10-Q 1 form_10q-valence.txt UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 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 December 31, 2006. or [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ____________ to ____________ Commission file number 0-20028 VALENCE TECHNOLOGY, INC. (Exact Name of Registrant as Specified in Its Charter) DELAWARE 77-0214673 (State or Other Jurisdiction of (I.R.S. Employer Incorporation or Organization) Identification No.) 12201 TECHNOLOGY BOULEVARD, SUITE 150, AUSTIN, TEXAS 78727 (Address of Principal Executive Offices) (Zip Code) (512) 527-2900 (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 [ ] Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer [X] Accelerated filer [ ] Non-accelerated filer [ ] Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X] Common Stock, $0.001 par value 104,347,897 (Class) (Outstanding at February 2, 2007) VALENCE TECHNOLOGY, INC. AND SUBSIDIARIES FORM 10-Q FOR THE QUARTER ENDED DECEMBER 31, 2006
INDEX PAGES PART I. FINANCIAL INFORMATION Item 1. Financial Statements (Unaudited): Condensed Consolidated Balance Sheets as of December 31, 2006 and March 31, 2006................................................................1 Condensed Consolidated Statements of Operations and Comprehensive Loss for Each of the Three- and Nine- Month Periods Ended December 31, 2006 and December 31, 2005.......................................................2 Condensed Consolidated Statements of Cash Flows for the Nine- Month Periods Ended December 31, 2006 and December 31, 2005.............................................................3 Notes to Condensed Consolidated Financial Statements................................................4 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations................................................................17 Item 3. Quantitative and Qualitative Disclosures about Market Risk.........................................37 Item 4. Controls and Procedures............................................................................38 PART II. OTHER INFORMATION Item 1. Legal Proceedings..................................................................................39 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds........................................39 Item 3. Defaults upon Senior Securities....................................................................39 Item 4. Submission of Matters to a Vote of Security Holders................................................39 Item 5. Other Information..................................................................................39 Item 6. Exhibits ..........................................................................................39 SIGNATURE ...................................................................................................41
i PART I - FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS (UNAUDITED) VALENCE TECHNOLOGY, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE AMOUNTS) (Unaudited)
December 31, 2006 March 31, 2006 --------------------------- ---------------------- Assets Current assets: Cash and cash equivalents $ 1,880 $ 612 Trade receivables, net of allowance of $113 and $99, respectively 2,261 2,376 Inventory 8,399 2,738 Prepaid and other current assets 2,123 2,566 --------------------------- ---------------------- Total current assets 14,663 8,292 Property, plant and equipment, net 3,449 3,052 Intellectual property, net 200 288 --------------------------- ---------------------- Total assets $ 18,312 $ 11,632 =========================== ====================== Liabilities and Stockholders' Deficit Current liabilities: Convertible notes payable to stockholder $ - $ 6,000 Accounts payable 3,178 1,599 Accrued expenses 3,829 4,479 Deferred revenue 224 464 --------------------------- ---------------------- Total current liabilities 7,231 12,542 Long-term interest payable to stockholder 17,743 15,580 Long-term debt, net of debt discount 18,364 17,942 Long-term debt to stockholder, net of debt discount 33,722 33,170 --------------------------- ---------------------- Total liabilities 77,060 79,234 --------------------------- ---------------------- Commitments and contingencies - - Redeemable convertible preferred stock, $0.001 par value, 1,000 shares authorized, 861 issued and outstanding as of December 31, 2006 and March 31, 2006, liquidation value $8,610 8,610 8,610 Stockholders' deficit: Common stock, $0.001 par value, 200,000,000 shares authorized; 102,939,645 and 89,883,539 shares outstanding as of December 31, 2006 and March 31, 2006 103 90 Additional paid-in capital 452,046 426,745 Notes receivable from stockholder (5,164) (5,164) Accumulated deficit (510,611) (494,224) Accumulated other comprehensive loss (3,732) (3,659) --------------------------- ---------------------- Total stockholders' deficit (67,358) (76,212) --------------------------- ---------------------- Total liabilities, preferred stock and stockholders' deficit $ 18,312 $ 11,632 =========================== ====================== The accompanying notes are an integral part of these condensed consolidated financial statements.
1
VALENCE TECHNOLOGY, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) (Unaudited) Three Months Ended Nine Months Ended December 31, December 31, ------------------------------------ ----------------------------------- 2006 2005 2006 2005 ------------------ -------------- ------------------ ------------- Revenue: Battery and system sales $ 2,085 $ 4,565 $ 11,261 $ 13,171 Licensing and royalty revenue 233 254 601 571 ------------------ -------------- ------------------ ------------- Total revenues 2,318 4,819 11,862 13,742 Cost of sales 2,782 5,971 11,224 18,642 ------------------ -------------- ------------------ ------------- Gross margin profit (loss) (464) (1,152) 638 (4,900) Operating expenses: Research and product development 911 1,185 2,800 3,961 Marketing 663 420 1,639 1,661 General and administrative 1,885 2,554 6,285 9,019 Share based compensation 426 - 1,132 - Depreciation and amortization 193 178 599 528 (Gain) /loss on disposal of assets (84) 11 (82) (611) Asset impairment charge - 170 - 170 Contract settlement charges - - 24 - ------------------ -------------- ------------------ ------------- Total operating expenses 3,994 4,518 12,397 14,728 ------------------ -------------- ------------------ ------------- Operating loss (4,458) (5,670) (11,759) (19,628) Interest and other income 348 138 696 425 Interest expense (1,809) (1,524) (5,195) (3,996) ------------------ -------------- ------------------ ------------- Net loss (5,919) (7,056) (16,258) (23,199) Dividends on preferred stock 43 43 130 130 Preferred stock accretion - 7 - 28 ------------------ -------------- ------------------ ------------- Net loss available to common stockholders, basic and diluted $ (5,962) $ (7,106) $ (16,388) $ (23,357) ================== ============== ================== ============= Other comprehensive loss: Net loss $ (5,919) $ (7,056) $ (16,258) $ (23,199) Change in foreign currency translation adjustments (62) 36 (73) 226 ------------------ -------------- ------------------ ------------- Comprehensive loss $ (5,981) $ (7,020) $ (16,331) $ (22,973) ================== ============== ================== ============= Net loss per share available to common stockholders $ (0.06) $ (0.08) $ (0.17) $ (0.26) ================== ============== ================== ============= Shares used in computing net loss per share available to common stockholders, basic and diluted. 101,801 89,715 98,053 89,223 ================== ============== ================== =============
The accompanying notes are an integral part of these condensed consolidated financial statements. 2
VALENCE TECHNOLOGY, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) (Unaudited) Nine Months Ended December 31, --------------------------------------------------- 2006 2005 ----------------------------- ------------------ Cash flows from operating activities: Net loss $ (16,258) $ (23,199) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization 599 528 Asset impairment charge - 170 Gain/(loss) on disposal of property, plant, equipment (82) (611) Accretion of debt discount and other 913 770 Interest income on stockholder note receivable - (210) Deferred compensation expense - 172 Share based compensation 1,132 - Changes in operating and other assets and liabilities: Trade receivables 115 (2,476) Inventory (5,661) (2,608) Prepaid and other current assets 443 (1,432) Accounts payable 1,579 207 Accrued expenses and long-term interest 1,513 2,022 Deferred revenue 240 (835) ----------------------------- ------------------ Net cash used in operating activities (15,467) (27,502) ----------------------------- ------------------ Cash flows from investing activities: Purchases of property, plant & equipment (1,430) (1,355) Proceeds from sale of property, plant & equipment 15 611 ----------------------------- ------------------ Net cash used in investing activities (1,415) (744) ----------------------------- ------------------ Cash flows from financing activities: Proceeds from note payable to stockholder 5,000 1,000 Proceeds from long-term debt - 19,639 Dividends paid - (130) Interest received on stockholder note receivable - 281 Proceeds from stock option exercises 245 656 Proceeds from issuance of common stock, net of issuance costs 12,832 5,906 ----------------------------- ------------------ Net cash provided by financing activities 18,077 27,352 ----------------------------- ------------------ Effect of foreign exchange rates on cash and cash equivalents 73 226 ----------------------------- ------------------ Increase (decrease) in cash and cash equivalents 1,268 (668) Cash and cash equivalents, beginning of period 612 2,500 ----------------------------- ------------------ Cash and cash equivalents, end of period $ 1,880 $ 1,832 ============================= ================== Supplemental information: Conversion of notes payable to stockholder into common stock 11,101 - Interest paid $ 1,406 $ - The accompanying notes are an integral part of these condensed consolidated financial statements.
3 VALENCE TECHNOLOGY, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS December 31, 2006 (Unaudited) 1. INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS: These interim condensed consolidated financial statements are unaudited but reflect, in the opinion of management, all normal recurring adjustments necessary to present fairly the financial position of Valence Technology, Inc. and its subsidiaries (the "Company") as of December 31, 2006, its consolidated results of operations for each of the three-and nine-month periods ended December 31, 2006 and December 31, 2005, and the consolidated cash flows for the nine-month periods ended December 31, 2006 and December 31, 2005. Because all the disclosures required by generally accepted accounting principles are not included, these interim condensed consolidated financial statements should be read in conjunction with the audited financial statements and notes thereto in the Company's Annual Report on Form 10-K as of and for the year ended March 31, 2006. The results for the three- and nine-month periods ended December 31, 2006 are not necessarily indicative of the results to be expected for the entire fiscal year ending March 31, 2007. The year-end condensed consolidated balance sheet data as of March 31, 2006 was derived from audited financial statements, but does not include all disclosures required by generally accepted accounting principles. 2. BUSINESS AND BUSINESS STRATEGY: Valence Technology, Inc. (with its subsidiaries, the "Company") was founded in 1989 and has commercialized the industry's first phosphate-based lithium-ion technology. The Company's mission is to drive the wide adoption of high-performance, safe, low-cost energy storage systems by drawing on the numerous benefits of its latest battery technology, the extensive experience of its management team, and the significant market opportunity available to it. In February 2002, the Company unveiled its Saphion(R) technology, a lithium-ion technology which utilizes a phosphate-based cathode material. The Company believes that Saphion(R) technology addresses the major weaknesses of existing technology while offering a solution that is competitive in cost and performance. The Company believes that by incorporating a phosphate-based cathode material, its Saphion(R) technology is able to offer greater thermal and electrochemical stability than traditional lithium-ion technologies, which will facilitate its adoption in large application markets not traditionally served by lithium-ion batteries such as motive power, vehicular, marine, portable appliances, telecommunications, and utility back-up systems. Currently, the Company offers its Saphion(R) technology in both cylindrical and polymer construction and have initiated the design of a prismatic cell. The Company's business plan and strategy focuses on the generation of revenue from product sales, while minimizing costs through a manufacturing plan that utilizes partnerships with contract manufacturers and internal manufacturing efforts through its wholly owned subsidiaries in China. These subsidiaries initiated operations in late fiscal 2005. The market for Saphion(R) technology will be developed by offering existing and new solutions that differentiate the Company's products and its customers' products in both the large-format and small-format markets through the Company's own product launches, such as the N-Charge(TM) Power System and U-Charge(R) Power System, and through products designed by others. In addition, the Company expects to continue to pursue a licensing strategy as our Saphion(R) technology receives greater market acceptance. 3. GOING CONCERN AND LIQUIDITY AND CAPITAL RESOURCES: GOING CONCERN: The accompanying condensed consolidated financial statements have been prepared assuming that the Company will continue as a going concern, which contemplates the realization of assets and satisfaction of 4 liabilities in the normal course of business. The Company has incurred operating losses each year since its inception in 1989 and had an accumulated deficit of $510.6 million as of December 31, 2006. For the nine-month period ended December 31, 2006 the Company has incurred a net loss available to common stockholders of $16.4 million. For the years ended March 31, 2006 and 2005, the Company sustained net losses of $32.9 and $32.2 million, respectively. These factors, among others, indicate that the Company may be unable to continue as a going concern for a reasonable period of time. The Company's ability to continue as a going concern is contingent upon its ability to meet its liquidity requirements. If the Company is unable to arrange for debt or equity financing on favorable terms or at all the Company's ability to continue as a going concern is uncertain. These financial statements do not give effect to any adjustments to the amounts and classifications of assets and liabilities which might be necessary should the Company be unable to continue as a going concern. LIQUIDITY AND CAPITAL RESOURCES: At December 31, 2006, the Company's principal sources of liquidity were cash and cash equivalents of $1.88 million. The Company expects its sources of liquidity will not be sufficient for the remaining fiscal year. The Company anticipates product sales during fiscal 2007 from the N-Charge(TM) Power System and the battery pack for Segway, Inc., which are subject to seasonal fluctuations and from the sale of U-Charge(R) Power Systems will be insufficient to cover the Company's operating expenses. Management depends upon the Company's ability to periodically arrange for additional equity or debt financing to meet liquidity requirements. Unless product sales are greater than management currently forecasts or there are other changes to the business plan, the Company will need to arrange for additional financing within the next three to six months to fund operating and capital needs. This financing could take the form of debt or equity. Given the historical operating results and the amount of our existing debt, as well as the other factors, the Company may not be able to arrange for debt or equity financing from third parties on favorable terms or at all. The Company's cash requirements may vary materially from those now planned because of changes in the Company's operations including the failure to achieve expected revenues, greater than expected expenses, changes in OEM relationships, market conditions, the failure to timely realize the Company's product development goals, and other adverse developments. These events could have a negative impact on the Company's available liquidity sources during the remaining fiscal year. 4. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: REVENUE RECOGNITION: Revenues are generated from sales of products including batteries and battery systems, and from licensing fees and royalties per technology license agreements. Product sales are recognized when all of the following criteria are met: persuasive evidence of an arrangement exists, delivery has occurred, seller's price to the buyer is fixed and determinable, and collectibility is reasonably assured. Product shipments that are not recognized as revenue during the period shipped, primarily product shipments to resellers that are subject to right of return, are recorded as deferred revenue and reflected as a liability on the Company's balance sheet. For reseller shipments where revenue recognition is deferred, the Company records revenue based upon sales to ultimate customers. For direct customers, the Company estimates a return rate percentage based upon its historical experience, reviewed on a quarterly basis. Customer rebates and other price adjustments are recognized as incurred. Licensing fees are recognized as revenue upon completion of an executed agreement and delivery of licensed information, if there are no significant remaining vendor obligations and collection of the related receivable is reasonably assured. Royalty revenues are recognized upon sales of licensed products and when collectibility is reasonably assured. IMPAIRMENT OF LONG-LIVED ASSETS: The Company performs a review of long-lived tangible and intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of these assets is measured by comparison of their carrying amounts to future undiscounted 5 cash flows that the assets are expected to generate. If long-lived assets are considered to be impaired, the impairment recognized equals the amount by which the carrying value of the assets exceeds its fair value and is recorded in the period the determination is made. STOCK-BASED COMPENSATION: Prior to April 1, 2006, the Company accounted for stock-based compensation under the recognition and measurement provisions of Accounting Principles Board ("APB") Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations, as permitted by Statement of Financial Accounting Standards ("SFAS") No. 123, Accounting for Stock-Based Compensation. No employee compensation cost for stock options was recognized in the consolidated income statements for periods prior to April 1, 2006, as all stock options granted had an exercise price equal to the market value of the underlying common stock on the date of grant. In December 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment ("SFAS 123R"), which revises SFAS 123. SFAS 123R also supersedes APB No. 25 and amends SFAS No. 95, Statement of Cash Flows. SFAS 123R eliminates the alternative to account for employee stock options under APB No. 25 and requires the fair value of all share-based payments to employees, including the fair value of grants of employee stock options to be recognized in the statement of operations, generally over the vesting period. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin ("SAB") No. 107, which provides additional implementation guidance for SFAS 123R. Among other things, SAB 107 provides guidance on share-based payment valuations, income statement classification and presentation, capitalization of costs and related income tax accounting. SFAS 123R provides for adoption using either the modified prospective or modified retrospective transition method. The Company adopted SFAS 123R on April 1, 2006 using the modified prospective transition method in which compensation cost is recognized beginning April 1, 2006 for all share-based payments granted on or after that date and for awards granted to employees prior to April 1, 2006 that remain unvested on that date. The Company uses the Black-Scholes option pricing model to determine the fair value of stock option awards. See Note 12 to the condensed consolidated financial statements for disclosures required by SFAS 123R and related pronouncements. RECENT ACCOUNTING PRONOUNCEMENTS: In November 2004, the FASB issued SFAS No. 151, Inventory Costs, an amendment of ARB No. 43, Chapter 4. The standard requires that abnormal amounts of idle capacity and spoilage costs should be excluded from the cost of inventory and expensed when incurred. The provision is effective for inventory beginning April 1, 2006. The adoption of this standard did not have a material effect on the Company's financial position, results of operations or cash flows. In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets, an amendment of APB No. 29, Accounting for Nonmonetary Transactions. SFAS No. 153 requires exchanges of productive assets to be accounted for at fair value, rather than at carryover basis, unless (1) neither the asset received nor the asset surrendered has a fair value that is determinable within reasonable limits or (2) the transactions lack commercial substance. SFAS No. 153 is effective for nonmonetary asset exchanges beginning April 1, 2006. The adoption of this standard did not have a material effect on the Company's financial position, results of operations or cash flows. In March 2005, the FASB issued FASB Interpretation No. 47, Accounting for Conditional Asset Retirement Obligations ("FIN 47"). FIN 47 clarifies that an entity must record a liability for a "conditional" asset retirement obligation if the fair value of the obligation can be reasonably estimated. The adoption of this standard did not have a material effect on the Company's financial position, results of operations or cash flows. In May 2005, the FASB issued SFAS No. 154, ACCOUNTING CHANGES AND ERROR CORRECTIONS--A REPLACEMENT OF APB OPINION NO. 20 AND FASB STATEMENT NO. 3. SFAS No. 154 changes the requirements for the accounting for and reporting of a change in accounting principle. This statement requires retrospective application to prior periods' financial statements of changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. This 6 statement redefines restatements as the revising of previously issued financial statements to reflect the correction of an error. SFAS No. 154 requires that retrospective application of a change in accounting principle be limited to the direct effects of the change. This statement also requires that a change in depreciation, amortization, or depletion method for long-lived, non-financial assets be accounted for as a change in accounting estimate affected by a change in accounting principle. SFAS No. 154 is effective for accounting changes and corrections of errors beginning April 1, 2006. The adoption of this standard did not have a material effect on the Company's financial position, results of operations or cash flows. NET LOSS PER SHARE: Net loss per share is computed by dividing the net loss available to common stockholders by the weighted average shares of common stock outstanding during the period. The dilutive effect of the options and warrants to purchase common stock are excluded from the computation of diluted net loss per share, since their effect is antidilutive. The antidilutive instruments excluded from the diluted net loss per share computation for the three-and nine-month periods ended December 31, 2006 and 2005 were as follows:
Three Months Ended Nine Months Ended December 31, December 31, 2006 2005 2006 2005 ------------- ------------ ------------ ------------ Shares reserved for conversion of Series C preferred stock 3,628,634 3,629,470 3,628,634 3,629,470 Common stock options 9,199,365 11,774,226 9,199,365 11,774,226 Warrants to purchase common stock 2.955,643 2,955,643 2,955,643 2,955,643 ------------- ------------ ------------ ------------ Total 15,783,642 18,359,339 15,783,642 18,359,339 ============= ============ ============ ============ 5. INVENTORY: Inventory consisted of the following (in thousands) at: December 31, 2006 March 31, 2006 ---------------------- --------------------- Raw materials $ 1,665 $ 891 Work in process 5,810 1,422 Finished goods 924 425 ---------------------- --------------------- $ 8,399 $ 2,738 ====================== =====================
Included in inventory at December 31, 2006 and March 31, 2006 were valuation allowances of $5.0 million and $5.3 million, respectively to reduce their carrying values to lower of cost or market. 6. PROPERTY, PLANT AND EQUIPMENT, NET: Property, plant and equipment, net of accumulated depreciation and impairment consisted of the following (in thousands) at:
December 31, 2006 March 31, 2006 ------------------------- ---------------------- Leasehold improvements $ 1,079 $ 738 Machinery and equipment 3,846 7,854 Office and computer equipment 2,556 2,032 Construction in progress 56 84 ------------------------- ---------------------- Total cost 7,537 10,708 Less: accumulated depreciation (4,006) (5,624) Less: impairment (82) (2,032) ------------------------- ---------------------- Total cost, net of depreciation $ 3,449 $ 3,052 ========================= ====================== 7 7. INTELLECTUAL PROPERTY: Intellectual property consisting of stacked battery construction technology acquired from Telcordia Technologies, Inc. in December 2000 is amortized over its estimated useful life. Intellectual property, net of accumulated amortization and impairment, consisted of the following (in thousands) at: December 31, 2006 March 31, 2006 ---------------------- --------------------- Intellectual property before impairment $ 13,602 $ 13,602 Less: accumulated amortization (4,908) (4,820) Less: Impairment (8,494) (8,494) ---------------------- --------------------- Intellectual property, net $ 200 $ 288 ====================== =====================
Amortization expense for the three- and nine-month periods ended December 31, 2006 and 2005 was approximately $29,000 and $88,000, respectively. 8. CONVERTIBLE NOTES PAYABLE TO STOCKHOLDER: On July 10, 2006, the Company issued convertible promissory notes in favor of Berg & Berg Enterprises, LLC ("Berg & Berg"), an affiliate of Carl Berg, the Company's chairman of the board and managing member of Berg & Berg, in the principal amounts of $2.0 million. On July 20, 2006 the Company issued convertible promissory notes in favor of Berg & Berg in the principal amount of $1.0 million. These convertible promissory notes accrued interest at the annual rate of 8.0% and were convertible at any time prior to maturity, into shares of common stock of the Company at a conversion price equal to the closing bid price of the Company's common stock on the trading day immediately prior to the conversion date, provided that the conversion price cannot be lower than $1.73 and $1.33, respectively, the closing bid price of the Company's common stock on July 9 and 19, 2006. The notes and accrued interest were converted into a total of 1,885,302 common shares of the Company at $1.73 and $1.38, respectively. The issuance of these shares of common stock was exempt from registration pursuant to Section 3(a)(9) of the Securities Act of 1933, as amended. Under Rule 144 of the Securities Act, these shares are restricted from trading by West Coast Venture Capital, an affiliate of Mr. Berg, for one year from the date of issuance, unless registered, and then may be traded only in compliance with the volume restrictions and other applicable restrictions. On June 21, 2006, the Company issued convertible promissory notes in favor of Berg & Berg in the principal amounts of $2.0 million. These convertible promissory notes accrued interest at the annual rate of 8.0% and were convertible at any time prior to maturity, into shares of common stock of the Company at a conversion price equal to the closing bid price of the Company's common stock on the trading day immediately prior to the conversion date, provided that the conversion price cannot be lower than $1.70, the closing bid price of the Company's common stock on June 20, 2006. The notes and accrued interest were converted into a total of 1,188,332 common shares of the Company on July 25, 2006. The issuance of these shares of common stock was exempt from registration pursuant to Section 3(a)(9) of the Securities Act of 1933, as amended. Under Rule 144 of the Securities Act, these shares are restricted from trading by West Coast Venture Capital for one year from the date of issuance, unless registered, and then may be traded only in compliance with the volume restrictions and other applicable restrictions. In February and March 2006, the Company issued convertible promissory notes in favor of Berg & Berg in an aggregate principal amount of $6.0 million (the "Notes"). The Notes accrued interest at the annual rate of 8.0% and matured on March 30 and June 30, 2006. The principal amount of the Notes, together with accrued interest, was converted into 2,965,870 shares of common stock of the Company, in accordance with their terms on April 3, 2006. The issuance of these shares of common stock was exempt from registration pursuant to Section 3(a)(9) of the Securities Act of 1933, as amended. Under Rule 144 of the Securities Act, these shares are restricted from trading by West Coast Venture Capital for one year from the date of issuance, unless registered, and then may be traded only in compliance with the volume restrictions and other applicable restrictions. 8
9. LONG TERM DEBT: (in thousands) December 31, 2006 March 31, 2006 ------------------------ ----------------------------- 2005 Loan balance $ 20,000 $ 20,000 Unaccreted debt discount (1,636) (2,058) ------------------------ ----------------------------- Balance $ 18,364 $ 17,942 ------------------------ ----------------------------- 2001 Loan to stockholder balance 20,000 20,000 1998 Loan to stockholder balance 14,950 14,950 Unaccreted debt discount (1,228) (1,780) ------------------------ ----------------------------- Balance $ 33,722 $ 33,170 ------------------------ -----------------------------
In June 2005, the Company obtained a $20.0 million funding commitment from Mr. Carl Berg, the Company's chairman of the board and principal stockholder. The amount of Mr. Berg's funding commitment was reduced in connection with the purchase of the Series C-2 Convertible Preferred Stock in July 2005 by Berg & Berg Enterprises LLC ("Berg & Berg"), the purchase of the Series C-1 Convertible Preferred Stock in December 2005 by Berg & Berg, and the convertible notes payable to stockholder discussed in Footnote 8. At December 31, 2006 this funding commitment has been fully utilized by the Company. On July 13, 2005, the Company secured a $20.0 million loan (the "2005 Loan") from a third party finance company, the full amount of which has been drawn down. The loan is guaranteed by Mr. Berg. The loan matures in a lump sum on July 13, 2010. Interest is due monthly based on a floating interest rate. The interest rate is calculated as the greater of 6.75% or the sum of LIBOR Rate, rounded to the nearest 1/16th of 1.0%, plus 4.0% (9.38% as of December 31, 2006). The loan may not be prepaid in whole or in part on or prior to July 12, 2007. The loan may be prepaid during the period beginning on July 13, 2007 through July 12, 2009, with a 1.0% prepayment premium, and on July 13, 2009 and thereafter with no prepayment premium. In connection with the loan, the Company purchased a rate cap agreement to protect against fluctuations in LIBOR for the full amount of the loan for a period of three years. The Company used $2.5 million of the proceeds from the loan to repay a June 30, 2005 draw from Mr. Berg's funding commitment. In connection with the loan both the third party finance company and Mr. Berg received warrants to purchase 600,000 shares of the Company's common stock at a price of $2.74 per share. The warrants are exercisable beginning on the date they were issued and will expire on July 13, 2008. The fair value assigned to these warrants, totaling approximately $2.037 million, has been recorded as a discount on the debt and will be accreted as interest expense over the life of the loan. The warrants were valued using the Black-Scholes valuation method using the assumptions of a life of 36 months, 96.45% volatility, and a risk free rate of 3.88%. Also in connection with the loan, the Company incurred a loan commitment fee and attorney's fees which, in addition to the interest rate cap agreement, have been recorded as a discount on the debt and will be accreted as interest expense. Through December 31, 2006, a total of approximately $742,000 has been accreted and included as interest expense. Interest payments on the loan are currently being paid on a monthly basis. In October 2001, the Company entered into a loan agreement ("2001 Loan") with Berg & Berg. Under the terms of the agreement, Berg & Berg agreed to advance the Company funds of up to $20 million between the date of the agreement and September 30, 2003. Interest on the 2001 Loan accrues at 8.0% per annum, payable from time to time. On July 13, 2005, Berg & Berg agreed to extend the maturity date for the loan principal and interest from September 30, 2006 to September 30, 2008. On November 8, 2002, the Company and Berg & Berg amended an affirmative covenant in the agreement to acknowledge the Nasdaq SmallCap Market as an acceptable market for the listing of the Company's Common Stock. 9 In conjunction with the 2001 Loan, Berg & Berg received a warrant to purchase 1,402,743 shares of the Company's common stock at the price of $3.208 per share. The warrants were exercisable beginning on the date they were issued and expire on September 30, 2008. The fair value assigned to these warrants, totaling approximately $2.768 million has been reflected as additional consideration for the debt financing, recorded as a discount on the debt and accreted as interest expense over the life of the loan. The warrants were valued using the Black-Scholes method using the assumptions of a life of 47 months, 100% volatility, and a risk-free rate of 5.5%. Through December 31, 2006, a total of $1.541 million has been accreted and included as interest expense. The amounts charged to interest expense on the outstanding balance of the loan for the three-month periods ended December 31, 2006 and 2005 were $409,000, respectively. Interest payments on the loan are currently being deferred, and are recorded as long-term interest. The accrued interest amounts for the 2001 Loan were $7.93 million and $6.708 million as of December 31, 2006 and March 31, 2006, respectively. In July 1998, the Company entered into an amended loan agreement ("1998 Loan") with Berg & Berg that allows the Company to borrow, prepay and re-borrow up to $10 million principal under a promissory note on a revolving basis. In November 2000, the 1998 Loan agreement was amended to increase the maximum amount to $15 million. As of December 31, 2006, the Company had an outstanding balance of $14.95 million under the 1998 Loan agreement. The loan bears interest at one percent over lender's borrowing rate (9.0% at December 31, 2006). On July 13, 2005, Berg & Berg agreed to extend the maturity date for the loan principal and interest from September 30, 2006 to September 30, 2008. On November 8, 2002, the Company and Berg & Berg amended an affirmative covenant in the agreement to acknowledge the Nasdaq SmallCap Market as an acceptable market for the listing of the Company's Common Stock. The accrued interest amounts for the 1998 Loan were $9.813 million and $8.51 million as of December 31, 2006 and March 31, 2006, respectively. In fiscal 1999, the Company issued warrants to purchase 594,031 shares of common stock to Berg & Berg in conjunction with the 1998 Loan agreement, as amended. The warrants were valued using the Black-Scholes valuation method and had an average weighted fair value of approximately $3.63 per warrant at the time of issuance, using the assumptions of a life of 36 months, 96.45% volatility, and a risk free rate of 3.88%. The fair value of these warrants, totaling approximately $2.159 million, has been reflected as additional consideration for the debt financing, recorded as a discount on the debt and accreted as interest expense to be amortized over the life of the line of credit. As of December 31, 2006, a total of $2.159 million has been accreted. Interest payments on the loan are currently being deferred, and are recorded as long-term interest. All of our assets are pledged as collateral under the 2001 Loan and the 1998 Loan to stockholder. 10. COMMITMENTS AND CONTINGENCIES: WARRANTIES: The Company has established a warranty reserve in connection with the sale of N-Charge(TM) Power Systems covering a 12-month warranty period during which the Company would provide a replacement unit to any customer returning a purchased product because of a product performance issue. The Company has also established a warranty reserve in relation to the sale of its battery pack for Segway, Inc. and its U-Charge(R) Power Systems. In addition, the Company has established a reserve for its 30-day right of return policy under which a direct customer may return a purchased N-Charge(TM) Power System. The total warranty liability as of December 31, 2006 is $1.292 million included in accrued expenses on the Company's balance sheet. LITIGATION: On February 14, 2006, Hydro-Quebec filed an action against Valence Technology, Inc. in the United States District Court for the Western District of Texas (Hydro-Quebec v. Valence Technology, Civil Action No. A06CA111). In its amended complaint filed April 13, 2006, Hydro-Quebec alleges that Saphion(R) Technology, the technology utilized in all of the Company's commercial products, infringes U.S. Patent No.'s 5,910,382 and 6,514,640 exclusively licensed to Hydro-Quebec. Hydro-Quebec's amended 10 complaint seeks injunctive relief and monetary damages. The action is in the initial pleading state and the Company has filed a response denying the allegations. The Court has issued a stay of proceedings pending the outcome of reexaminations of the two patents by the US Patent and Trademark Office. The Company's management believes the action by Hydro-Quebec is without merit and intends to vigorously defend the lawsuit, as well as pursue all of its available legal remedies. The Company is subject to, from time to time, various claims and litigation in the normal course of business. In the opinion of management, all pending legal matters are either covered by insurance or, if not insured, will not have a material adverse impact on the Company's consolidated financial statements. 11. REDEEMABLE CONVERTIBLE PREFERRED STOCK: On June 2, 2003, the Company issued 1,000 shares of Series C Convertible Preferred Stock and warrants to purchase the Company's common stock for $10,000 per share, raising net proceeds of $9.416 million. On January 22, 2004, the holder of the Series C Convertible Preferred Stock converted 139 of its 1,000 shares with the principal amount of $1.39 million, including accrued and unpaid dividends, into 327,453 shares of the Company's common stock at the conversion price of $4.25 per share. On November 30, 2004, the Company entered into an amendment and exchange agreement to exchange all outstanding 861 shares of the Company's Series C Convertible Preferred Stock, representing $8.6 million of principal. The Series C Convertible Preferred Stock was exchanged for 431 shares of Series C-1 Convertible Preferred Stock, with a stated value of $4.3 million, and 430 shares of Series C-2 Convertible Preferred Stock, with a stated value of $4.3 million. When issued, the Series C-1 Convertible Preferred Stock and Series C-2 Convertible Preferred Stock were convertible into common stock at $4.00 per share. Each series carries a 2% annual dividend rate, payable quarterly in cash or shares of common stock, and were redeemable on December 15, 2005. The Company has the right to convert the preferred stock if the average of the dollar-volume weighted average price of the Company's common stock for a ten-day trading period is at or above $6.38 per share. If the preferred shares are not redeemed in accordance with their terms, the holder of the preferred stock shall have the option to require the Company to convert all or part of the redeemed shares at a price of 95% of the lowest closing bid price of the Company's common stock during the three days ending on and including the conversion date. The preferred shares are currently outstanding and subject to redemption or conversion at the holder's discretion. Pursuant to assignment agreements entered into between the Company and Berg & Berg on July 14, 2005 and December 14, 2005, Berg & Berg purchased all of the outstanding Series C-1 Convertible Preferred Stock and Series C-2 Convertible Preferred Stock from its original holder. Pursuant to the terms of the assignment agreement, Berg & Berg agreed that the failure of the Company to redeem the preferred stock on December 15, 2005 did not constitute a default under the certificate of designations and has waived the accrual of any default interest applicable in such circumstance. In exchange, the Company has agreed (i) that the Series C-1 Convertible Preferred Stock may be converted, at any time, into the Company's common stock at the lower of $4.00 per share or the closing bid price of the Company's common stock on December 13, 2005 ($1.98) and (ii) that the Series C-2 Convertible Preferred Stock may be converted, at any time, into the Company's common stock at the lower of $4.00 per share or the closing bid price of the Company's common stock on July 13, 2005 ($2.96). In connection with the issue of the original issuance of the Series C Convertible Preferred Stock, in June 2003, the Company issued to the Series C Convertible Preferred Stock original holder a warrant to purchase 352,900 shares of the Company's common stock. The warrant is exercisable at a purchase price of $5.00 per share and expires in June 2008. The warrant was valued using the Black-Scholes valuation model. The warrant was recorded to additional paid in capital at its relative fair value to the Series C Convertible Preferred Stock at $933,000. Accretion to the remaining redemption value of $8.61 million was recorded over the eighteen-month period of the Series C Convertible Preferred Stock ending December 2, 2004. 12. STOCK-BASED COMPENSATION The Company has a stock option plan (the "1990 Plan") under which options granted may be incentive stock options or supplemental stock options. Options are to be granted at a price not less than fair market value (incentive options) or 85% of fair market value (supplemental options) on the date of grant. The 11 options vest as determined by the Board of Directors and are generally exercisable over a five-year period. Unvested options are canceled and returned to the 1990 Plan upon an employee's termination. Generally, vested options, not exercised within three months of termination, are also canceled and returned to the Plan. The 1990 Plan terminated on July 17, 2000, and as such, options may not be granted after that date. Options granted prior to July 17, 2000 expire no later than ten years from the date of grant. In February 1996, the Board of Directors adopted a stock plan for outside Directors (the "1996 Non-Employee Director's Stock Option Plan"). The plan provides that new directors will receive an initial stock option of 100,000 shares of common stock upon their election to the Board. The exercise price for this initial option will be the fair market value on the day it is granted. This initial option will vest one-fifth on the first and second anniversaries of the grant of the option, and quarterly over the next three years. A director who had not received an option upon becoming a director will receive an initial stock option of 100,000 shares on the date of the adoption of the plan. During the first and second quarter of fiscal 2007, no shares were granted under this plan. At December 31, 2006, the Company had 21,260 shares available for grant under the 1996 Non-Employee Director's Stock Option Plan. In October 1997, the Board of Directors adopted the 1997 Non-Officer Stock Option Plan (the "1997 Plan"). The Company may grant options to non-officer employees and consultants under the 1997 Plan. Options are to be granted at a price not less than fair market value (incentive options) on the date of grant. The options vest as determined by the Board of Directors, generally quarterly over a three- or four-year period. The options expire no later than ten years from the date of grant. Unvested options are canceled and returned to the 1997 Plan upon an employee's termination. Vested options, not exercised within three months of termination, also are canceled and returned to the 1997 Plan. During the first and second quarter of fiscal 2007, no shares were granted under this plan. At December 31, 2006, the Company had 833,940 shares available for grant under the 1997 Plan. In January 2000, the Board of Directors adopted the 2000 Stock Option Plan (the "2000 Plan"). The Company may grant incentive stock options to employees and non-statutory stock options to non-employee members of the Board of Directors and consultants under the 2000 Plan. Options are to be granted at a price not less than fair market value on the date of grant. In the case of an incentive stock option granted to an employee who owns stock possessing more than 10% of the total combined voting power of all classes of stock of the Company or any affiliate, the option is to be granted at a price not less than 110% of the fair market value on the date of grant. The options are exercisable as determined by the Board of Directors, generally over a four-year period. The options expire no later than ten years from the date of grant. Unvested options are canceled and returned to the 2000 Plan upon an employee's termination. Vested options, not exercised within three months of termination, also are canceled and returned to the 2000 Plan. During the first, second, and third quarter of fiscal 2007, 681,000 shares were granted under this plan. At December 31, 2006, the Company had 2,368,822 shares available for grant under the 2000 Plan. When options are exercised the Company issues new shares to the grantee. Aggregate option activity is as follows (shares in thousands): Outstanding Options ---------------------------------------------------- Number of Weighted Average Shares Exercise Price ----------------------- ------------------------- Balance at March 31, 2006 9,045 $ 4.97 ----------------------- ------------------------- Granted 681 $ 1.81 Exercised (151) $ 1.49 Canceled (3,600) $ 4.82 ----------------------- ------------------------- Balance at December 31, 2006 5,975 $ 4.52 ======================= ========================= 12 The following table summarizes information about fixed stock options outstanding at December 31, 2006 (shares in thousands):
Options Outstanding Options Exercisable --------------------------------------------------------------------------------------------- Weighted Average Weighted Remaining Average Range of Number Contractual Life Weighted Average Number Exercise Exercise Prices Outstanding (years) Exercise Price Exercisable Price ------------------------------------------------------------------------------------------------------------------------------ $0.63 - $1.99 1,410 7.82 1.65 373 1.49 $1.99 - $4.62 2,753 7.58 3.05 732 3.37 $4.62 - $10.06 1,538 2.35 6.49 1,480 6.54 $10.06 - $15.75 60 3.65 11.73 60 11.73 $15.75 - $23.56 113 3.14 20.41 113 20.41 $23.56 - $34.62 101 2.92 32.93 101 32.93 ------------------------------------------------------------------------------------------------------------------------------ $0.63 - $34.62 5,975 6.09 4.52 2,859 6.66
Compensation expense for stock plans has been determined based on the fair value at the grant date for options granted in the current fiscal year. For the three- and nine-months ended December 31, 2006, $426,000 and $1.132 million of stock based compensation expense has been included in operating expenses in the condensed consolidated statements of operations and comprehensive loss. For fiscal year 2006, compensation expense was not recorded consistent with the provisions of SFAS 123, as amended by SFAS 148. Had compensation expense been recorded the pro forma net loss would have been reported as follows (in thousands):
THREE MONTHS ENDED NINE MONTHS ENDED DECEMBER 31, DECEMBER 31, 2005 2005 -------------------- --------------------- Net loss available to stockholders - as reported $ (7,106) $ (23,357) Add: stock-based compensation expense, net of related taxes (639) (1,917) -------------------- --------------------- Net loss available to stockholders - pro forma $ (7,745) $ (25,274) ==================== ===================== Net loss available to stockholders per share, basic and $ (0.08) $ (0.26) diluted - as reported Net loss available to stockholders per share, basic and $ (0.09) $ (0.28) diluted - pro forma As of December 31, 2006 the Company had a total of $3.021 million in compensation costs related to stock-based compensation to recognize over a remaining service period of 5 years for non-vested options. The fair value of each option grant is estimated at the date of grant using the Black-Scholes pricing model with the following weighted average assumptions for grants in fiscal years 2007 and 2006: DECEMBER 31, 2006 2005 --------------- ---------------- Risk-free interest rate 4.65% 4.35% Expected life 5.0 years 5.0 years Volatility 83.19% 92.55% Dividend yield None None
13 13. RELATED PARTY TRANSACTIONS: On December 27, 2006, West Coast Venture Capital purchased 613,497 shares of the Company's common stock for $1.0 million. The purchase price of $1.63 per share equaled the closing bid price of the Company's common stock as of December 26, 2006. On December 15, 2006, West Coast Venture Capital purchased 549,541 shares of the Company's common stock for $1.0 million. The purchase price of $1.82 per share equaled the closing bid price of the Company's common stock as of December 15, 2006. On August 17, 2006, West Coast Venture Capital purchased 534,759 shares of the Company's common stock for $1.0 million. The purchase price of $1.87 per share equaled the closing bid price of the Company's common stock as of August 16, 2006. On August 3, 2006, West Coast Venture Capital purchased 1,298,702 shares of the Company's common stock for $2.0 million. The purchase price of $1.54 per share equaled the closing bid price of the Company's common stock as of August 3, 2006. On May 11, 2006, West Coast Venture Capital purchased 646,552 shares of the Company's common stock for $1.5 million. This represented a funding on the $20.0 million funding commitment previously made by Berg & Berg. The purchase price of $2.32 per share equaled the closing bid price of the Company's common stock as of May 10, 2006. On April 3, 2006, West Coast Venture Capital purchased 401,606 shares of the Company's common stock for $1.0 million. This represented a funding on the $20.0 million funding commitment previously made by Berg & Berg. The purchase price of $2.49 per share equaled the closing bid price of the Company's common stock as of March 31, 2006. In June 2005, Mr. Carl Berg, our chairman of the board and principal stockholder, agreed to provide a funding commitment of $20.0 million. On June 30, 2005, the Company drew down $2.5 million of this commitment. This draw took the form of a loan at a 5.0% annual interest rate and was repaid with proceeds from a July 2005 loan from a third party finance company. This funding commitment was reduced by $4.3 million upon the purchase of the Series C-2 Convertible Preferred Stock on July 14, 2005 by Berg & Berg. On December 14, 2005, Mr. Berg's funding commitment was further reduced by $4.3 million in connection with the purchase of the Company's Series C-1 Convertible Preferred Stock by Berg & Berg. In February and March 2006, the Company issued convertible promissory notes in favor of Berg & Berg in an aggregate principal amount of $6.0 million (the "Notes"). The Notes accrued interest at the annual rate of 8.0% and matured on March 30 and June 30, 2006. The principal amount of the Notes, together with accrued interest, was converted into 2,965,870 shares of common stock of the Company, in accordance with their terms on April 3, 2006. In June 2004, Mr. Berg agreed to provide a $20 million backup equity funding commitment. This funding commitment was in the form of an equity line of credit and allowed the Company to request Mr. Berg to purchase shares of common stock from time to time at the average closing bid price of the stock for the five days prior to the purchase date. As of June 30, 2006, the Company had drawn down all of this commitment. This commitment can be reduced by the amount of net proceeds received from the sale of the building or equipment from the Company's Mallusk, Northern Ireland facility or the amount of net proceeds in a debt or equity transaction, and may be increased if necessary under certain circumstances. As of the date of this report, Mr. Berg has not requested that his commitment be reduced. In October 2001, the Company entered into a loan agreement ("2001 Loan") with Berg & Berg. Under the terms of the agreement, Berg & Berg agreed to advance the Company funds of up to $20 million between the date of the agreement and September 30, 2003. Interest on the 2001 Loan accrues at 8.0% per annum, payable from time to time. On July 13, 2005, Berg & Berg agreed to extend the maturity date for the loan principal and interest from September 30, 2006 to September 30, 2008. On November 8, 2002, the 14 Company and Berg & Berg amended an affirmative covenant in the agreement to acknowledge the Nasdaq SmallCap Market as an acceptable market for the listing of the Company's Common Stock. In July 1998, the Company entered into an amended loan agreement (the "1998 Loan") with Berg & Berg that allows the Company to borrow, prepay and re-borrow up to $10.0 million principal under a promissory note on a revolving basis. In November 2000, the 1998 Loan agreement was amended to increase the maximum amount to $15.0 million. As of December 31, 2006, the Company had an outstanding balance of $14.95 million under the 1998 Loan agreement. The loan bears interest at one percent over the lender's borrowing rate (approximately 9.0% at December 31, 2006). On July 13, 2005, the parties agreed to extend the loan's maturity date from September 30, 2006 to September 30, 2008. On January 1, 1998, the Company granted options to Mr. Dawson, the Company's then Chairman of the Board, Chief Executive Officer and President, an incentive stock option to purchase 39,506 shares, which was granted pursuant to the Company's 1990 Plan (the "1990 Plan"). Also, an option to purchase 660,494 shares was granted pursuant to the Company's 1990 Plan and an option to purchase 300,000 shares was granted outside of any equity plan of the Company, neither of which were incentive stock options (the "Nonstatutory Options"). The exercise price of all three options is $5.0625 per share, the fair market value on the date of the grant. The Compensation Committee of the Company approved the early exercise of the Nonstatutory Options on March 5, 1998. The options permitted exercise by cash, shares, full recourse notes or non-recourse notes secured by independent collateral. The Nonstatutory Options were exercised on March 5, 1998 with non-recourse promissory notes in the amounts of $3,343,750 ("Dawson Note One") and $1,518,750 ("Dawson Note Two") (collectively, the "Dawson Notes") secured by the shares acquired upon exercise plus 842,650 shares previously held by Mr. Dawson. As of December 31, 2006, principal and interest amounts of $3.50 million and $1.59 million were outstanding under Dawson Note One and Dawson Note Two, respectively, and under each of the Dawson Notes, interest from the issuance date accrues on unpaid principal at the rate of 5.77% per annum, or at the maximum rate permissible by law, whichever is less. On April 20, 2005, the Company's Board of Directors approved a resolution to extend the maturity dates of each of the Dawson Notes from September 5, 2005 to September 5, 2007. As of December 31, 2006 and March 31, 2006, amounts of $5.16 million were outstanding under Dawson Note One and Dawson Note Two. Under each of the Dawson Notes, interest from the Issuance Date accrues on unpaid principal at the rate of 5.69% per annum, or at the maximum rate permissible by law, whichever is less. In accordance with the Dawson Notes, interest is due annually, has been paid through March 4, 2005, and is in arrears at December 31, 2006. 14. SEGMENT AND GEOGRAPHIC INFORMATION: The Company's chief operating decision maker is its Chief Executive Officer, who reviews operating results to make decisions about resource allocation and to assess performance. The Company's chief operating decision maker views results of operations of a single operating segment, the development and marketing of the Company's Saphion(R) technology. The Company's Chief Executive Officer has organized the Company functionally to develop, market and manufacture Saphion(R) products. Long-lived asset information by geographic area at December 31, 2006 and March 31, 2006 is as follows (in thousands):
December 31, 2006 March 31, 2006 ---------------------- --------------------- United States $ 601 $ 648 International 3,048 2,692 ---------------------- --------------------- Total $ 3,649 $ 3,340 ====================== =====================
15 Revenues by geographic area for the three- and nine-month periods ended December 31, 2006 and 2005 are as follows (in thousands):
Three Months Ended December 31, Nine Months Ended December 31, -------------------------------------- ------------------------------------- 2006 2005 2006 2005 ------------------ ---------------- ----------------- ---------------- United States $ 1,843 $ 4,273 $ 9,835 $ 12,610 International 475 546 2,027 1,132 ------------------ ---------------- ----------------- ---------------- Total $ 2,318 $ 4,819 $ 11,862 $ 13,742 ================== ================ ================= ================
15. SUBSEQUENT EVENTS: From January 1, 2007 through February 2, 2007, the Company placed 823,000 shares through a Controlled Equity Common Stock offering for a total net proceeds amount of $1.274 million. On January 18, 2007, West Coast Venture Capital purchased 662,252 shares of the Company's common stock for $1.0 million. The purchase price of $1.51 per share equaled the closing bid price of the Company's common stock as of January 17, 2007. On February 2, 2007 West Coast Venture Capital purchased 657,894 shares of the Company's common stock for $1.0 million. The purchase price of $1.52 per share equaled the closing bid price of the Company's common stock as of February 1, 2007. 16 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS THIS REPORT CONTAINS STATEMENTS THAT CONSTITUTE "FORWARD-LOOKING STATEMENTS" WITHIN THE MEANING OF SECTION 21E OF THE SECURITIES EXCHANGE ACT OF 1934, AS AMENDED, AND SECTION 27A OF THE SECURITIES ACT OF 1933, AS AMENDED. THE WORDS "EXPECT," "ESTIMATE," "ANTICIPATE," "PREDICT," "BELIEVE" AND SIMILAR EXPRESSIONS AND VARIATIONS THEREOF ARE INTENDED TO IDENTIFY FORWARD-LOOKING STATEMENTS. THESE STATEMENTS APPEAR IN A NUMBER OF PLACES IN THE REPORT AND INCLUDE STATEMENTS REGARDING THE INTENT, BELIEF OR CURRENT EXPECTATIONS OF VALENCE TECHNOLOGY, INC., TO WHICH WE REFER IN THIS REPORT AS THE COMPANY, WE OR US, OUR DIRECTORS OR OFFICERS WITH RESPECT TO, AMONG OTHER THINGS, (A) TRENDS AFFECTING OUR FINANCIAL CONDITION OR RESULTS OF OPERATIONS, (B) OUR PRODUCT DEVELOPMENT STRATEGIES, (C) TRENDS AFFECTING OUR MANUFACTURING CAPABILITIES; (D) TRENDS AFFECTING THE COMMERCIAL ACCEPTABILITY OF OUR PRODUCTS, AND (E) OUR BUSINESS AND GROWTH STRATEGIES. YOU ARE CAUTIONED NOT TO PUT UNDUE RELIANCE ON FORWARD-LOOKING STATEMENTS. FORWARD-LOOKING STATEMENTS ARE NOT GUARANTEES OF FUTURE PERFORMANCE AND INVOLVE RISKS AND UNCERTAINTIES, AND ACTUAL RESULTS MAY DIFFER MATERIALLY FROM THOSE PROJECTED IN THIS REPORT, FOR THE REASONS, AMONG OTHERS, DISCUSSED IN THE SECTIONS - "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS" AND "CAUTIONARY STATEMENTS AND RISK FACTORS." THE FOLLOWING DISCUSSION SHOULD BE READ IN CONJUNCTION WITH OUR FINANCIAL STATEMENTS AND RELATED NOTES, WHICH ARE A PART OF THIS REPORT OR INCORPORATED BY REFERENCE TO OUR REPORTS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION, TO WHICH WE REFER IN THIS REPORT AS THE COMMISSION. WE UNDERTAKE NO OBLIGATION TO PUBLICLY REVISE THESE FORWARD-LOOKING STATEMENTS TO REFLECT EVENTS OR CIRCUMSTANCES THAT ARISE AFTER THE DATE HEREOF. THE RESULTS FOR THE THREE- AND NINE-MONTH PERIOD ENDED DECEMBER 31, 2006 ARE NOT NECESSARILY INDICATIVE OF THE RESULTS TO BE EXPECTED FOR THE ENTIRE FISCAL YEAR ENDING MARCH 31, 2007. OVERVIEW We have commercialized the first phosphate-based lithium-ion technology and have brought to market several products utilizing this technology. Our mission is to drive the wide adoption of high-performance, safe, low-cost energy storage systems by drawing on the numerous benefits of our latest battery technology, Saphion(R), the extensive experience of our management team and the significant market opportunity available to us. The introduction of lithium-ion technology to the market was the result of consumer demand for high-energy, small battery solutions to power portable electronic devices. The battery industry, consequently, focused on high-energy solutions at the expense of safety. Additionally, because of safety concerns, lithium-ion technology has been limited in adoption to small-format applications, such as notebook computers, cell phones and personal digital assistant devices. Our Saphion(R) technology, a phosphate-based cathode material, addresses the need for a safe lithium-ion solution, especially in large-format applications. Our business plan and strategy focus on the generation of revenue from a combination of product sales and licensing activities, while minimizing costs through a manufacturing plan that utilizes partnerships with contract manufacturers, and internal manufacturing efforts through our wholly owned subsidiaries in China. These subsidiaries initiated operations in late fiscal 2005. We plan to drive the adoption of our Saphion(R) technology by offering existing and new solutions that differentiate our own products and customers' products in both the large-format and small-format markets. In addition, we will seek to expand the fields of use of our Saphion(R) technology through the licensing of our intellectual property related to our battery chemistries and manufacturing processes. To date, we have achieved the following successes in implementing our business plan: o Proven the commercial feasibility of our technology; o Launched new Saphion(R) technology-based products, including our N-Charge(TM) Power System family and introduced our U-Charge(R) Power System family of products, intended to be a direct replacement for existing lead acid battery applications in the market today and to compete for emerging motive applications; o Established relationships with top tier customers across many of the target markets for our products, while continuing to build our brand awareness in multiple channels; 17 o Closed and sold our high-cost manufacturing facility in Northern Ireland and established key manufacturing partnerships in Asia to facilitate low-cost, quality production; o Established key manufacturing partnerships in Asia to facilitate low-cost, quality production; o Announced a joint technology development program with Segway Inc. to develop long-range battery packs using our Saphion(R) technology for Segway's human transporter product. Production of the Segway battery packs began in March 2005 and they are currently available through Segway's distribution channel; o Consolidated three China facilities into one site to serve as our powder production, research and development, and assembly facility; o Closed the Oxford, UK research facility; and; o Developed a phosphate-based lithium-ion power cell. Batteries designed with power cells can be discharged and charged more quickly than batteries designed with energy cells. This makes them ideal for applications that require powerful bursts rather than slow discharges of energy, such as portable appliances and future generations of hybrid and electric vehicles. Our new Saphion(R) power cell offers significant cycling, weight and longevity benefits over nickel metal hydride (NiMeH) and nickel-cadmium (NiCd) battery technologies. At $2.3 million, our revenue for the third quarter of fiscal 2007 was within our previously announced revenue guidance. Third quarter revenue for fiscal 2007 decreased $2.5 million, or 51.9%, from the third quarter of fiscal 2006. Gross margin loss was (20.0%) for the third quarter of fiscal 2007, compared with gross margin loss of (23.9%) for the third quarter of fiscal 2006. During the third quarter of fiscal 2007, we continued our efforts to drive down costs while increasing production at our subsidiaries in China, which became operational in late fiscal 2005. Our business headquarters is located in Austin, Texas, our research and development center is in Las Vegas, Nevada, our European sales is in Mallusk, Northern Ireland, our Asia sales office in Shanghai, China and our manufacturing and product development center is in Suzhou, China. BASIS OF PRESENTATION, CRITICAL ACCOUNTING POLICIES AND ESTIMATES We prepare our condensed consolidated financial statements in conformity with generally accepted accounting principles in the United States. The preparation of our financial statements requires us to make estimates and assumptions that affect reported amounts. We believe our most critical accounting policies and estimates relate to revenue recognition and impairment of long-lived assets. Our accounting policies are described in the Notes to Condensed Consolidated Financial Statements, Note 4, Summary of Significant Accounting Policies. The following further describes the methods and assumptions we use in our critical accounting policies and estimates: REVENUE RECOGNITION We generate revenues from sales of products including batteries and battery systems, and from licensing fees and royalties per technology license agreements. Product sales are recognized when all of the following criteria are met: persuasive evidence of an arrangement exists, delivery has occurred, seller's price to the buyer is fixed and determinable, and collectibility is reasonably assured. Product shipments that are not recognized as revenue during the period shipped, primarily product shipments to resellers that are subject to right of return, are recorded as deferred revenue and reflected as a liability on our balance sheet. For reseller shipments where revenue recognition is deferred, we record revenue based upon the reseller-supplied reporting of sales to their end customers or their inventory reporting. For direct customers, we estimate a return rate percentage based upon our historical experience. We review this estimate on a quarterly basis. From time to time we provide sales incentives in the form of rebates or other price adjustments; these are recorded as reductions to revenue as incurred. Licensing fees are recognized as revenue upon completion of an executed agreement and delivery of licensed information, if there are no significant 18 remaining vendor obligations and collection of the related receivable is reasonably assured. Royalty revenues are recognized upon licensee revenue reporting and when collectibility is reasonably assured. IMPAIRMENT OF LONG-LIVED ASSETS We perform a review of long-lived tangible and intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of these assets is measured by comparison of their carrying amounts to future undiscounted cash flows that the assets are expected to generate. If long-lived assets are considered to be impaired, the impairment to be recognized equals the amount by which the carrying value of the assets exceeds its fair value and is recorded in the period the determination was made. RESULTS OF OPERATIONS The following table summarizes the results of our operations for the three-months (also referred to as the third quarter) and nine-months ended December 31, 2006 and December 31, 2005:
Three Months Ended Nine Months Ended ---------------------------------------- ------------------------------------------ December 31, 2006 December 31, 2005 December 31, 2006 December 31, 2005 ---------------------------------------- ------------------------------------------ (dollars in thousands) % of Revenue % of Revenue % of Revenue % of Revenue Battery and systems sales $ 2,085 90% $ 4,565 95% $ 11,261 95% $ 13,171 96% Licensing and royalty 233 10% 254 5% 601 5% 571 4% ---------------------------------------- ------------------------------------------ Total revenues 2,318 100% 4,819 100% 11,862 100% 13,742 100% Gross profit (loss) (464) -20% (1,152) -24% 638 5% (4,900) -36% Operating expenses 3,994 172% 4,518 94% 12,397 105% 14,728 107% Operating loss (4,458) -192% (5,670) -118% (11,759) -99% (19,628) -143% ---------------------------------------- ------------------------------------------ Net loss (5,919) -255% (7,056) -146% (16,258) -137% $ (23,199) -169% ======================================== ==========================================
REVENUES AND GROSS MARGIN BATTERY AND SYSTEM SALES: Battery and system sales decreased by $2.48 million, or (54.3%), to $2.085 million in the third quarter of fiscal 2007 from $4.565 million in the third quarter of fiscal 2006. Battery and system sales decreased by $1.91 million, or (14.5%), in the first nine-months of fiscal 2007 from $13.171 million in the first nine-months of fiscal 2006. The decrease in battery and system sales was primarily the result of a revised shipping schedule of batteries to Segway and a temporary shortage of key components. Overall, we saw a 68% decrease in large-format sales in the third quarter of fiscal 2007 compared to the second quarter of fiscal 2007. These systems comprised 62% of our total revenue for the three months ended December 31, 2006. Due to the shift in our revenue base from small-format to large-format products and the high cost of doing business in the retail channel during the third quarter of fiscal 2006, we ceased sales of N-Charge products through our retail channels. We continue to sell the N-Charge product through our reseller channels with a continued emphasis in the healthcare and education sectors. Revenues from the sales of our small-format products accounted for 21% and 24% of our total revenue for the three months ended December 31, 2006 and 2005. Product shipments to resellers that are subject to right of return and monies received for future obligations are recorded on the balance sheet as deferred revenue. We had $224,000 in deferred revenue on our balance sheet at December 31, 2006. LICENSING AND ROYALTY REVENUE: Licensing and royalty revenues relate to revenue from licensing agreements for our battery construction technology. Fiscal third quarter 2007 licensing and royalty revenue was $233,000 compared with $254,000 for the same quarter in fiscal 2006. Licensing and royalty revenue was primarily from our license agreement with Amperex Technology Limited (ATL), which makes on-going royalty payments as sales are made using our technology. We expect to continue to pursue a licensing strategy as our Saphion(R) technology receives greater market acceptance. 19 GROSS MARGIN (LOSS): Gross margin as a percentage of revenue was (20.0)% for the third quarter of fiscal 2007 as compared to (23.9%) in the third quarter of fiscal 2006. Gross margin was 5.4% in the first nine-months of fiscal 2007 and was (35.6%) in the first nine-months of fiscal 2006. Gross margins in fiscal 2006 were impacted by the ramp-up cost of the Segway Inc. product as well as the manufacturing transition to China. We have successfully transitioned our battery manufacturing and product assembly operations to contract manufacturers in Asia and as well as our manufacturing and product development operations to our subsidiaries in Suzhou, China. As is the case in the first quarter of 2007, we expect cost of sales to continue to decrease as a percentage of sales as production volumes increase, manufacturing yields improve and as we fully capitalize on our lower-cost manufacturing strategy. OPERATING EXPENSES The following table summarizes operating expenses for the three months and nine months ended December 31, 2006 and December 31, 2005:
Three Months Ended December 31, Nine Months Ended December 31, ---------------------------------------------- ------------------------------------------------ (dollars in thousands) Increase/ % Increase/ % 2006 2005 (Decrease) Change 2006 2005 (Decrease) Change -------- -------- ---------- -------- --------- ---------- ---------- -------- Research and product development 911 $1,185 (274) -23% 2,800 3,961 (1,161) -29% Marketing 663 420 243 58% 1,639 1,661 (22) -1% General and administrative 1,885 2,554 (669) -26% 6,285 9,019 (2,734) -30% Share based Compensation 426 - 426 100% 1,132 - 1,132 100% Depreciation and amortization 193 178 15 8% 599 528 71 13% (Gain)/Loss on disposal of assets (84) 11 (95) -864% (82) (611) (693) -113% Asset impairment charge - 170 (170) -100% - 170 (170) -100% Contract settlement - - - - 24 - 24 100% Total operating expenses 3,994 $4,518 (524) -12% 12,397 $14,728 2,331 -16% Percentage of revenues 172% 94% 105% 107%
During the third quarter of fiscal 2007, operating expenses were 172.3% of revenue and 93.8% of revenue during the same quarter last year. In the first nine-months of fiscal 2007, operating expenses were 104.5% of revenue and were 107.2% of revenue in the first nine-months of fiscal 2006. The year-to-date decrease is primarily the result of personnel and expense reduction actions taken during the last three quarters. We reduced operating expenses by $2.331 million or 15.8% for the first nine-months of fiscal 2007, as compared with the first nine-months of fiscal 2006. RESEARCH AND PRODUCT DEVELOPMENT. Research and product development expenses consist primarily of personnel, equipment and materials to support our efforts to develop battery chemistry and products, as well as to improve our manufacturing processes. Research and product development expenses decreased by $274,000, or 23.1%, to $911,000 for the third quarter of fiscal 2007 from $1.185 million for the third quarter of fiscal 2006. Research and product development expenses decreased by $1.161 million, or 29.3%, in the first nine-months of fiscal 2007 to $2.8 million from $3.961 million in the first nine-months of fiscal 2006. The decrease in research and development expenses is the result of cessation of product development work in our Northern Ireland and Oxford England facilities, as well as reduced temporary staff and consulting expenses and materials usage in our Henderson, Nevada facility. 20 MARKETING. Marketing expenses consist primarily of costs related to sales and marketing personnel, public relations and promotional materials. Marketing expenses of $663,000 in the third quarter of fiscal 2007 were $243,000 higher than the comparable period of fiscal 2006. This increase in marketing expenses is the result of increased marketing efforts in the current quarter. First nine-months of fiscal 2007 marketing expenses of $1.639 million were $22,000 lower than the comparable period in fiscal 2006. The decrease in marketing expenses was the result of reduced spending for consulting related to European market development, and reduced lead generation and media advertising expenditures applicable to the retail channel. We expect marketing expenses to grow as we expand and develop our channels, launch additional Saphion(R) products, and continue our branding efforts. GENERAL AND ADMINISTRATIVE. General and administrative expenses consist primarily of salaries and other related costs for finance, human resources, facilities, accounting, information technology, legal, and corporate-related expenses, including our China initiatives. General and administrative expenses totaled $1.885 million and $2.554 million for the third fiscal quarters of 2007 and 2006, respectively. General and administrative expenses decreased by $2.734 million, or 30.3%, to $6.285 million in the first nine-months of fiscal 2007 from $9.019 million in the first nine-months of fiscal 2006. The decrease was largely due to the continued shift of resources to our Asian operations and improved efficiencies in our US support operations. GAIN ON SALE OF ASSETS. Gains on sales of the facility and production and development equipment from our former Mallusk, Northern Ireland facility were $615,000 in the first quarter of fiscal 2006. The majority of the gain is related to the sale of our Northern Ireland facility property and equipment completed in April 2005. Additionally, we determined that some equipment was not required in our manufacturing and development operations in Suzhou, China, and was sold for fair value. DEPRECIATION AND AMORTIZATION. Depreciation and amortization expenses were $193,000 and $178,000 for the third quarters of fiscal 2006 and 2005, respectively. Depreciation and amortization expenses were $599,000 and $528,000 in the first nine-months of fiscal 2007 and 2006 respectively. The nominal increase in depreciation expense relates to recent additions to property, plant, and equipment in the U.S and in China during the past four fiscal quarters. INTEREST EXPENSE. Interest expense relates to our short-term and long-term debt to stockholders and the long term debt from the third party loan obtained on July 13, 2005. Interest expense was $1.809 million and $1.524 million for the third quarter of fiscal 2007 and 2006, respectively, and was $5.195 million and $3.996 million for the first nine-months of fiscal 2007 and fiscal 2006, respectively. The increase in interest expense is related to only having a partial year of long-term debt outstanding in 2005. SHARE BASED COMPENSATION. Share based compensation of $1.132 million for the first nine-months of 2007 represents compensation costs recognized for all share-based payments granted on or after April 1, 2006 and awards granted to employees prior to April 1, 2006 that remain unvested on that date. LIQUIDITY AND CAPITAL RESOURCES LIQUIDITY At December 31, 2006, the Company's principal sources of liquidity were cash and cash equivalents of $1.88 million. The Company expects our sources of liquidity will not be sufficient for the remaining fiscal year. The Company anticipates product sales during fiscal 2007 from the N-Charge(TM) Power System and the battery pack for Segway, Inc., which are subject to seasonal fluctuations and the sale of the U-Charge(R) Power System will be insufficient to cover the Company's operating expenses. Management depends upon our ability to periodically arrange for additional equity or debt financing to meet our liquidity requirements. Unless our product sales are greater than management currently forecasts or there are other changes to our business plan, we will need to arrange for additional financing within the next three to six months to fund operating and capital needs. This financing could take the form of debt or equity. Given our historical operating results and the amount of our existing debt, as well as the other factors, we may not be able to arrange for debt or equity financing from third parties on favorable terms or at all. 21 The Company's cash requirements may vary materially from those now planned because of changes in the Company's operations including the failure to achieve expected revenues, greater than expected expenses, changes in OEM relationships, market conditions, the failure to timely realize the Company's product development goals, and other adverse developments. These events could have a negative impact on the Company's available liquidity sources during the remaining fiscal year. As a result of our limited cash resources and history of operating losses, our previous auditors have expressed in their report on our consolidated financial statements included in our audited March 31, 2006 consolidated financial statements that there is substantial doubt about our ability to continue as a going concern. We presently have no further commitments for financing by Mr. Berg or any other source. If we are unable to obtain financing from Mr. Berg or others on terms acceptable to us, or at all, we may be forced to cease all operations and liquidate our assets. Our cash requirements may vary materially from those now planned because of changes in our operations, including the failure to achieve expected revenues, greater than expected expenses, changes in OEM relationships, market conditions, the failure to timely realize our product development goals, and other adverse developments. These events could have a negative impact on our available liquidity sources during fiscal 2007. The following table summarizes our statement of cash flows for the nine months ended December 31, 2006 and 2005:
Nine Months Ended December 31, ------------------------------------ -- (dollars in thousands) 2006 2005 --------------- ----------------- Net cash flows provided by (used in) Operating activities $ (15,467) $ (27,502) Investing activities (1,415) (744) Financing activities 18,077 27,352 Effect of foreign exchange rates 73 226 --------------- ----------------- Net increase/(decrease) in cash and cash equivalents $ 1,268 $ (688) =============== =================
Our use of cash from operations the first nine-months of fiscal 2007 and fiscal 2006 was $15.467 million and $27.502 million, respectively. The cash used for operating activities during the first nine months of our fiscal 2007 operating activities was primarily for operating losses and working capital. Cash used for operating losses in the first nine months of fiscal 2007 decreased from the same period of fiscal 2006 by $12.035 million. Working capital in the first nine months of fiscal 2007 was more than working capital in the first nine months of fiscal 2006 by $3.393 million. The increase in working capital was primarily due to increases in inventory. In the first nine months of fiscal 2007, we had a net decrease in net cash from investing activities of $1.415 million. Cash used in investing activities during the first nine months of fiscal 2006 relates to purchases of equipment domestically and in China. We obtained cash from financing activities of $18.077 million and $27.352 million during the first nine months of fiscal 2007 and 2006, respectively. The financing activities in the first nine months of fiscal 2007 included $5.0 million convertible short term notes payable to Berg & Berg, a $7.5 million issuance of common stock to West Coast Venture Capital, an affiliate of Mr. Berg, and $245,000 in stock option exercises. In addition, the Company received net proceeds of $5.332 million from the sale of stock under a controlled equity offering agreement with Cantor Fitzgerald. As a result of the above, we had a net increase in cash and cash equivalents of $1.268 million during the first nine months of fiscal 2007. CAPITAL COMMITMENTS AND DEBT At December 31, 2006, we had commitments for capital expenditures for the next 12 months of approximately $761,000 relating to manufacturing equipment. We may require additional capital expenditures in order to meet 22 greater demand levels for our products than are currently anticipated and/or to support our transition of operations to China. Our cash obligations for short-term and long-term debt, gross of unaccreted discount, consisted of: (Dollars in thousands) December 31, 2006 --------------------- 1998 long-term debt to Berg & Berg $ 14,950 2001 long-term debt to Berg & Berg 20,000 2005 long-term debt to third-party 20,000 Interest on long-term debt 17,743 Current portion of interest on long-term debt 126 --------------------- Total long-term debt $ 72,819 ===================== Repayment obligations of short-term and long-term debt principal as of December 31, 2006 are:
Fiscal year ---------------------------------------------------------------------------------------- (Dollars in thousands) 2007 2008 2009 2010 2011 Thereafter Total ------- -------- --------- --------- --------- ------------ ---------- Principal repayment - - $34,950 - $20,000 - $54,950
If not converted to common stock, the redemption obligation for the Series C-1 Convertible Preferred Stock and Series C-2 Convertible Preferred Stock is $8.6 million. The Series C-1 Convertible Preferred Stock may be converted, at any time, into shares of our common stock at the lower of $4.00 or the closing price of our common stock on the conversion date, provided the conversion price can be no lower than $1.98, the closing price of the common stock on December 13, 2005. The Series C-2 Convertible Preferred Stock may be converted, at any time, into shares of our common stock at the lower of $4.00 or the closing price of our common stock on the conversion date, provided the conversion price can be no lower than $2.96, the closing bid price of our common stock on July 13, 2005. The preferred shares are currently outstanding and subject to redemption or conversion at the holder's discretion. If cash flow from operations is not adequate to meet debt obligations, additional debt or equity financing will be required. There can be no assurance that we could obtain the additional financing. INFLATION Historically, our operations have not been materially affected by inflation. However, our operations may be affected by inflation in the future. TABULAR DISCLOSURE OF CONTRACTUAL OBLIGATIONS The following table sets forth, as of December 31, 2006, our scheduled principal, interest and other contractual annual cash obligations due for each of the periods indicated below (in thousands):
PAYMENT DUE BY PERIOD -------------------------------------------------------------------------- LESS THAN MORE THAN CONTRACTUAL OBLIGATIONS TOTAL ONE YEAR 1-2 YEARS 3-5 YEARS 5 YEARS ---------------------------------------- ------------- ------------ ---------- ----------- ------------ Short and long-term debt obligations $ 72,819 $ 126 $ - $ 72,693 $ - Operating lease obligations 1,142 273 403 466 - Purchase obligations 22,479 22,479 - - - Redemption of Convertible Preferred Stock 8,610 8,610 - - - ------------- ------------ ---------- ----------- ------------ Total $ 105,050 $ 31,488 $ 403 $ 73,159 $ - ============= ============ ========== =========== ============
23 CHANGE IN CERTIFYING ACCOUNTANT On January 22, 2007, the Company was informed that its principal independent registered public accounting firm, Helin, Donovan, Trubee & Wilkinson, LLP (HDT&W) had consummated a merger with Pohl, McNabola, Berg & Co., LLP located in San Francisco, California. The name of the post merger firm is PMB Helin Donovan, LLP and the post-merger firm will succeed HDT&W as our principal independent registered public accounting firm. 24 CAUTIONARY STATEMENTS AND RISK FACTORS SEVERAL OF THE MATTERS DISCUSSED IN THIS REPORT CONTAIN FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS AND UNCERTAINTIES. FACTORS ASSOCIATED WITH THE FORWARD-LOOKING STATEMENTS THAT COULD CAUSE ACTUAL RESULTS TO DIFFER FROM THOSE PROJECTED OR FORECASTED IN THIS REPORT ARE INCLUDED IN THE STATEMENTS BELOW. IN ADDITION TO OTHER INFORMATION CONTAINED IN THIS REPORT, YOU SHOULD CAREFULLY CONSIDER THE FOLLOWING CAUTIONARY STATEMENTS AND RISK FACTORS. THE RISKS AND UNCERTAINTIES DESCRIBED BELOW ARE NOT THE ONLY RISKS AND UNCERTAINTIES WE FACE. ADDITIONAL RISKS AND UNCERTAINTIES NOT PRESENTLY KNOWN TO US OR THAT WE CURRENTLY DEEM IMMATERIAL ALSO MAY IMPAIR OUR BUSINESS OPERATIONS. IF ANY OF THE FOLLOWING RISKS ACTUALLY OCCUR, OUR BUSINESS, FINANCIAL CONDITION, AND RESULTS OF OPERATIONS COULD SUFFER. IN THAT EVENT, THE TRADING PRICE OF OUR COMMON STOCK COULD DECLINE, AND YOU MAY LOSE ALL OR PART OF YOUR INVESTMENT IN OUR COMMON STOCK. THE RISKS DISCUSSED BELOW ALSO INCLUDE FORWARD-LOOKING STATEMENTS AND OUR ACTUAL RESULTS MAY DIFFER SUBSTANTIALLY FROM THOSE DISCUSSED IN THESE FORWARD-LOOKING STATEMENTS. RISKS RELATED TO OUR BUSINESS THERE IS DOUBT ABOUT OUR ABILITY TO CONTINUE AS A GOING CONCERN We have experienced significant operating losses in the current and prior years. At December 31, 2006 our principal sources of liquidity were cash and cash equivalents of $1.88 million. Although Mr. Berg may continue to fund the Company's operations he is under no obligation to do so. We intend to improve our liquidity by the continued monitoring and reduction of manufacturing, facility and administrative costs. However, notwithstanding these efforts, we do not expect that our cash on hand and cash generated by operations will be sufficient to fund our operating and capital needs beyond the next three months. As a result of our limited cash resources and history of operating losses, our previous auditors have expressed in their report on our consolidated financial statements included in our audited March 31, 2006 consolidated financial statements that there is substantial doubt about our ability to continue as a going concern. We presently have no further commitments for financing by Mr. Berg or any other source. If we are unable to obtain financing from Mr. Berg or others on terms acceptable to us, or at all, we may be forced to cease all operations and liquidate our assets. WE HAVE ENCOUNTERED PROBLEMS IN OUR PRODUCTION PROCESSES THAT HAVE LIMITED OUR ABILITY AT TIMES TO PRODUCE SUFFICIENT BATTERIES TO MEET THE DEMANDS OF OUR CUSTOMERS. IF THESE ISSUES RECUR AND WE ARE UNABLE TO TIMELY RESOLVE THESE PROBLEMS, OUR INABILITY TO PRODUCE BATTERIES WILL HAVE A MATERIAL ADVERSE IMPACT ON OUR ABILITY TO GROW REVENUES AND MAINTAIN OUR CUSTOMER BASE. During the third and fourth quarter of fiscal 2006 we experienced problems in our production processes that limited our ability to produce a sufficient number of batteries to meet the demands of our customers. These production issues have had a negative impact on gross margins as manufacturing yields have suffered. Any inability to timely produce batteries may have a material adverse impact on our ability to grow revenues and maintain our customer base. OUR LIMITED FINANCIAL RESOURCES COULD MATERIALLY AFFECT OUR BUSINESS, OUR ABILITY TO COMMERCIALLY EXPLOIT OUR TECHNOLOGY AND OUR ABILITY TO RESPOND TO UNANTICIPATED DEVELOPMENT, AND COULD PLACE US AT A DISADVANTAGE TO OUR COMPETITORS. Currently, we do not have sufficient capital resources, sales and gross profit to generate the cash flows required to meet our operating and capital needs. As a consequence, one of our primary objectives has been to reduce expenses and overhead, thus limiting the resources available to the development and commercialization of our technology. Our limited financial resources could materially affect our ability, and the pace at which, we are able to commercially exploit our Saphion(R) technology. For example, it could: o limit the research and development resources we are able to commit to the further development of our technology and the development of products that can be commercially exploited in our marketplace; o limit the sales and marketing resources that we are able to commit to the marketing of our technology; o have an adverse impact on our ability to attract top-tier companies as our technology and marketing partners; 25 o have an adverse impact on our ability to employ and retain qualified employees with the skills and expertise necessary to implement our business plan; o make us more vulnerable to failure to achieve our forecasted results, economic downturns, adverse industry conditions or catastrophic external events; o limit our ability to withstand competitive pressures and reduce our flexibility in planning for, or responding to, changing business and economic conditions; and o place us at a disadvantage to our competitors that have greater financial resources than we have. WE HAVE A HISTORY OF LOSSES AND AN ACCUMULATED DEFICIT AND MAY NEVER ACHIEVE OR SUSTAIN SIGNIFICANT REVENUES OR PROFITABILITY. We have incurred operating losses each year since our inception in 1989 and had an accumulated deficit of $510.6 million as of December 31, 2006. We have sustained recurring losses related primarily to the research and development and marketing of our products combined with the lack of sufficient sales to provide for these needs. We anticipate that we will continue to incur operating losses and negative cash flows during fiscal 2007. We may never achieve or sustain sufficient revenues or profitability in the future. IF WE CONTINUE TO EXPERIENCE SIGNIFICANT LOSSES WE MAY BE UNABLE TO MAINTAIN SUFFICIENT LIQUIDITY TO PROVIDE FOR OUR OPERATING NEEDS. We reported a net loss available to common stockholders of $16.4 million for the nine-month period ended December 31, 2006, a net loss available to common stockholders of $32.9 million for the fiscal year ended March 31, 2006 and a net loss available to common stockholders of $32.2 million for the fiscal year ended March 31, 2005. If we cannot achieve a competitive cost structure, achieve profitability and access the capital markets on acceptable terms, we will be unable to fund our obligations and sustain our operations and may be required to liquidate our assets. OUR WORKING CAPITAL REQUIREMENTS MAY INCREASE BEYOND THOSE CURRENTLY ANTICIPATED. We have planned for an increase in sales and, if we experience sales in excess of our plan, our working capital needs and capital expenditures would likely increase from that currently anticipated. Our ability to meet this additional customer demand would depend on our ability to arrange for additional equity or debt financing since it is likely that cash flow from sales will lag behind these increased working capital requirements. OUR INDEBTEDNESS AND OTHER OBLIGATIONS ARE SUBSTANTIAL AND COULD MATERIALLY AFFECT OUR BUSINESS AND OUR ABILITY TO INCUR ADDITIONAL DEBT TO FUND FUTURE NEEDS. We have and will continue to have a significant amount of indebtedness and other obligations. As of December 31, 2006, we had approximately $69.9 million of total consolidated indebtedness. Included in this amount are $33.7 million of loans outstanding to an affiliate, $17.7 million of accumulated interest associated with those loans and $18.5 million of principal and interest outstanding with a third party finance company. Our substantial indebtedness and other obligations could negatively impact our operations in the future. For example, it could: o limit our ability to obtain additional financing for working capital, capital expenditures, acquisitions and general corporate purposes; o require us to dedicate a substantial portion of our cash flow from operations to the payment of principal of, and interest on, our indebtedness, thereby reducing the funds available to us for other purposes; 26 o make us more vulnerable to failure to achieve our forecasted results, economic downturns, adverse industry conditions or catastrophic external events, limit our ability to withstand competitive pressures and reduce our flexibility in planning for, or responding to, changing business and economic conditions; and o place us at a disadvantage to our competitors that have relatively less debt than we have. ALL OF OUR ASSETS ARE PLEDGED AS COLLATERAL UNDER OUR LOAN AGREEMENTS. OUR FAILURE TO MEET THE OBLIGATIONS UNDER OUR LOAN AGREEMENTS COULD RESULT IN FORECLOSURE OF OUR ASSETS. All of our assets are pledged as collateral under various loan agreements with Mr. Berg or related entities. If we fail to meet our obligations pursuant to these loan agreements, these lenders may declare all amounts borrowed from them to be due and payable together with accrued and unpaid interest. If this were to occur, we would not have the financial resources to repay our debt and these lenders could proceed against our assets. WE DEPEND ON A SMALL NUMBER OF CUSTOMERS FOR OUR REVENUES, AND OUR RESULTS OF OPERATIONS AND FINANCIAL CONDITION COULD BE HARMED IF WE WERE TO LOSE THE BUSINESS OF ANY ONE OF THEM. To date, our existing purchase orders in commercial quantities are from a limited number of customers. During the nine-month period ended December 31, 2006, Segway Inc., D&H Distributing Co., Inc., and PC Connection, Inc. contributed 52%, 11%, and 9%, of our revenues, respectively. We anticipate that sales of our products to a limited number of key customers will continue to account for a significant portion of our total revenues. We do not have long-term agreements with any of our customers and do not expect to enter into any long-term agreements in the near future. As a result, we face the substantial risk that one or more of the following events could occur: o reduction, delay or cancellation of orders from a customer; o development by a customer of other sources of supply; o selection by a customer of devices manufactured by one of our competitors for inclusion in future product generations; o loss of a customer or a disruption in our sales and distribution channels; or o failure of a customer to make timely payment of our invoices. If we were to lose one or more customers, or if we were to lose revenues due to a customer's inability or refusal to continue to purchase our batteries, our business, results of operations and financial condition could be harmed. OUR BUSINESS WILL BE ADVERSELY AFFECTED IF OUR SAPHION(R) TECHNOLOGY BATTERIES ARE NOT COMMERCIALLY ACCEPTED. We are researching and developing batteries based upon phosphate chemistry. Our batteries are designed and manufactured as components for other companies and end-user customers. Our success depends on the acceptance of our batteries and the products using our batteries in their markets. Technical issues may arise that may affect the acceptance of our products by our customers. Market acceptance may also depend on a variety of other factors, including educating the target market regarding the benefits of our products. Market acceptance and market share are also affected by the timing of market introduction of competitive products. If we, or our customers, are unable to gain any significant market acceptance for Saphion(R) technology-based batteries, our business will be adversely affected. It is too early to determine if Saphion(R) technology-based batteries will achieve significant market acceptance. IF WE ARE UNABLE TO DEVELOP, MANUFACTURE AND MARKET PRODUCTS THAT GAIN WIDE CUSTOMER ACCEPTANCE, OUR BUSINESS WILL BE ADVERSELY AFFECTED. The process of developing our products is complex and failure to anticipate our customers' changing needs and to develop products that receive widespread customer acceptance could significantly harm our results of operations. 27 We must make long-term investments and commit significant resources before knowing whether our predictions will eventually result in products that the market will accept. After a product is developed, we must be able to manufacture sufficient volumes quickly and at low costs. To accomplish this, we must accurately forecast volumes, mix of products and configurations that meet customer requirements, and we may not succeed. IF OUR PRODUCTS FAIL TO PERFORM AS EXPECTED, WE COULD LOSE EXISTING AND FUTURE BUSINESS, AND OUR ABILITY TO DEVELOP, MARKET AND SELL OUR BATTERIES COULD BE HARMED. If our products, when introduced, do not perform as expected, our reputation could be severely damaged, and we could lose existing or potential future business. This performance failure may have the long-term effect of harming our ability to develop, market and sell our products. OUR FAILURE TO COST-EFFECTIVELY MANUFACTURE OUR TECHNOLOGICALLY COMPLEX BATTERIES IN COMMERCIAL QUANTITIES WHICH SATISFY OUR CUSTOMERS' PRODUCT SPECIFICATIONS AND THEIR EXPECTATIONS FOR PRODUCT QUALITY AND DELIVERY COULD DAMAGE OUR CUSTOMER RELATIONSHIPS AND RESULT IN SIGNIFICANT LOST BUSINESS OPPORTUNITIES FOR US. To be successful, we must cost-effectively manufacture commercial quantities of our technologically complex batteries that meet our customer specifications for quality and timely delivery. To facilitate commercialization of our products, we will need to further reduce our manufacturing costs, which we intend to do through the effective utilization of manufacturing partners and continuous improvement of our manufacturing and development operations in our wholly foreign owned enterprises in China. We currently manufacture our batteries and assemble our products in China. We are dependent on the performance of our manufacturing partners, as well as our own manufacturing operations to manufacture and deliver our products to our customers. We have experienced production process issues, which have limited our ability to produce a sufficient number of batteries to meet current demand. If we fail to correct these issues in a manner that allows us to meet customer demand, or if any of our manufacturing partners are unable to manufacture products in commercial quantities on a timely and cost-effective basis, we could lose our customers and adversely impact our ability to attract future customers. IN ADDITION TO BEING USED IN OUR OWN PRODUCT LINES, OUR BATTERY CELLS ARE INTENDED TO BE INCORPORATED INTO OTHER PRODUCTS. IF WE DO NOT FORM EFFECTIVE ARRANGEMENTS WITH OEMS TO COMMERCIALIZE THESE PRODUCTS, OUR PROFITABILITY COULD BE IMPAIRED. Our business strategy contemplates that we will be required to rely on assistance from OEMs to gain market acceptance for our products. We therefore will need to identify acceptable OEMs and enter into agreements with them. Once we identify acceptable OEMs and enter into agreements with them, we will need to meet these companies' requirements by developing and introducing new products and enhanced or modified versions of our existing products on a timely basis. OEMs often require unique configurations or custom designs for batteries, which must be developed and integrated into their product well before the product is launched. This development process not only requires substantial lead-time between the commencement of design efforts for a customized power system and the commencement of volume shipments of the power systems to the customer, but also requires the cooperation and assistance of the OEMs for purposes of determining the requirements for each specific application. We may have technical issues that arise that may affect the acceptance of our product by OEMs. If we are unable to design, develop, and introduce products that meet OEMs' requirements, we may lose opportunities to enter into additional purchase orders and our reputation may be damaged. As a result, we may not receive adequate assistance from OEMs or pack assemblers to successfully commercialize our products, which could impair our profitability. FAILURE TO IMPLEMENT AN EFFECTIVE LICENSING BUSINESS STRATEGY WILL ADVERSELY AFFECT OUR REVENUE, CASH FLOW AND PROFITABILITY. Our long-term business strategy anticipates achieving significant revenue from the licensing of our intellectual property assets, such as our Saphion(R) technology. We have not entered into any licensing agreements for our Saphion(R) technology. Our future operating results could be adversely affected by a variety of factors including: o our ability to secure and maintain significant licensees of our proprietary technology; 28 o the extent to which our future licensees successfully incorporate our technology into their products; o the acceptance of new or enhanced versions of our technology; o the rate at which our licensees manufacture and distribute their products to OEMs; and o our ability to secure one-time license fees and ongoing royalties for our technology from licensees. Our future success will also depend on our ability to execute our licensing operations simultaneously with our other business activities. If we fail to substantially expand our licensing activities while maintaining our other business activities, our results of operations and financial condition will be adversely affected. THE FACT THAT WE DEPEND ON A SOLE SOURCE SUPPLIER OR A LIMITED NUMBER OF SUPPLIERS FOR KEY RAW MATERIALS MAY DELAY OUR PRODUCTION OF BATTERIES. We depend on a sole source supplier or a limited number of suppliers for certain key raw materials used in manufacturing and developing our power systems. We generally purchase raw materials pursuant to purchase orders placed from time to time and have no long-term contracts or other guaranteed supply arrangements with our sole or limited source suppliers. As a result, our suppliers may not be able to meet our requirements relative to specifications and volumes for key raw materials, and we may not be able to locate alternative sources of supply at an acceptable cost. In the past, we have experienced delays in product development due to the delivery of nonconforming raw materials from our suppliers. If in the future we are unable to obtain high quality raw materials in sufficient quantities, on competitive pricing terms and on a timely basis, it may delay battery production, impede our ability to fulfill existing or future purchase orders and harm our reputation and profitability. WE HAVE THREE KEY EXECUTIVES, THE LOSS OF ANY OF WHICH COULD HARM OUR BUSINESS. Without qualified executives, we face the risk that we will not be able to effectively run our business on a day-to-day basis or execute our long-term business plan. We do not have key man life insurance policies with respect to any of our key members of management. OUR ONGOING MANUFACTURING AND DEVELOPMENT OPERATIONS IN CHINA ARE COMPLEX AND HAVING THESE REMOTE OPERATIONS MAY DIVERT MANAGEMENT'S ATTENTION, LEAD TO DISRUPTIONS IN OPERATIONS AND DELAY IMPLEMENTATION OF OUR BUSINESS STRATEGY. We have relocated most of our manufacturing and development operations to China. We may not be able to find or retain suitable employees in China and we may have to train personnel to perform necessary functions for our manufacturing, senior management and development operations. This may divert management's attention, lead to disruptions in operations and delay implementation of our business strategy, all of which could negatively impact our profitability. WE EXPECT TO SELL A SIGNIFICANT PORTION OF OUR PRODUCTS TO AND DERIVE A SIGNIFICANT PORTION OF OUR LICENSING REVENUES FROM CUSTOMERS LOCATED OUTSIDE THE UNITED STATES. FOREIGN GOVERNMENT REGULATIONS, CURRENCY FLUCTUATIONS AND INCREASED COSTS ASSOCIATED WITH INTERNATIONAL SALES COULD MAKE OUR PRODUCTS AND LICENSES UNAFFORDABLE IN FOREIGN MARKETS, WHICH WOULD REDUCE OUR FUTURE PROFITABILITY. We expect that international sales of our product and licenses, as well as licensing royalties, represent a significant portion of our sales potential. International business can be subject to many inherent risks that are difficult or impossible for us to predict or control, including: o changes in foreign government regulations and technical standards, including additional regulation of rechargeable batteries, technology, or the transport of lithium or phosphate, which may reduce or eliminate our ability to sell or license in certain markets; 29 o foreign governments may impose tariffs, quotas, and taxes on our batteries or our import of technology into their countries; o requirements or preferences of foreign nations for domestic products could reduce demand for our batteries and our technology; o fluctuations in currency exchange rates relative to the U.S. dollar could make our batteries and our technology unaffordable to foreign purchasers and licensees or more expensive compared to those of foreign manufacturers and licensors; o longer payment cycles typically associated with international sales and potential difficulties in collecting accounts receivable, which may reduce the future profitability of foreign sales and royalties; o import and export licensing requirements in Europe and other regions, including China, where we intend to conduct business, which may reduce or eliminate our ability to sell or license in certain markets; and o political and economic instability in countries, including China, where we intend to conduct business, which may reduce the demand for our batteries and our technology or our ability to market our batteries and our technology in those countries. These risks may increase our costs of doing business internationally and reduce our sales and royalties or future profitability. WE MAY NEED TO EXPAND OUR EMPLOYEE BASE AND OPERATIONS IN ORDER TO EFFECTIVELY DISTRIBUTE OUR PRODUCTS COMMERCIALLY, WHICH MAY STRAIN OUR MANAGEMENT AND RESOURCES AND COULD HARM OUR BUSINESS. To implement our growth strategy successfully, we have had to increase our staff in China, with personnel in manufacturing, engineering, sales, marketing, and product support capabilities, as well as third party and direct distribution channels. However, we face the risk that we may not be able to attract new employees to sufficiently increase our staff or product support capabilities, or that we will not be successful in our sales and marketing efforts. Failure in any of these areas could impair our ability to execute our plans for growth and adversely affect our future profitability. COMPETITION FOR PERSONNEL, IN PARTICULAR FOR PRODUCT DEVELOPMENT AND PRODUCT IMPLEMENTATION PERSONNEL, IS INTENSE, AND WE MAY HAVE DIFFICULTY ATTRACTING THE PERSONNEL NECESSARY TO EFFECTIVELY OPERATE OUR BUSINESS. We believe that our future success will depend in large part on our ability to attract and retain highly skilled technical, managerial, and marketing personnel who are familiar with and experienced in the battery industry. If we cannot attract and retain experienced sales and marketing executives, we may not achieve the visibility in the marketplace that we need to obtain purchase orders, which would have the result of lowering our sales and earnings. We compete in the market for personnel against numerous companies, including larger, more established competitors who have significantly greater financial resources than we do. We cannot be certain that we will be successful in attracting and retaining the skilled personnel necessary to operate our business effectively in the future. INTERNATIONAL POLITICAL EVENTS AND THE THREAT OF ONGOING TERRORIST ACTIVITIES COULD INTERRUPT MANUFACTURING OF OUR BATTERIES AND OUR PRODUCTS AT OUR OEM FACILITIES OR OUR OWN FACILITIES AND CAUSE US TO LOSE SALES AND MARKETING OPPORTUNITIES. The terrorist attacks that took place in the United States on September 11, 2001, along with the U.S. military campaigns against terrorism in Iraq, Afghanistan, and elsewhere, and continued violence in the Middle East have created many economic and political uncertainties, some of which may materially harm our business and revenues. International political instability resulting from these events could temporarily or permanently disrupt manufacturing of our batteries and products at our OEM facilities or our own facilities in Asia and elsewhere, and have an immediate adverse impact on our business. Since September 11, 2001, some economic commentators have indicated that spending on capital equipment of the type that use our batteries has been weaker than spending in the 30 economy as a whole, and many of our customers are in industries that also are viewed as under-performing in the overall economy, such as the telecommunications, industrial, and utility industries. The long-term effects of these events on our customers, the market for our common stock, the markets for our products, and the U.S. economy as a whole are uncertain. Terrorist activities could temporarily or permanently interrupt our manufacturing, development, sales and marketing activities anywhere in the world. Any delays also could cause us to lose sales and marketing opportunities, as potential customers would find other vendors to meet their needs. The consequences of any additional terrorist attacks, or any expanded armed conflicts are unpredictable, and we may not be able to foresee events that could have an adverse effect on our markets or our business. IF WE ARE SUED ON A PRODUCT LIABILITY CLAIM, OUR INSURANCE POLICIES MAY NOT BE SUFFICIENT. Although we maintain general liability insurance and product liability insurance, our insurance may not cover all potential types of product liability claims to which manufacturers are exposed or may not be adequate to indemnify us for all liability that may be imposed. Any imposition of liability that is not covered by insurance or is in excess of our insurance coverage could harm our business. OUR PATENT APPLICATIONS MAY NOT RESULT IN ISSUED PATENTS, WHICH WOULD HAVE A MATERIAL ADVERSE EFFECT ON OUR ABILITY TO COMMERCIALLY EXPLOIT OUR PRODUCTS. Patent applications in the United States are maintained in secrecy until the patents are issued or are published. Since publication of discoveries in the scientific or patent literature tends to lag behind actual discoveries by several months, we cannot be certain that we are the first creator of inventions covered by pending patent applications or the first to file patent applications on these inventions. We also cannot be certain that our pending patent applications will result in issued patents or that any of our issued patents will afford protection against a competitor. In addition, patent applications filed in foreign countries are subject to laws, rules and procedures that differ from those of the United States, and thus we cannot be certain that foreign patent applications related to issued U.S. patents will be issued. Furthermore, if these patent applications issue, some foreign countries provide significantly less effective patent enforcement than in the United States. The status of patents involves complex legal and factual questions and the breadth of claims allowed is uncertain. Accordingly, we cannot be certain that the patent applications that we file will result in patents being issued, or that our patents and any patents that may be issued to us in the near future will afford protection against competitors with similar technology. In addition, patents issued to us may be infringed upon or designed around by others and others may obtain patents that we need to license or design around, either of which would increase costs and may adversely affect our operations. IF WE CANNOT PROTECT OR ENFORCE OUR EXISTING INTELLECTUAL PROPERTY RIGHTS OR IF OUR PENDING PATENT APPLICATIONS DO NOT RESULT IN ISSUED PATENTS, WE MAY LOSE THE ADVANTAGES OF OUR RESEARCH AND MANUFACTURING SYSTEMS. Our ability to compete successfully will depend on whether we can protect our existing proprietary technology and manufacturing processes. We rely on a combination of patent and trade secret protection, non-disclosure agreements and cross-licensing agreements. These measures may not be adequate to safeguard the proprietary technology underlying our batteries. Employees, consultants, and others who participate in the development of our products may breach their non-disclosure agreements with us, and we may not have adequate remedies in the event of their breaches. In addition, our competitors may be able to develop products that are equal or superior to our products without infringing on any of our intellectual property rights. We currently manufacture and export some of our products from China. The legal regime protecting intellectual property rights in China is weak. Because the Chinese legal system in general, and the intellectual property regime in particular, are relatively weak, it is often difficult to enforce intellectual property rights in China. In addition, there are other countries where effective copyright, trademark and trade secret protection may be unavailable or limited. Accordingly, we may not be able to effectively protect our intellectual property rights outside of the United States. 31 INTELLECTUAL PROPERTY INFRINGEMENT CLAIMS BROUGHT AGAINST US COULD BE TIME-CONSUMING AND EXPENSIVE TO DEFEND, AND IF ANY OF OUR PRODUCTS OR PROCESSES IS FOUND TO BE INFRINGING, WE MAY NOT BE ABLE TO PROCURE LICENSES TO USE PATENTS NECESSARY TO OUR BUSINESS AT REASONABLE TERMS, IF AT ALL. In recent years, there has been significant litigation in the United States involving patents and other intellectual property rights. While we are currently engaged in one intellectual property proceeding alleging the Company's SAPHION(R) I cathode material infringes two patents owned by the University of Texas, while the Company believes it has strong defenses to such allegations, an adverse decision could force us to do one or more of the following: o stop selling, incorporating, or using our products that use the SAPHION(R) I cathode material challenged intellectual property; o pay damages for the use of SAPHION(R) I cathode material; o obtain a license to sell or use the SAPHION(R) I cathode material, which license may not be available on reasonable terms, or at all; or o redesign those products or manufacturing processes that use the SAPHION(R) I cathode material, which may not be economically or technologically feasible. We may become involved in more litigation and proceedings in the future. In the future we may be subject to claims or an inquiry regarding our alleged unauthorized use of a third party's intellectual property. An adverse outcome in such future litigation could result in similar risks as noted above with respect to the third party's intellectual property. Whether or not an intellectual property litigation claim is valid, the cost of responding to it, in terms of legal fees and expenses and the diversion of management resources, could be expensive and harm our business. RISKS ASSOCIATED WITH DOING BUSINESS IN CHINA SINCE OUR PRODUCTS ARE MANUFACTURED IN CHINA AND WE HAVE TRANSFERRED ADDITIONAL OPERATIONS TO CHINA, WE FACE RISKS IF CHINA LOSES NORMAL TRADE RELATIONS STATUS WITH THE UNITED STATES. We manufacture and export our products from China. Our products sold in the United States are currently not subject to U.S. import duties. On September 19, 2000, the United States Senate voted to permanently normalize trade with China, which provides a favorable category of United States import duties. In addition, on December 11, 2001, China was accepted into the World Trade Organization ("WTO"), a global international organization that regulates international trade. As a result of opposition to certain policies of the Chinese government and China's growing trade surpluses with the United States, there has been, and in the future may be, opposition to the extension of Normal Trade Relations ("NTR") status for China. The loss of NTR status for China, changes in current tariff structures or adoption in the United States of other trade policies adverse to China could have an adverse affect on our business. Furthermore, our business may be adversely affected by the diplomatic and political relationships between the United States and China. These influences may adversely affect our ability to operate in China. If the relationship between the United States and China were to materially deteriorate, it could negatively impact our ability to control our operations and relationships in China, enforce any agreements we have with Chinese manufacturers or otherwise deal with any assets or investments we may have in China. BECAUSE THE CHINESE LEGAL SYSTEM IN GENERAL, AND THE INTELLECTUAL PROPERTY REGIME IN PARTICULAR, ARE RELATIVELY WEAK, WE MAY NOT BE ABLE TO ENFORCE INTELLECTUAL PROPERTY RIGHTS IN CHINA AND ELSEWHERE. We currently manufacture and export our products from China. The legal regime protecting intellectual property rights in China is weak. Because the Chinese legal system in general, and the intellectual property regime in particular, are relatively weak, it is often difficult to enforce intellectual property rights in China. 32 ENFORCING AGREEMENTS AND LAWS IN CHINA IS DIFFICULT OR MAY BE IMPOSSIBLE AS CHINA DOES NOT HAVE A COMPREHENSIVE SYSTEM OF LAWS. We are dependent on our agreements with our Chinese manufacturing partners. Enforcement of agreements may be sporadic and implementation and interpretation of laws may be inconsistent. The Chinese judiciary is relatively inexperienced in interpreting agreements and enforcing the laws, leading to a higher than usual degree of uncertainty as to the outcome of any litigation. Even where adequate law exists in China, it may be impossible to obtain swift and equitable enforcement of such law, or to obtain enforcement of a judgment by a court of another jurisdiction. THE GOVERNMENT OF CHINA MAY CHANGE OR EVEN REVERSE ITS POLICIES OF PROMOTING PRIVATE INDUSTRY AND FOREIGN INVESTMENT, IN WHICH CASE OUR ASSETS AND OPERATIONS MAY BE AT RISK. China is a socialist state, which since 1949 has been, and is expected to continue to be, controlled by the Communist Party of China. Our existing and planned operations in China are subject to the general risks of doing business internationally and the specific risks related to the business, economic and political conditions in China, which include the possibility that the central government of China will change or even reverse its policies of promoting private industry and foreign investment in China. Many of the current reforms which support private business in China are unprecedented or experimental. Other political, economic and social factors, such as political changes, changes in the rates of economic growth, unemployment or inflation, or in the disparities of per capita wealth among citizens of China and between regions within China, could also lead to further readjustment of the government's reform measures. It is not possible to predict whether the Chinese government will continue to be as supportive of private business in China, nor is it possible to predict how future reforms will affect our business. THE GOVERNMENT OF CHINA CONTINUES TO EXERCISE SUBSTANTIAL CONTROL OVER THE CHINESE ECONOMY WHICH COULD HAVE A NEGATIVE IMPACT ON OUR BUSINESS. The government of China has exercised and continues to exercise substantial control over virtually every section of the Chinese economy through regulation and state ownership. China's continued commitment to reform and the development of a vital private sector in that country have, to some extent, limited the practical effects of the control currently exercised by the government over individual enterprises. However, the economy continues to be subject to significant government controls, which, if directed towards our business activities, could have a significant adverse impact on us. For example, if the government were to limit the number of foreign personnel who could work in the country, substantially increase taxes on foreign businesses or impose any number of other possible types of limitations on our operations, the impact would be significant. CHANGES IN CHINA'S POLITICAL AND ECONOMIC POLICIES COULD HARM OUR BUSINESS. The economy of China has historically been a planned economy subject to governmental plans and quotas and has, in certain aspects, been transitioning to a more market-oriented economy. Although we believe that the economic reform and the macroeconomic measures adopted by the Chinese government have had a positive effect on the economic development of China, we cannot predict the future direction of these economic reforms or the effects these measures may have on our business, financial position or results of operations. In addition, the Chinese economy differs from the economies of most countries belonging to the Organization for Economic Cooperation and Development ("OECD"). These differences include: o economic structure, o level of government involvement in the economy, o level of development o level of capital reinvestment, o control of foreign exchange 33 o methods of allocating resources, and o balance of payments position. As a result of these differences, our operations, including our current manufacturing operations in China, may not develop in the same way or at the same rate as might be expected if the Chinese economy were similar to the OECD member countries. BUSINESS PRACTICES IN CHINA MAY ENTAIL GREATER RISK AND DEPENDENCE UPON THE PERSONAL RELATIONSHIPS OF SENIOR MANAGEMENT THAN IS COMMON IN NORTH AMERICA AND THEREFORE SOME OF OUR AGREEMENTS WITH OTHER PARTIES IN CHINA COULD BE DIFFICULT OR IMPOSSIBLE TO ENFORCE. The business structure of China is, in some respects, different from the business culture in Western countries and may present some difficulty for Western investors reviewing contractual relationships among companies in China and evaluating the merits of an investment. Personal relationships among business principals of companies and business entities in China are very significant in the business culture. In some cases, because so much reliance is based upon personal relationships, written contracts among businesses in China may be less detailed and specific than is commonly accepted for similar written agreements in Western countries. In some cases, material terms of an understanding are not contained in the written agreement but exist as oral agreements only. In other cases, the terms of transactions which may involve material amounts of money are not documented at all. In addition, in contrast to Western business practices where a written agreement specifically defines the terms, rights and obligations of the parties in a legally-binding and enforceable manner, the parties to a written agreement in China may view that agreement more as a starting point for an ongoing business relationship which will evolve and require ongoing modification. As a result, written agreements in China may appear to the Western reader to look more like outline agreements that precede a formal written agreement. While these documents may appear incomplete or unenforceable to a Western reader, the parties to the agreement in China may feel that they have a more complete understanding than is apparent to someone who is only reading the written agreement without having attended the negotiations. As a result, contractual arrangements in China may be more difficult to review and understand. Also, despite legal developments in China over the past 20 years, adequate laws, comparable with Western standards, do not exist in all areas and it is unclear how many of our business arrangements would be interpreted or enforced by a court in China. OUR OPERATIONS COULD BE MATERIALLY INTERRUPTED, AND WE MAY SUFFER A LARGE AMOUNT OF LOSS, IN THE CASE OF FIRE, CASUALTY OR THEFT AT ONE OF OUR MANUFACTURING OR OTHER FACILITIES. Firefighting and disaster relief or assistance in China is substandard by Western standards. Consistent with common practice in China for companies of our size and/or the size of our business partners in China, neither we nor they, to our knowledge, maintain fire, casualty, theft insurance or business interruption insurance. In the event of any material damage to, or loss of, the manufacturing plants where our products are or will be produced due to fire, casualty, theft, severe weather, flood or other similar causes, we would be forced to replace any assets lost in those disaster without the benefit of insurance. Thus our financial position could be materially compromised or we might have to cease doing business. Also, consistent with customary business practices among enterprises in China, we do not carry business interruption insurance. THE SYSTEM OF TAXATION IN CHINA IS UNCERTAIN AND SUBJECT TO UNPREDICTABLE CHANGE THAT COULD AFFECT OUR PROFITABILITY. Many tax rules are not published in China and those that are published can be ambiguous and contradictory leaving a considerable amount of discretion to local tax authorities. China currently offers tax and other preferential incentives to encourage foreign investment. However, the country's tax regime is undergoing review and there is no assurance that such tax and other incentives will continue to be made available. Currently, China levies a 10% withholding tax on dividends received from Chinese-foreign joint ventures. If we enter into a joint venture with a Chinese company as part of our strategy to reduce costs, such a joint venture may be considered a Chinese-foreign joint venture if the majority of its equity interests are owned by a foreign shareholder. A temporary exemption from 34 this withholding tax has been granted to foreign investors. However, there is no indication when this exemption will end. IT IS UNCERTAIN WHETHER WE WILL BE ABLE TO RECOVER VALUE-ADDED TAXES IMPOSED BY THE CHINESE TAXING AUTHORITY. China's turnover tax system consists of value-added tax ("VAT"), consumption tax and business tax. Export sales are exempted under VAT rules and an exporter who incurs VAT on purchase or manufacture of goods should be able to claim a refund from Chinese tax authorities. However, due to a reduction in the VAT export refund rate of some goods, exporters might bear part of the VAT they incurred in conjunction with the exported goods. In 2003, changes to the Chinese value-added tax system were announced affecting the recoverability of input VAT beginning January 1, 2004. Our VAT expense will depend on the reaction of both our suppliers and customers. Continued efforts by the Chinese government to increase tax revenues could result in revisions to tax laws or their interpretation, which could increase our VAT and various tax liabilities. ANY RECURRENCE OF SEVERE ACUTE RESPIRATORY SYNDROME ("SARS"), AVIAN FLU, OR ANOTHER WIDESPREAD PUBLIC HEALTH PROBLEM, COULD ADVERSELY AFFECT OUR BUSINESS AND RESULTS OF OPERATIONS. A renewed outbreak of SARS, avian flu, or another widespread public health problem in China, where we have moved our manufacturing operations and may move additional operations, could have a negative effect on our operations. Our operations may be impacted by a number of health-related factors, including the following: o quarantines or closures of some of our manufacturing or other facilities which would severely disrupt our operations, or o the sickness or death of key officers or employees of our manufacturing or other facilities. Any of the foregoing events or other unforeseen consequences of public health problems in China could adversely affect our business and results of operations. OUR PRODUCTION AND SHIPPING CAPABILITIES COULD BE ADVERSELY AFFECTED BY ONGOING TENSIONS BETWEEN THE CHINESE AND TAIWANESE GOVERNMENTS. Key components of our products are manufactured in China and assembled in Taiwan into end products or systems. In the event that Taiwan does not adopt a plan for unifying with China, the Chinese government has threatened military action against Taiwan. As of yet, Taiwan has not indicated that it intends to propose and adopt a reunification plan. If an invasion by China were to occur, the ability of our manufacturing and assembly partners could be adversely affected, potentially limiting our production capabilities. An invasion could also lead to sanctions or military action by the United States and/or European countries, which could further adversely affect our business. RISKS ASSOCIATED WITH OUR INDUSTRY IF COMPETING TECHNOLOGIES THAT OUTPERFORM OUR BATTERIES WERE DEVELOPED AND SUCCESSFULLY INTRODUCED, THEN OUR PRODUCTS MIGHT NOT BE ABLE TO COMPETE EFFECTIVELY IN OUR TARGETED MARKET SEGMENTS. Rapid and ongoing changes in technology and product standards could quickly render our products less competitive, or even obsolete. Other companies who are seeking to enhance traditional battery technologies, such as lead-acid and nickel-cadmium, have recently introduced or are developing batteries based on nickel metal-hydride, liquid lithium-ion and other emerging and potential technologies. These competitors are engaged in significant development work on these various battery systems, and we believe that much of this effort is focused on achieving higher energy densities for low power applications such as portable electronics. One or more new, higher energy rechargeable battery technologies could be introduced which could be directly competitive with, or superior to, our technology. The capabilities of many of these competing technologies have improved over the past several years. Competing technologies that outperform our batteries could be developed and successfully introduced, and as a result, there is a risk that our products may not be able to compete effectively in our targeted market segments. 35 We have invested in research and development of next-generation technology in energy solutions. If we are not successful in developing and commercially exploiting new energy solutions based on new materials, or we experience delays in the development and exploitations of new energy solutions, compared to our competitors, our future growth and revenues will be adversely affected. OUR PRINCIPAL COMPETITORS HAVE GREATER FINANCIAL AND MARKETING RESOURCES THAN WE DO AND THEY MAY THEREFORE DEVELOP BATTERIES SIMILAR OR SUPERIOR TO OURS OR OTHERWISE COMPETE MORE SUCCESSFULLY THAN WE DO. Competition in the rechargeable battery industry is intense. The industry consists of major domestic and international companies, most of which have financial, technical, marketing, sales, manufacturing, distribution and other resources substantially greater than ours. There is a risk that other companies may develop batteries similar or superior to ours. In addition, many of these companies have name recognition, established positions in the market, and long-standing relationships with OEMs and other customers. We believe that our primary competitors are existing suppliers of cylindrical lithium-ion, nickel cadmium, nickel metal-hydride and in some cases, non-SLI lead-acid batteries. These suppliers include Sanyo, Matsushita Industrial Co., Ltd. (Panasonic), Sony, Toshiba, SAFT E-One Moli Energy, as well as numerous lead-acid manufacturers throughout the world. Most of these companies are very large and have substantial resources and market presence. We expect that we will compete against manufacturers of other types of batteries in our targeted application segments. There is also a risk that we may not be able to compete successfully against manufacturers of other types of batteries in any of our targeted applications. LAWS REGULATING THE MANUFACTURE OR TRANSPORTATION OF BATTERIES MAY BE ENACTED WHICH COULD RESULT IN A DELAY IN THE PRODUCTION OF OUR BATTERIES OR THE IMPOSITION OF ADDITIONAL COSTS THAT COULD HARM OUR ABILITY TO BE PROFITABLE. At the present time, international, federal, state or local laws do not directly regulate the storage, use and disposal of the component parts of our batteries. However, laws and regulations may be enacted in the future which could impose environmental, health and safety controls on the storage, use and disposal of certain chemicals and metals used in the manufacture of lithium polymer batteries. Satisfying any future laws or regulations could require significant time and resources from our technical staff and possible redesign which may result in substantial expenditures and delays in the production of our product, all of which could harm our business and reduce our future profitability. The transportation of lithium and lithium-ion batteries is regulated both domestically and internationally. Under recently revised United Nations recommendations and as adopted by the International Air Transport Association ("IATA"), our N-Charge(TM) Power System (Model VNC-65) and N-Charge(TM) Power System II are exempt from a Class 9 designation for transportation, while our N-Charge(TM) Power System (Model VNC-130), and U-Charge(R) Power System currently fall within the level such that they are not exempt and require a Class 9 designation for transportation. The revised United Nations recommendations are not U.S. law until such time as they are incorporated into the Department of Transportation ("DOT") Hazardous Material Regulations. However, DOT has proposed new regulations harmonizing with the U.N. guidelines. At present it is not known if or when the proposed regulations would be adopted by the United States. While we fall under the equivalency levels for the United States and comply with all safety packaging requirements worldwide, future DOT or IATA regulations or enforcement policies could impose costly transportation requirements. In addition, compliance with any new DOT and IATA approval process could require significant time and resources from our technical staff and, if redesign were necessary, could delay the introduction of new products. GENERAL RISKS ASSOCIATED WITH STOCK OWNERSHIP CORPORATE INSIDERS OR THEIR AFFILIATES WILL BE ABLE TO EXERCISE SIGNIFICANT CONTROL OVER MATTERS REQUIRING STOCKHOLDER APPROVAL THAT MIGHT NOT BE IN THE BEST INTERESTS OF OUR STOCKHOLDERS AS A WHOLE. As of February 2, 2007, our officers, directors and their affiliates as a group beneficially owned approximately 48.0% of our outstanding common stock. Carl Berg, our chairman of the board, beneficially owns approximately 46.0% of our outstanding common stock. As a result, these stockholders will be able to exercise significant control over all matters requiring stockholder approval, including the election of directors and the approval of significant corporate transactions, which could delay or prevent someone from acquiring or merging with us. The interest of our officers and directors, when acting in their capacity as stockholders, may lead them to: 36 o vote for the election of directors who agree with the incumbent officers' or directors' preferred corporate policy; or o oppose or support significant corporate transactions when these transactions further their interest as incumbent officers or directors, even if these interests diverge from their interests as stockholders per se and thus from the interests of other stockholders. SOME PROVISIONS OF OUR CHARTER DOCUMENTS MAY MAKE TAKEOVER ATTEMPTS DIFFICULT, WHICH COULD DEPRESS THE PRICE OF OUR STOCK AND LIMIT THE PRICE THAT POTENTIAL ACQUIRERS MAY BE WILLING TO PAY FOR OUR COMMON STOCK. Our board of directors has the authority, without any action by the outside stockholders, to issue additional shares of our preferred stock, which shares may be given superior voting, liquidation, distribution, and other rights as compared to those of our common stock. The rights of the holders of our capital stock will be subject to, and may be adversely affected by, the rights of the holders of any preferred stock that may be issued in the future. The issuance of additional shares of preferred stock could have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock. These provisions may have the effect of delaying, deferring or preventing a change in control, may discourage bids for our common stock at a premium over its market price, may decrease the market price and may infringe upon the voting and other rights of the holders of our common stock. AT ANY GIVEN TIME WE MIGHT NOT MEET THE CONTINUED LISTING REQUIREMENTS OF THE NASDAQ SMALLCAP MARKET. Given the volatility of our stock and trends in the stock market in general, at any given time we might not meet the continued listing requirements of The Nasdaq SmallCap Market. Among other requirements, Nasdaq requires the minimum bid price of a company's registered shares to be $1.00. On February 2, 2007, the closing price of our common stock was $1.57. If we are not able to maintain the requirements for continued listing on The Nasdaq SmallCap Market, it could have a materially adverse effect on the price and liquidity of our common stock. OUR STOCK PRICE IS VOLATILE, WHICH COULD RESULT IN A LOSS OF YOUR INVESTMENT. The market price of our common stock has been and is likely to continue to be highly volatile. Factors that may have a significant effect on the market price of our common stock include the following: o fluctuation in our operating results, o announcements of technological innovations or new commercial products by us or our competitors, o failure to achieve operating results projected by securities analysts, o governmental regulation, o developments in our patent or other proprietary rights or our competitors' developments, o our relationships with current or future collaborative partners, and o other factors and events beyond our control. In addition, the stock market in general has experienced extreme volatility that often has been unrelated to the operating performance of particular companies. These broad market and industry fluctuations may adversely affect the trading price of our common stock, regardless of our actual operating performance. As a result of this potential stock price volatility, investors may be unable to sell their shares of our common stock at or above the cost of their purchase prices. In addition, companies that have experienced volatility in the market price of their stock have been the object of securities class action litigation. If we were the subject of securities class action litigation, this could result in substantial costs, a diversion of our management's attention and resources and harm to our business and financial condition. 37 FUTURE SALES OF CURRENTLY OUTSTANDING SHARES COULD ADVERSELY AFFECT OUR STOCK PRICE. The market price of our common stock could drop as a result of sales of a large number of shares in the market or in response to the perception that these sales could occur. In addition, these sales might make it more difficult for us to sell equity or equity-related securities in the future at a time and price that we deem appropriate. We had outstanding 102,939,645 shares of common stock as of December 31, 2006. In addition, at December 31, 2006, we had 12,155,008 shares of our common stock reserved for issuance under warrants and stock options plans. In connection with the potential conversion of the Series C-1 Convertible Preferred Stock and Series C-2 Convertible Preferred Stock, issued on December 1, 2004, we may need to issue up to 2,174,242 and 1,454,392 shares, respectively, of our common stock (based on a conversion price of $1.98 and $2.96, respectively). WE DO NOT INTEND TO PAY DIVIDENDS ON OUR COMMON STOCK, AND THEREFORE STOCKHOLDERS WILL BE ABLE TO RECOVER THEIR INVESTMENT IN OUR COMMON STOCK, IF AT ALL, ONLY BY SELLING THE SHARES OF OUR STOCK THAT THEY HOLD. Some investors favor companies that pay dividends on common stock. We have never declared or paid any cash dividends on our common stock. We currently intend to retain any future earnings for funding growth and we do not anticipate paying cash dividends on our common stock in the foreseeable future. Because we may not pay dividends, a return on an investment in our stock likely depends on the ability to sell our stock at a profit. OUR BUSINESS IS SUBJECT TO CHANGING REGULATIONS RELATING TO CORPORATE GOVERNANCE AND PUBLIC DISCLOSURE THAT HAS INCREASED BOTH OUR COSTS AND THE RISK OF NONCOMPLIANCE. Because our common stock is publicly traded, we are subject to certain rules and regulations of federal, state and financial market exchange entities charged with the protection of investors and the oversight of companies whose securities are publicly traded. These entities, including the Public Company Accounting Oversight Board, the Commission, and NASDAQ, have recently issued new requirements and regulations and continue to develop additional regulations and requirements in response to recent laws enacted by Congress, most notably Section 404 of the Sarbanes-Oxley Act of 2002. Our efforts to comply with these new regulations have resulted in, and are likely to continue to result in, materially increased general and administrative expenses and a significant diversion of management time and attention from revenue-generating and cost-reduction activities to compliance activities. In particular, our efforts to comply with Section 404 of the Sarbanes-Oxley Act of 2002 and the related regulations regarding our required assessment of our internal controls over financial reporting and our independent registered public accounting firm's audit of that assessment has required, and continues to require, the commitment of significant financial and managerial resources. There is no assurance that these efforts will be completed on a timely and successful basis. Because these laws, regulations and standards are subject to varying interpretations, their application in practice may evolve over time as new guidance becomes available. This evolution may result in continuing uncertainty regarding compliance matters and additional costs necessitated by ongoing revisions to our disclosure and governance practices. In the event that our Chief Executive Officer, Chief Financial Officer, or independent registered public accounting firm determine that our internal controls over financial reporting are not effective as defined under Section 404 of the Sarbanes-Oxley Act of 2002, there may be a material adverse impact in investor perceptions and a decline in the market price of our stock. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We considered the provisions of Financial Reporting Release No. 48, "Disclosures of Accounting Policies for Derivative Financial Instruments and Derivative Commodity Instruments, and Disclosures of Quantitative and Qualitative Information about Market Risk Inherent in Derivative Commodity Instruments." On July 13, 2005, in connection with a $20.0 million loan agreement with a third party finance company with an adjustable interest rate equal to the greater of 6.75% or the sum of the LIBOR rate plus 4.0% (9.375% at December 31, 2006), we entered into a rate cap agreement which caps the LIBOR rate at 5.5% (On January 8, 2007, the most recent adjustment date, the LIBOR rate was 5.32%) In addition, we are exposed to financial market risks, including changes in foreign currency exchange rates and interest rates. 38 We also have long-term debt in the form of two loans to a stockholder, which mature in September 2008, and one loan to a third party finance company which matures in July 2010. The first loan to the stockholder has an adjustable rate of interest at 1.0% above the lender's borrowing rate (9.0% at September 30, 2006) and the second loan to the stockholder has a fixed interest rate of 8.0%. The loan to the third party finance company has a monthly floating interest rate as described above. The table below presents principal amounts by fiscal year for our long-term and short-term debt:
2007 2008 2009 2010 2011 THEREAFTER TOTAL (dollars in thousands) Liabilities: Fixed rate debt $ - - 20,000 - - - $ 20,000 Variable rate debt $ - - 14,950 - - - $ 14,950 Variable rate debt $ - - - - 20,000 - $ 20,000
Based on borrowing rates currently available to us for loans with similar terms, the carrying value of our debt obligations approximates fair value. ITEM 4. CONTROLS AND PROCEDURES The term "disclosure controls and procedures" refers to the controls and other procedures of a company that are designed to ensure that information required to be disclosed by the company in the reports that it files under the Securities Exchange Act of 1934 ("Exchange Act") is recorded, processed, summarized and reported, within required time periods. Disclosure controls and procedures, include, without limitation, controls and procedures designed to ensure that information required to be disclosed in the reports the Company files or submits under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer as appropriate to allow timely decisions regarding required disclosure. Our management, with the participation of our Chief Executive Officer and Chief Financial Officer carried out an evaluation of the effectiveness of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-15(b). MATERIAL WEAKNESS IN INTERNAL CONTROL OVER FINANCIAL REPORTING A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. Management conducted an evaluation of the effectiveness of internal control over financial reporting based on the framework in Internal Control. Management determined there were an insufficient number of personnel with appropriate technical accounting and SEC reporting expertise to perform a timely financial close process, adhere to certain control disciplines, and to evaluate and properly record certain non-routine and complex transactions. Management determined that this control deficiency constitutes a material weakness. CHANGES IN INTERNAL CONTROLS There was no change in our internal controls during the fiscal first and second quarters of 2007 that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting. 39 PART II - OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS On February 14, 2006, Hydro-Quebec filed an action against us in the United States District Court for the Western District of Texas (Hydro-Quebec v. Valence Technology, Civil Action No. A06CA111). In its amended complaint filed April 13, 2006, Hydro-Quebec alleges that Saphion(R) Technology, the technology utilized in all of our commercial products, infringes U.S. Patent No. 5,910,382 and 6,514,640 exclusively licensed to Hydro-Quebec. Hydro-Quebec's complaint seeks injunctive relief and monetary damages. The action is in the initial pleading state and we have filed a response denying the allegations in the amended complaint. Our management believes the action by Hydro-Quebec is without merit and intends to vigorously defend the lawsuit, as well as pursue all of its available legal remedies. The court has issued a stay of proceedings pending the outcome of reexaminations of the two patents by the US Patent and Trademark Office. We are subject to, from time to time, various claims and litigation in the normal course of business. In our opinion, all pending legal matters are either covered by insurance or, if not insured, will not have a material adverse impact on our consolidated financial statements ITEM 1A. RISK FACTORS Information regarding risk factors appears in Item 2 "Management's Discussion and Analysis of Financial Condition and Results of Operations," and various risk factors faced by us are also discussed elsewhere in Item 2 of this report. In addition, risk factors are included in Item 1A of our Annual Report on Form 10-K for our fiscal year ending March 31, 2006, filed with the Commission on June 29, 2006. There are no material changes from the risk factors previously disclosed on our Annual Report on Form 10-K for the fiscal year ending March 31, 2006. . ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS None. ITEM 3. DEFAULTS UPON SENIOR SECURITIES None. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. ITEM 5. OTHER INFORMATION None. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits EXHIBIT NO.
10.10 (1) Letter from Helin, Donovan, Trubee & Wilkinson, LLP dated February 6, 2007. 31.1 Certification of James R. Akridge, Principal Executive Officer, pursuant to Rule 13a-14 and 15d-14 of the Securities Exchange Act of 1934. 31.2 Certification of Thomas F. Mezger, Principal Financial Officer, pursuant to Rule 13a-14 and 15d-14 of the Securities Exchange Act of 1934 32.1 Certification of James R. Akridge, Principal Executive Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 40 32.2 Certification of Thomas F. Mezger, Principal Financial Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. FOOTNOTES (1) Incorporated by reference to the exhibit so described in the Company's Current Report on Form 8-K, dated February 6, 2007, filed with the Securities and Exchange Commission on February 6, 2007.
41 SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereto duly authorized. VALENCE TECHNOLOGY, INC. Dated: February 6, 2007 By: /s/ James R. Akridge --------------------------------------- James R. Akridge Chief Executive Officer (Principal Executive Officer) By: /s/ Thomas F. Mezger --------------------------------------- Thomas F. Mezger Chief Financial Officer and Assistant Secretary (Principal Financial Officer) 42
EXHIBIT INDEX EXHIBIT NO. 10.10 (1) Letter from Helin, Donovan, Trubee & Wilkinson, LLP dated February 6, 2007. 31.1 Certification of James R. Akridge, Principal Executive Officer, pursuant to Rule 13a-14 and 15d-14 of the Securities Exchange Act of 1934. 31.2 Certification of Thomas F. Mezger, Principal Financial Officer, pursuant to Rule 13a-14 and 15d-14 of the Securities Exchange Act of 1934 32.1 Certification of James R. Akridge, Principal Executive Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 32.2 Certification of Thomas F. Mezger, Principal Financial Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. FOOTNOTES (1) Incorporated by reference to the exhibit so described in the Company's Current Report on Form 8-K, dated February 6, 2007, filed with the Securities and Exchange Commission on February 6, 2007.