 

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. There are no substantive conditions attached to this award that will require repayment of amounts received if those conditions are not met. Through March 31, 2011, the Company has incurred $201.2 million in qualified expenses, of which 50%, or $100.6 million, are allowable costs for reimbursement.   For the three months ended March 31, 2010, the Company incurred allowable costs of $3.1 million, of which $2.5 million and $0.6 million was recorded as an offset to property, plant and equipment and operating expenses, respectively.  For the three months ended March 31, 2011, the Company incurred allowable costs of $11.6 million, of which $7.7 million and $3.9 million was recorded as an offset to property, plant and equipment and operating expenses, respectively.  As of December 31, 2010 and March 31, 2011, the Company recorded $2.1 million and $3.1 million, respectively, as receivables in prepaid expenses and other current assets in the condensed consolidated balance sheets.

 

3.  Inventory

 

Inventory consists of the following (in thousands):

 

 

 

December 31, 2010

 

March 31, 2011

 

 

 

 

 

 

 

Raw materials

 

$

18,929

 

$

32,424

 

Work-in-process

 

27,226

 

29,222

 

Finished goods

 

2,632

 

2,246

 

 

 

 

 

 

 

 

 

$

48,787

 

$

63,892

 

 

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):

 

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Table of Contents

 

A123 Systems, Inc.

Notes to Condensed Consolidated Financial Statements

 

 

 

December 31, 2010

 

March 31, 2011

 

 

 

 

 

 

 

Computer equipment and software

 

$

11,913

 

$

15,204

 

Furniture and fixtures

 

3,415

 

4,981

 

Automobiles

 

404

 

390

 

Machinery and equipment

 

122,187

 

131,477

 

Buildings

 

26,810

 

27,115

 

Leasehold improvements

 

34,540

 

46,746

 

Equipment not in service

 

154,357

 

171,644

 

 

 

 

 

 

 

Property, plant and equipment, basis

 

353,626

 

397,557

 

 

 

 

 

 

 

Less reduction for costs reimbursable under government grants

 

164,999

 

182,061

 

 

 

 

 

 

 

Property, plant and equipment, carrying value

 

188,627

 

215,496

 

 

 

 

 

 

 

Less net accumulated depreciation and amortization

 

44,629

 

44,226

 

 

 

 

 

 

 

Property, plant and equipment, net

 

$

143,998

 

$

171,270

 

 

The Company has deposits for equipment not yet received of $11.6 million and $6.6 million at December 31, 2010 and March 31, 2011, 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 $1.7 million and $0.1 million at December 31, 2010 and March 31, 2011, respectively.

 

Property, plant and equipment under capital lease consists of the following (in thousands):

 

 

 

December 31, 2010

 

March 31, 2011

 

 

 

 

 

 

 

Computer equipment and software, at cost

 

$

2,758

 

$

2,758

 

Buildings, at cost

 

16,446

 

16,446

 

Leasehold improvements, at cost

 

2,091

 

2,091

 

Accumulated depreciation and amortization

 

(1,631

)

(2,324

)

 

 

 

 

 

 

Property, plant and equipment under capital lease, net

 

$

19,664

 

$

18,971

 

 

Net depreciation expense for the three months ended March 31, 2010 and 2011, was $3.6 million and $4.9 million, respectively. For the three months ended March 31, 2010 and 2011, the Company recorded $0 and $2.7 million, respectively, as a reduction to depreciation expense related to reduced carrying value due to government grant reimbursements.

 

5.  Investments

 

Cost-Method Investments

 

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 December 31, 2010 and March 31, 2011, the Company has recorded an investment of $20.5 million in the condensed consolidated balance sheets. The Company is accounting for its investment under the cost method. Through March 31, 2011, there have been no changes in circumstances that may have a significant adverse effect on the fair value of the investment.

 

Equity-Method Investments

 

In December 2009, the Company entered into a joint venture agreement with an automaker in China to assist the Company in growing the Company’s business and sales in China’s transportation industry and created Shanghai Advanced Traction Battery Systems, Co. Ltd. (the “Joint Venture”). Under the terms of the joint venture agreement, the Company is required to invest $4.7 million into the Joint Venture over a period of approximately 15 months, in return for a 49% interest in the Joint Venture. The Company made the first capital contribution of $1.9 million to the Joint Venture in July 2010 and the second capital contribution of $1.4 million in January 2011. As of March 31, 2011, no other capital contributions have been required under the terms of the agreement. The Company expects to make the final capital contribution of $1.4 million in the second half of 2011.  The Company is accounting for its investment under the equity method.

 

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Table of Contents

 

A123 Systems, Inc.

Notes to Condensed Consolidated Financial Statements

 

In August 2010, the Company entered into an agreement to transfer certain patents held by the Company to a privately-held company, 24M Technologies, Inc. (“24M”), in return for a 12% ownership interest in 24M. The Company has recorded the investment on the condensed consolidated balance sheet at the fair value of the ownership interest received of approximately $0.2 million. The Company is accounting for its investment under the equity method as it has determined it has significant influence over the operating and financial decisions of the third party.

 

For the three months ended March 31, 2011, the Company recorded $0.2 million of equity method losses included in other income in the condensed consolidated statement of operations.

 

6.  Commitments and Contingencies

 

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. As a result, the scope of the claims in each patent were narrowed from those of the original claims made. 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. The United States Court of Appeals for the Federal Court upheld the Massachusetts Court’s decision on November 10, 2010. 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 The University of Texas (“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 entered a schedule for the case leading to a claim construction hearing, which was held on December 2, 2010. On March 29, 2011, the United States District Court for the Northern District of Texas issued a Memorandum Opinion and Order on Claim Construction. The judge has ordered the parties to submit their joint status report on or before April 26, 2011.  The parties submitted the joint status report on April 26, 2011 in accordance with the court’s order, which included the proposed deadlines for discovery and pre-trial motions.  The court issued a scheduling order on April 27, 2011 with trial set to begin in December 2011. 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.

 

7.  Financing Arrangements

 

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

 

 

 

December 31, 2010

 

March 31, 2011

 

 

 

 

 

 

 

Term loan

 

$

7,069

 

$

5,819

 

Mass Clean Energy loan

 

2,534

 

2,573

 

Korean subsidiary debt

 

 

 

 

 

Technology funds loan

 

44

 

30

 

Korean government loans

 

335

 

266

 

 

 

 

 

 

 

Total

 

9,982

 

8,688

 

Less amounts classified as current

 

5,379

 

5,088

 

 

 

 

 

 

 

Long-term debt

 

$

4,603

 

$

3,600

 

 

Term Loan— The Company has an agreement with a financial institution for a term loan facility of $15.0 million. The term loan facility is repayable over a 36-month period and accrues interest at the financial institution’s prime rate (which was 4.0% at December 31, 2010 and March 31, 2011) plus 0.75%. This term loan facility matures in September 2012.

 

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.

 

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Table of Contents

 

A123 Systems, Inc.

Notes to Condensed Consolidated Financial Statements

 

Mass Clean Energy Loan—The Company has a forgivable loan from the Massachusetts Clean Energy Technology Center for $5.0 million. If the Company complies with certain capital expenditure conditions, $2.5 million of the loan will be forgiven and if the Company complies with certain employment conditions an additional $2.5 million will be forgiven. As of December 31, 2010 and March 31, 2011, $2.5 million is recorded as an offset to property, plant and equipment in the condensed consolidated balance sheets as the Company is reasonably assured that the Company will comply with the conditions for the forgiveness related to the capital expenditure condition. As of December 31, 2010 and March 31, 2011, the remaining $2.5 million is recorded as long-term debt. The loan has a fixed interest rate of 6.0% and all funds borrowed under the agreement and accrued interest is due upon maturity in October 2017 if the Company has not complied with the forgiveness conditions.

 

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

 

· Technology funds loan—The Company has a technology funds loan agreement with a variable interest rate. The weighted average interest rate for the loan as of March 31, 2011 was 4.54%. 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. Certain grants are refundable, depending on the successful development and commercialization of the technology or products, and a company receiving such government grants is required to refund between 20% and 30% of the grants received for such development.

 

Revolving Credit Facilities—The Company entered into a line of credit (“LOC”) for $8.0 million with a financial institution. The line of credit accrues interest at the financial institution’s prime (4.0% at December 31, 2010 and March 31, 2011).  The outstanding balance at December 31, 2010 and March 31, 2011 was $8.0 million. The LOC has a maturity date of June 20, 2011, and the Company is required to comply with the same financial covenants required under the Term Loan mentioned above.

 

8.  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 and nonqualified stock options or other awards 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.  Through March 31, 2010, 500,000 shares from the 2001 Plan were added to the number of shares available under the 2009 Plan.  On January 1, 2010 and 2011, 5,000,000 and 3,000,000 shares were added to the 2009 Plan in connection with the annual increases, respectively.  As of March 31, 2011, the Company had 7,903,153 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 Company estimates forfeitures at the time of grant and revises the estimates, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The following table presents stock-based compensation expense included in the Company’s condensed consolidated statements of operations (in thousands):

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2010

 

2011

 

 

 

 

 

 

 

Cost of sales

 

$

415

 

$

587

 

Research, development and engineering

 

962

 

1,322

 

Sales and marketing

 

298

 

386

 

General and administrative

 

812

 

1,004

 

 

 

 

 

 

 

Total

 

$

2,487

 

$

3,299

 

 

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

 

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A123 Systems, Inc.

Notes to Condensed Consolidated Financial Statements

 

As of March 31, 2011, there was approximately $29.8 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 2.63 years.

 

Stock Options—The 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 three months ended March 31, 2011:

 

 

 

Shares

 

Weighted
Average
Exercise
Price

 

Weighted
Average
Remaining
Contractual
Term

 

Aggregate
Intrinsic
Value

 

 

 

(In thousands)

 

 

 

 

 

(In thousands)

 

 

 

 

 

 

 

 

 

 

 

Outstanding - January 1, 2011

 

10,783

 

$

7.64

 

7.41

 

$

27,743

 

 

 

 

 

 

 

 

 

 

 

Granted

 

340

 

9.57

 

 

 

 

 

Exercised

 

(562

)

3.33

 

 

 

 

 

Forfeited

 

(303

)

10.08

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Outstanding - March 31, 2011

 

10,258

 

$

7.87

 

7.43

 

$

9,789

 

 

 

 

 

 

 

 

 

 

 

Vested or expected to vest - March 31, 2011

 

9,803

 

$

7.77

 

7.34

 

$

9,785

 

 

 

 

 

 

 

 

 

 

 

Options exercisable - March 31, 2011

 

5,177

 

$

6.00

 

6.19

 

$

9,508

 

 

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.

 

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

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2010

 

2011

 

Risk-free interest rate

 

3.15

%

2.68 - 3.03%

 

Expected term

 

6.25

 

6.25  

 

Expected volatility

 

73.8

%

73.6%

 

Expected dividends

 

0

%

0%

 

 

The Company derived the risk-free interest rate assumption from the U.S. Treasury’s rates for U.S. Treasury zero-coupon bonds with maturities similar to those of the expected term of the awards being valued. The Company based the assumed dividend yield on its expectation of not paying dividends in the foreseeable future. The Company calculated the weighted average expected term of options using the simplified method as prescribed by the Stock Compensation Subtopic of the Codification. This decision was based on the lack of relevant historical data due to the Company’s limited operating experience. In addition, due to the Company’s limited historical data, the estimated volatility also reflects the application of the Stock Compensation Subtopic, incorporating the historical volatility of comparable companies with publicly-available share prices.

 

The weighted average grant date fair value of options granted during the three months ended March 31, 2011 was $6.45. The intrinsic value of options exercised during the three months ended March 31, 2010 and 2011 was $17.1 million and $3.4 million, respectively. The Company received $0.5 million and $1.9 million in cash from option exercises during the three months ended March 31, 2010 and 2011, respectively.

 

Restricted Stock Units—During the three months ended March 31, 2011, 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 three months ended March 31, 2011:

 

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A123 Systems, Inc.

Notes to Condensed Consolidated Financial Statements

 

 

 

Shares

 

Weighted
Average Fair
Value

 

 

 

(In thousands)

 

 

 

 

 

 

 

 

 

Non-vested - January 1, 2011

 

203

 

$

10.13

 

 

 

 

 

 

 

Granted

 

 

 

Vested

 

 

 

Forfeited

 

(20

)

10.11

 

 

 

 

 

 

 

Non-vested - March 31, 2011

 

183

 

$

10.13

 

 

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 Select Market on the grant date.

 

9. Related Party Transactions

 

Transactions with Joint Venture Partner’s Affiliate—In December 2009, the Company entered into a joint venture (the “Joint Venture”) with an automaker in China (the “Chinese Automaker”) to assist the Company in growing business and sales in China’s transportation industry. The Company entered into two development agreements with the Chinese Automaker. During the three months ended March 31, 2010 and 2011, the Company recorded revenue related to the development and supply agreements with the Chinese Automaker of $0.7 and $0.1 million, respectively. As of December 31, 2010 and March 31, 2011, $0.5 million and $0.2 million, respectively, is recorded in deferred revenue on the condensed consolidated balance sheets related to the development and supply agreements, which will be recognized upon completion and acceptance of the deliverables. As of December 31, 2010 and March 31, 2011, the balance due from the automaker was $1.9 million and $0.3 million, respectively, which is included within accounts receivable, net on the condensed consolidated balance sheets.

 

Transactions with Cost-Method Investment—In January 2010, the Company entered into a supply agreement with the Automaker in which the Company also holds an investment of preferred stock. The Company recognizes revenue on product shipments to the Automaker, within the condensed consolidated statements of operations, when all revenue recognition criteria are met. During the three months ended March 31, 2010 and 2011, the Company recorded $0 and $1.7 million of revenue from the Automaker, respectively. The balance due from the Automaker as of December 31, 2010 and March 31, 2011, of $0.6 million and $2.1 million, respectively, is included within accounts receivable, net on the condensed consolidated balance sheets.

 

Transactions with Equity-Method Investment—During March 2010, the Company entered into a technology license contract to license certain patents and technology to the Company’s Joint Venture for the term of the Joint Venture, which extends to April 28, 2030. In conjunction with the license agreement, the Joint Venture paid the Company the first payment of the license fee of $1.0 million in 2010. Revenue on the license fee will be amortized over the term of the license. Revenue recognition is expected to commence upon the successful completion of training provided to employees of the Joint Venture. As of December 31, 2010 and March 31, 2011, the $1.0 million of the license fee is recorded in deferred revenue on the condensed consolidated balance sheets. During December 2010, the Company entered into a service agreement to provide technical development, design, analysis and consultation services to the Joint Venture. Additionally, the Company entered into an agreement to provide sample battery system packs to the Joint Venture. For the three months ended March 31, 2011, the Company recognized $0.3 million of revenue and at December 31, 2010 and March 31, 2011 the Company deferred $0.2 million and $0 million, respectively, of service and product revenue related to the service agreement and initial sample shipments. As of December 31, 2010 and March 31, 2011, $0.5 million and $0.6 million are included within accounts receivable, net on the condensed consolidated balance sheets for amounts due from the Joint Venture.

 

10.  Subsequent Events

 

In April 2011, the Company issued $143.8 million in principal of convertible unsecured subordinated notes (the “Convertible Notes”) and issued 20.2 million shares of the Company’s common stock at $6.00 per share for net proceeds after deducting issuance costs of $138.8 million and $115.1 million, respectively.  The Convertible Notes bear interest at 3.75%, which shall be payable semi-annually in arrears on April 15 and October 15 each year, beginning on October 15, 2011, and mature on April 15, 2016.  Holders may surrender their Convertible Notes, in integral multiples of $1,000 principal amount, for conversion any time prior to the close of business on the third business day immediately preceding the maturity date. The initial conversion rate of 138.8889 shares of common stock per $1,000 aggregate principal amount of Convertible Notes, equivalent to a conversion price of approximately $7.20 per share of our common stock, is subject to adjustment in certain events.  Upon conversion, the Company will deliver shares of common stock.  If the Company undergoes a fundamental change (as defined in the prospectus supplement relating to the notes), holders of the Convertible Notes have the option to require the Company to repurchase all or any portion of their Convertible Notes. The Company

 

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A123 Systems, Inc.

Notes to Condensed Consolidated Financial Statements

 

may not redeem the Convertible Notes prior to the maturity date.  The Company intends to use the net proceeds from the offerings for general corporate purposes and to fund the manufacturing expansion. Pending use, the Company intends to invest the net proceeds from the common stock and Convertible Notes offerings in interest-bearing investment-grade securities.

 

The Company has evaluated the period from March 31, 2011, the date of the condensed consolidated financial statements, to the date of the issuance and filing, and has determined that, other than disclosed above, no material subsequent events have occurred that would affect the information presented in these condensed consolidated 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 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, 2010 included in our Annual Report on Form 10-K filed with the Securities and Exchange Commission, or SEC, on March 11, 2011. 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,” “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 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 sales have been 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 commissioning. 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 additional 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 760 million watt hours. 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 margin, as higher production volumes will provide for increased absorption of manufacturing overhead and will reduce, on a percentage basis, the costs associated with 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 agreement, the DOE will provide cost reimbursement for 50% of qualified expenditures incurred from December 1, 2009 to November 30, 2012 and for reimbursement of pre-award costs incurred from June 1, 2009 to November 30, 2009.  Through March 31, 2011, we have received $97.4 million in reimbursement for costs incurred. As of March 31, 2011, we have incurred additional allowable costs entitling us to receive $3.1 million in reimbursements, which have been recorded as a receivable.

 

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, as well as the specific terms and conditions applicable to any loan we may receive 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 payments made for 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 tax credit proceeds shall not exceed $25.0 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 for the tax credit proceeds to be non-refundable. 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 March 31, 2011 we have incurred expenses of $158.8 million in qualified expenses related to the construction of the Livonia and Romulus facilities. When we have met the filing requirements for the tax year ending December 31, 2012, we expect to begin receiving $79.4 million in proceeds related to these expenses limited to $25.0 million per year over a four year period. As of March 31, 2011, we have recorded an undiscounted receivable of $79.4 million, as it is reasonably assured that we will comply with the conditions of the tax credit and will receive proceeds. Upon recording the receivable, we reduced the basis in the fixed assets acquired in accordance with the tax credit and this will be recognized in the condensed consolidated statements of operations over their estimated useful lives of the depreciable asset as reduced depreciation expense.

 

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 three months ended March 31, 2010 and 2011, product revenue represented 81% and 85% of our total revenue, respectively.

 

A significant portion of our revenue is generated from a limited number of customers. Two of our largest customers (BAE Systems, or BAE, and AES Energy Storage, LLC, or AES) accounted for approximately 56% and 11% of our total revenue during the three months ended March 31, 2010 and 2011, respectively.  Additionally, we had one customer which represented 12% of our total revenue during the three months ended March 31, 2011.  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,

 

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AES and Fisker are expected to represent a significant portion of our revenue in the near term, and the loss of BAE, AES or Fisker as a customer could have a material adverse effect on our short-term revenue. We expect the transportation market and the electric grid market to represent 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 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. We have received and recorded as deferred revenue a total of $28.0 million in up-front, support and additional payments in connection with our license agreement with Gillette. 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 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.

 

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.

 

We are rapidly expanding our capacity to meet anticipated customer demand, including building out additional manufacturing capacity at our Livonia and Romulus, Michigan facilities. During 2010, we more than doubled our worldwide manufacturing capacity from 169 MWh to approximately 345 MWh. This expansion is part of our plan to support annual manufacturing capacity of 760 MWh. During December 2010, we qualified the first production line at our Livonia facility and we expect to qualify our Romulus facility during the first half of 2011. Also, we have put into place manufacturing overhead, including supply chain and quality organizations, which are sized to support significantly higher production volumes than we are currently producing. Increasing our production volume will allow us to reduce per-unit cell costs, improve the absorption of manufacturing overhead costs, and improve our gross margins.

 

However, pending the qualification and production ramp-up at our Michigan facilities, we are currently producing the majority of our cells in a low-volume pilot production plant. Utilizing a pilot production plant imposes capacity constraints, limiting our ability to

 

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produce at higher volumes and decrease our per-unit cost of goods sold, thereby contributing to our negative gross margins. As we ramp-up production at our Michigan facilities, we anticipate a significant increase in production volumes and therefore lower per-unit costs.

 

Our long-term financial objective is to achieve and support sustained profitable growth. To meet this objective, we are currently focusing on completing the expansion of our manufacturing capacity and increasing production volumes to achieve lower material costs due to volume purchase discounts and improved absorption of our manufacturing overhead costs, thereby reducing per-unit production cost.

 

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 hired a significant number of new employees in order to support our growth and increase in our infrastructure. 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. During the third quarter of 2010, we opened our manufacturing facility in Livonia, Michigan, and our Livonia facility was qualified for production in December 2010. The Romulus facility began qualification for production in the first quarter of 2011.

 

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. 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.  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.

 

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, 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 to continue to incur general and administrative expenses 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 is qualified for production, including the cost of raw materials, and the related labor and overhead, run through the production line during the qualification phase. We expect to incur additional production start-up expenses in the near term related to our facility in Romulus, Michigan and the qualification of our second production line in Livonia, Michigan. The Livonia facility began qualification for production in the third quarter of 2010 and the first production line was qualified in December 2010. The Romulus facility began qualification for production in the first quarter of 2011.

 

Other Income (Expense), Net.  Other income (expense), net consists primarily of interest income on cash balances, interest expense on borrowings, foreign currency-related gains and losses, equity earnings and other gains or 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.  Other income includes equity losses related of our proportional share of earnings in investments accounted for under the equity method and will vary each reporting period depending on the earnings or losses of these entities and gains or losses on long-term investments will vary each reporting period depending on the timing of any joint

 

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ventures or other equity investments we may enter into, the investment made by us, and the ongoing operations of the investee.  Additionally, for the three months ended March 31, 2011, other income includes the gain recognized on the deconsolidation of our joint venture previously consolidated as a variable interest entity.

 

Provision for Income Taxes.  Through March 31, 2011, 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 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 in Part I, Item 1A of our Annual Report on Form 10-K filed with the SEC on March 11, 2011, 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 estimated demand from existing supply agreements, from our projection of future development and supply agreement wins and from anticipated timelines of customer orders. 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, several of our smaller customers, or one of our existing supply agreements for significant future revenues, could materially harm our business.

 

Critical Accounting Policies

 

Our condensed consolidated 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 long-lived assets;

 

 

·

Government grants;

 

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·

Investments in non-public companies.

 

During the three months ended March 31, 2011, there were no significant changes in our critical accounting policies or estimates. See our Annual Report on Form 10-K for the year ended December 31, 2010, filed with the SEC on March 11, 2011, for additional information about these critical accounting policies, as well as a description of our other significant accounting policies.

 

Results of Consolidated Operations

 

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

 

 

 

March 31,

 

 

 

2010

 

2011

 

 

 

 

 

 

 

Revenue:

 

 

 

 

 

Product

 

$

19,774

 

$

15,458

 

Services

 

4,694

 

2,639

 

 

 

 

 

 

 

Total revenue

 

24,468

 

18,097

 

 

 

 

 

 

 

Cost of revenue:

 

 

 

 

 

Product

 

22,354

 

31,096

 

Services

 

4,155

 

2,478

 

 

 

 

 

 

 

Total cost of revenue

 

26,509

 

33,574

 

 

 

 

 

 

 

Gross loss

 

(2,041

)

(15,477

)

 

 

 

 

 

 

Operating expenses:

 

 

 

 

 

Research, development and engineering

 

14,116

 

20,359

 

Sales and marketing

 

2,800

 

4,082

 

General and administrative

 

8,240

 

9,111

 

Production start-up

 

1,811

 

4,621

 

 

 

 

 

 

 

Total operating expenses

 

26,967

 

38,173

 

 

 

 

 

 

 

Operating loss

 

(29,008

)

(53,650

)

 

 

 

 

 

 

Other income (expense):

 

 

 

 

 

Interest, net

 

(218

)

(641

)

Gain on foreign exchange

 

245

 

2

 

Other income, net

 

 

1,026

 

 

 

 

 

 

 

Total other income, net

 

27

 

387

 

 

 

 

 

 

 

Loss from operations, before tax

 

(28,981

)

(53,263

)

 

 

 

 

 

 

Provision for income taxes

 

121

 

410

 

 

 

 

 

 

 

Net loss

 

(29,102

)

(53,673

)

 

 

 

 

 

 

Less: Net loss attributable to the noncontrolling interest

 

77

 

27

 

 

 

 

 

 

 

Net loss attributable to A123 Systems, Inc.

 

$

(29,025

)

$

(53,646

)

 

 

 

 

 

 

Other Operating Data:

 

 

 

 

 

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

 

16,252

 

14,326

 

 

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Table of Contents

 

Three Months Ended March 31, 2010 and 2011

 

Revenue

 

 

 

Three Months Ended March 31,

 

 

 

 

 

 

 

2010

 

2011

 

$ Change

 

% Change

 

 

 

(Dollars in thousands)

 

Revenue

 

 

 

 

 

 

 

 

 

Product

 

 

 

 

 

 

 

 

 

Transportation

 

$

10,250

 

$

12,314

 

$

2,064

 

20.1

%

Commercial

 

4,284

 

3,134

 

(1,150

)

-26.8

%

Electric grid

 

5,240

 

10

 

(5,230

)

-99.8

%

 

 

 

 

 

 

 

 

 

 

Total product

 

19,774

 

15,458

 

(4,316

)

-21.8

%

Services

 

4,694

 

2,639

 

(2,055

)

-43.8

%

 

 

 

 

 

 

 

 

 

 

Total revenue

 

$

24,468

 

$

18,097

 

$

(6,371

)

-26.0

%

 

Product Revenue.  The increase in sales in the transportation industry of $2.1 million for the three months ended March 31, 2011 compared to the three months ended March 31, 2010 was primarily due to the transition of several of our customers from development programs to prototype production programs.  These increases were partially offset by a decrease of $6.4 million in sales to BAE. In the future, we expect sales to BAE to decrease as a percentage of revenue as revenue from other customers increases. The decrease in sales in the commercial industry of $1.2 million for the three months ended March 31, 2011 compared to the three months ended March 31, 2010 was primarily due to a decrease in sales to a commercial customer and its affiliates of $1.6 million, partially offset by an increase of $0.4 million in sales to other commercial customers. Sales to customers in the electric grid industry decreased by $5.2 million due to the timing of electric grid storage system shipments and the timing of revenue recognition.

 

Services Revenue.  The decrease in services revenue was related to the decrease in revenue from government agency research contracts, which was primarily due to the timing of project milestones and revenue recognition on active projects.

 

Cost of Revenue and Gross Profit (Loss)

 

 

 

Three Months Ended March 31,

 

 

 

 

 

 

 

2010

 

2011

 

$ Change

 

% Change

 

 

 

(Dollars in thousands)

 

Cost of revenue

 

 

 

 

 

 

 

 

 

Product

 

$

22,354

 

$

31,096

 

$

8,742

 

39.1

%

Services

 

4,155

 

2,478

 

(1,677

)

-40.4

%

 

 

 

 

 

 

 

 

 

 

Total cost of revenue

 

$

26,509

 

$

33,574

 

$

7,065

 

26.7

%

 

 

 

 

 

 

 

 

 

 

Gross profit (loss)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Product

 

$

(2,580

)

$

(15,638

)

$

(13,058

)

506.1

%

Services

 

539

 

161

 

(378

)

-70.1

%

 

 

 

 

 

 

 

 

 

 

Total gross profit (loss)

 

$

(2,041

)

$

(15,477

)

$

(13,436

)

658.3

%

 

Cost of Product Revenue. The increase in cost of product revenue was primarily due to an unfavorable change in the mix of products sold in the three months ended March 31, 2011, which included a higher ratio of prismatic cell products to cylindrical cell products, as compared to the three months ended March 31, 2010. In addition, due to low factory utilization, unabsorbed manufacturing expenses were $4.9 million for the three months ended March 31, 2010, compared to $9.5 million for the three months ended March 31, 2011.

 

Cost of Services Revenues. The decrease in costs of services revenue resulted from the decrease in services revenues in addition to the mix of government and non-government contracts for the three months ended March 31, 2011 as compared to the three months ended March 31, 2010.

 

Product Gross Profit (Loss). We experienced a product gross loss during the three months ended March 31, 2011, primarily due to low factory utilization and an unfavorable change in the mix of products sold in the three months ended March 31, 2011 as the three months ended March 31, 2011 included a higher ratio of prismatic cell products to cylindrical cell products, as compared to the three months ended March 31, 2010.  Our future gross profit will be affected by numerous factors, including the build-out of our manufacturing capacity, the timing of the production of new product designs and our ability to reduce cell costs. While we complete the expansion of our manufacturing capacity and ramp-up production volume of prismatic cells, our gross loss will be negatively

 

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affected by higher per-unit costs.  When we increase our prismatic production volumes we anticipate lower per-unit costs due to lower material costs, improved absorption of our manufacturing overhead costs, and improved efficiencies that will all drive down the per-unit prismatic cell costs, and positively impact our gross profit.  Unabsorbed manufacturing expenses were $9.5 million during the three months ended March 31, 2011.  Due to unabsorbed manufacturing costs, we anticipate our gross profit or loss will vary significantly from period-to period going forward.

 

Services Gross Profit. Services gross profit decreased in the three months ended March 31, 2011 as compared to the three months ended March 31, 2010 due to the decrease in services revenue and the timing of project milestones.  We recognize services project costs as incurred and, for programs which include milestones, we recognize services revenue upon the completion of project milestones when collectability is reasonably assured.  As such, our services gross profit will fluctuate period over period.

 

Operating Expenses

 

 

 

Three Months Ended March 31,

 

 

 

 

 

 

 

2010

 

2011

 

$ Change

 

% Change

 

 

 

(Dollars in thousands)

 

Operating expenses

 

 

 

 

 

 

 

 

 

Research, development and engineering

 

$

14,116

 

$

20,359

 

$

6,243

 

44.2

%

Sales and marketing

 

2,800

 

4,082

 

1,282

 

45.8

%

General and administrative

 

8,240

 

9,111

 

871

 

10.6

%

Production start-up

 

1,811

 

4,621

 

2,810

 

155.2

%

 

 

 

 

 

 

 

 

 

 

Total operating expenses

 

$

26,967

 

$

38,173

 

$

11,206

 

41.6

%

 

Research, Development and Engineering Expenses. A portion of research, development and engineering expenses was offset by cost-sharing funding. Our research, development and engineering expenditures are summarized as follows:

 

 

 

Three Months Ended March 31,

 

 

 

 

 

 

 

2010

 

2011

 

$ Change

 

% Change

 

 

 

(Dollars in thousands)

 

Research, development and engineering expenses

 

 

 

 

 

 

 

 

 

Aggregated research, development and engineering expenditures

 

$

14,655

 

$

21,311

 

$

6,656

 

45.4

%

Research, development and engineering reimbursements

 

(539

)

(952

)

(413

)

76.6

%

 

 

 

 

 

 

 

 

 

 

Research, development and engineering expenses

 

$

14,116

 

$

20,359

 

$

6,243

 

44.2

%

 

The increase in research, development and engineering expenses for the three months ended March 31, 2011 compared to the three months ended March 31, 2010 was primarily attributable to an increase of $5.3 million in personnel-related expenses associated with an increase in research, development and engineering personnel who primarily focus on process improvement, material science chemistry and battery and battery systems technology and who support the increase in customer product development programs.  Also, other research, development and engineering cost increased by $0.9 million in the three months ended March 31, 2011. Research, development and engineering expense was 58% of revenue for the three months ended March 31, 2010, compared to 112% for the three months ended March 31, 2011.

 

Sales and Marketing Expenses. The increase in sales and marketing expenses for the three months ended March 31, 2011 compared to the three months ended March 31, 2010 was primarily attributable to an increase of $1.3 million in personnel-related expenses associated with an increase in sales and marketing personnel.  Sales and marketing expense was 11% of revenue for the three months ended March 31, 2010, compared to 23% for the three months ended March 31, 2011.

 

General and Administrative Expenses. The increase in general and administrative expenses for the three months ended March 31, 2011 compared to the three months ended March 31, 2010 was primarily due to an increase in personnel-related expenses of $0.9 million, associated with an increase in general and administrative personnel.  General and administrative expense was 34% of revenue for the three months ended March 31, 2010, compared to 50% for the three months ended March 31, 2011.

 

Production start-up. A portion of production start-up expenses was offset primarily by government grant funding. Our production start-up expenditures are summarized as follows:

 

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Three Months Ended March 31,

 

 

 

 

 

 

 

2010

 

2011

 

$ Change

 

% Change

 

 

 

(Dollars in thousands)

 

Production start-up expenditures

 

 

 

 

 

 

 

 

 

Aggregated production start-up expenditures

 

$

2,105

 

$

6,997

 

$

4,892

 

232.4

%

Production start-up reimbursements

 

(294

)

(2,376

)

(2,082

)

708.2

%

 

 

 

 

 

 

 

 

 

 

Production start-up expenses

 

$

1,811

 

$

4,621

 

$

2,810

 

155.2

%

 

The increase in production start-up expenses for the three months ended March 31, 2011 compared to the three months ended March 31, 2010 was primarily due to increased production start-up expenses related to our manufacturing expansion at our Romulus, Michigan facility. This increase was partially offset by cost offsets from government grant funding totaling $2.4 million. Production start-up expenses were 7% of revenue for the three months ended March 31, 2010, compared to 26% for the three months ended March 31, 2011.

 

Other Income (Expense), Net

 

 

 

Three Months Ended March 31,