MECHANICAL TECHNOLOGY INC - 10-Q Quarterly Report

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

/X/ Quarterly report pursuant to Section 13 or 15 (d) of the Securities

Exchange Act of 1934

For the quarterly period ended March 31, 2004

/ / 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 0-6890

MECHANICAL TECHNOLOGY INCORPORATED

(Exact name of registrant as specified in its charter)

New York	14-1462255
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

431 New Karner Road, Albany, New York 12205

(Address of principal executive offices) (Zip Code)

(518) 533-2200

(Registrant's telephone number, including area code)

Not Applicable

(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 an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.

Class	Outstanding at May 7, 2004
Common Stock, $1.00 Par Value	29,224,666 Shares

MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES

INDEX

Part I. FINANCIAL INFORMATION	Page No.

Item 1. Financial Statements Financial Statements of Mechanical Technology Incorporated and Subsidiaries

Consolidated Balance Sheets - March 31, 2004 (Unaudited) and December 31, 2003	3-4

Consolidated Statements of Operations - Three months ended March 31, 2004 and 2003 (Unaudited)	5

Consolidated Statements of Shareholders' Equity and Comprehensive Income - Three months ended March 31, 2004 and 2003 (Unaudited)	6

Consolidated Statements of Cash Flows - Three months ended March 31, 2004 and 2003 (Unaudited)	7

Notes to Interim Consolidated Financial Statements (Unaudited)	8-28

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations	29-36

Item 3. Quantitative and Qualitative Disclosures About Market Risk	36

Item 4. Controls and Procedures	36

Part II. OTHER INFORMATION

Item 1. Legal Proceedings	37
Item 2. Changes in Securities and Use of Proceeds	37
Item 3. Defaults Upon Senior Securities	37
Item 4. Submission of Matters to a Vote of Security Holders	37
Item 5. Other Information	37
Item 6. Exhibits and Reports on Form 8-K	37-38

Signatures	39

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements
MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

As of March 31, 2004 (Unaudited) and December 31, 2003

(Dollars in thousands)

	Mar. 31,	Dec. 31,
	2004	2003
Assets
Current Assets:
Cash and cash equivalents	$22,376	$12,380
Securities available for sale	20,792	44,031
Accounts receivable	1,482	962
Other receivables - related parties	22	-
Inventories, net	1,277	1,300
Prepaid expenses and other current assets	800	514
Total Current Assets	46,749	59,187

Long Term Assets:
Securities available for sale - restricted	23,160	-
Property, plant and equipment, net	2,200	1,999
Deferred income taxes	-	4,652
Notes receivable-noncurrent, less allowance of $660	-	-
Total Assets	$72,109	$65,838

The accompanying notes are an integral part of the consolidated financial statements.

MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

As of March 31, 2004 (Unaudited) and December 31, 2003

(Dollars in thousands, except share data)

	Mar. 31,	Dec. 31,
	2004	2003
Liabilities and Shareholders' Equity

Current Liabilities:
Accounts payable	$ 1,196	$ 692
Accrued liabilities	1,622	1,528
Accrued liabilities - related parties	77	48
Income taxes payable	7	12
Deferred income taxes	6,443	14,481
Total Current Liabilities	9,345	16,761
Long-Term Liabilities:
Derivative liability	3,020	-
Deferred income taxes and other liabilities	3,330	24
Total Liabilities	15,695	16,785

Commitments and Contingencies
Minority interests	525	787

Shareholders' Equity:
Common stock, par value $1 per share, authorized 75,000,000; issued 37,246,352 in March 2004 and 35,776,510 in December 2003	37,246	35,776
Paid-in-capital	74,770	68,708
Accumulated deficit	(62,675)	(62,433)
	49,341	42,051
Accumulated Other Comprehensive Income:
Unrealized gain on securities available for sale, net of taxes	20,302	19,944
Common stock in treasury, at cost, 8,040,736 shares in March 2004 and 8,035,974 shares in December 2003	(13,754)	(13,729)
Total Shareholders' Equity	55,889	48,266
Total Liabilities and Shareholders' Equity	$ 72,109	$ 65,838

The accompanying notes are an integral part of the consolidated financial statements.

MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)

(Dollars in thousands, except per share data)

	Three months ended
	Mar. 31,	Mar. 31,
	2004	2003
Revenues:
Product revenue	$ 1,579	$ 1,283
Funded research and development revenue	388	522
Total revenues	1,967	1,805
Operating costs and expenses:
Cost of product revenue	647	555
Research and product development expenses:
Funded research and product development	1,154	820
Unfunded research and product development	1,514	951
Total research and product development expenses	2,668	1,771
Selling, general and administrative expenses	1,307	1,432
Operating loss	(2,655)	(1,953)
Interest expense	-	(3)
Loss on derivatives	(1,281)	(6)
Gain on sale of securities available for sale, net	3,129	1,720
Other expenses, net	(13)	(26)
Loss from operations before income taxes and
minority interests	(820)	(268)
Income tax benefit	316	89
Minority interests in losses of consolidated subsidiary	262	116
Net loss	$ (242)	$ (63)
Loss per Share (Basic and Diluted):
Loss per share	$(0.01)	$ -

The accompanying notes are an integral part of the consolidated financial statements.

MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY AND COMPREHENSIVE INCOME (Unaudited)

(Dollars in thousands)

	Three months ended
	Mar. 31,	Mar. 31,
	2004	2003
COMMON STOCK
Balance, beginning	$ 35,776	$ 35,648
Issuance of shares - options	51	11
Issuance of shares - private placement	1,419	-
Balance, ending	$ 37,246	$ 35,659
PAID-IN-CAPITAL
Balance, beginning	$ 68,708	$ 67,479
Issuance of shares - options	78	9
MTI MicroFuel Cell investment	-	2
Private placement	5,909	-
Compensatory options	-	11
Stock option exercises recognized differently for financial
reporting and tax purposes	75	1
Balance, ending	$ 74,770	$ 67,502
ACCUMULATED DEFICIT
Balance, beginning	$(62,433)	$(61,874)
Net loss	(242)	(63)
Balance, ending	$(62,675)	$(61,937)
ACCUMULATED OTHER COMPREHENSIVE INCOME:
UNREALIZED GAIN ON SECURITIES AVAILABLE FOR SALE,
NET OF TAXES
Balance, beginning	$ 19,944	$ 13,170
Less reclassification adjustment for gains included in net income	(1,248)	(818)
Change in unrealized gain on securities available for sale, net of taxes	1,606	2,325
Balance, ending	$ 20,302	$ 14,677
RESTRICTED STOCK GRANT
Balance, beginning	$ -	$ (40)
Grants vested	-	12
Balance, ending	$ -	$ (28)
TREASURY STOCK
Balance, beginning	$(13,729)	$(13,635)
Stock acquisition	(25)	-
Balance, ending	$(13,754)	$(13,635)
SHAREHOLDERS' EQUITY
Balance, ending	$ 55,889	$ 42,238
TOTAL COMPREHENSIVE INCOME (LOSS):
Net loss	$ (242)	$ (63)
Other comprehensive income:
Change in unrealized gain on securities available for sale, net of taxes	358	1,507
Total comprehensive income	$ 116	$ 1,444

The accompanying notes are an integral part of the consolidated financial statements.

MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

(Dollars in thousands)

	Three months ended
	Mar. 31, 2004	Mar. 31, 2003
Operating Activities
Net loss	$ (242)	$ (63)
Adjustments to reconcile net loss to net cash used by operations:
Loss on derivatives	1,281	6
Minority interests in losses of consolidated subsidiary	(262)	(116)
Depreciation and amortization	191	138
Gain on sale of securities available for sale, net	(3,129)	(1,720)
Loss on disposal of fixed assets	5	-
Deferred income taxes and other credits	(243)	(111)
Stock based compensation	-	23
Changes in operating assets and liabilities :
Accounts receivable	(520)	106
Other receivables - related parties	(22)	-
Inventories	23	34
Prepaid expenses and other current assets	(286)	(147)
Accounts payable	504	(28)
Income taxes	(5)	(28)
Accrued liabilities - related parties	29	(135)
Accrued liabilities	94	244
Net cash used by operating activities	(2,582)	(1,797)
Investing Activities
Purchases of property, plant and equipment	(397)	(150)
Proceeds from sale of securities available for sale	3,804	2,776
Net cash provided by investing activities	3,407	2,626
Financing Activities
Gross proceeds from private placement	10,000	-
Costs of private placement	(933)	-
Purchase of common stock for treasury	(25)	-
Proceeds from stock option exercises	129	20
Net cash provided by financing activities	9,171	20
Increase in cash and cash equivalents	9,996	849
Cash and cash equivalents - beginning of period	12,380	7,320
Cash and cash equivalents - end of period	$ 22,376	$ 8,169

The accompanying notes are an integral part of the consolidated financial statements.

MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Basis of Presentation

In the opinion of management, the accompanying unaudited consolidated financial statements have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission ("SEC") and contain all adjustments, consisting of only normal, recurring adjustments, necessary for a fair presentation of results for such periods. The results for any interim period are not necessarily indicative of results for the full year. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been omitted. These consolidated financial statements should be read in conjunction with the financial statements and notes thereto for the year ended December 31, 2003.

Significant Accounting Policies

Revenue Recognition

Mechanical Technology Incorporated ("the Company") recognizes revenue from product sales in accordance with Staff Accounting Bulletin ("SAB") No. 104, Revenue Recognition. Product revenue is recognized when there is persuasive evidence of an arrangement, delivery of the product to the customer or distributor has occurred, at which time title generally is passed to the customer or distributor, and the Company has determined that collection of a fixed fee is probable, all of which occur upon shipment of the product. If the product requires installation to be performed by the Company, all revenue related to the product is deferred and recognized upon the completion of the installation.

The Company performs funded research and development for government agencies and companies under cost reimbursement contracts, which generally require the Company to absorb up to 50% of the total costs incurred. Cost reimbursement contracts provide for the reimbursement of allowable costs. Revenues are generally recognized in proportion to the reimbursable costs incurred. When government agencies are providing funding they do not expect the government to be the only significant end user of the resulting products. These contracts do not require delivery of products that meet defined performance specifications, but are best efforts arrangements to achieve overall research and development objectives. Included in accounts receivable are billed and unbilled work-in-progress on cost reimbursed contracts.

While the Company's accounting for these contract costs is subject to audit by the sponsoring entity, in the opinion of management, no material adjustments are expected as a result of such audits. Cost of product revenue includes material, labor and overhead. Costs incurred in connection with funded research and development

arrangements are included in funded research and product development expenses.

Deferred revenue consists of payments received from customers in advance of services performed, products shipped or installation completed.

Warranty

The Company records a warranty reserve at the time product revenue is recorded based on a historical rate. The reserve is reviewed during the year and is adjusted, if appropriate, to reflect new product offerings or changes in experience. Actual warranty claims are tracked by product.

Stock Based Compensation

The Company has two stock-based employee compensation plans, which are described more fully in Note 13 of the financial statements and notes thereto for the year ended December 31, 2003. Statement of Financial Accounting Standards ("SFAS") No. 123, Accounting for Stock-Based Compensation, requires the measurement of the fair value of stock options or warrants granted to employees to be included in the consolidated statements of operations or, alternatively, disclosed in the notes to consolidated financial statements. The Company accounts for stock-based compensation of employees under the intrinsic value method of Accounting Principles Board ("APB") Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations and has elected the disclosure-only alternative under SFAS No. 123. The Company records the fair market value of stock options and warrants granted to non-employees in

MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Significant Accounting Policies (Continued)

exchange for services in accordance with Emerging Issues Task Force ("EITF") Issue No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services, in the consolidated statements of operations. The Company has adopted the disclosure provisions but does not intend to adopt the transition provisions of SFAS No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure.

The following table illustrates the effect on net loss and loss per share as if the Company had applied the fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation.

(Dollars in thousands, except per share data)	Three months ended
	Mar. 31,	Mar. 31,
	2004	2003
Net loss, as reported	$ (242)	$ (63)
Add: Total stock-based employee
compensation expense already recorded in
financial statements, net of related tax effects	-	7

Deduct: Total stock-based employee
compensation expense determined under fair
value based method for all awards, net of
related tax effects	(58)	(371)
Pro forma net loss	$ (300)	$ (427)

Loss per share:
Basic and diluted - as reported	$ (0.01)	$ (0.00)
Basic and diluted - pro forma	$ (0.01)	$ (0.02)

Accounting for Derivative Instruments

On October 1, 2000, the Company adopted SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended by SFAS No. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities, which establishes a new model for accounting for derivatives and hedging activities. These standards required the Company to recognize all derivative instruments as either assets or liabilities in the statement of financial position and measure these instruments at fair value. Fair value is estimated using option pricing models including the Binomial and Black Scholes models.

In September 2000, the EITF issued EITF Issue No. 00-19, Accounting for Derivative Financial Instruments Indexed to and Potentially Settled in, a Company's Own Stock, which requires freestanding contracts that are settled in a company's own stock, including common stock warrants, to be designated as an equity instrument, asset or a liability. Under the provisions of EITF Issue No. 00-19, a contract designated as an asset or a liability must be carried at fair value, with any changes in fair value recorded in the results of operations. A contract designated as an equity instrument must be included within equity, and no fair value adjustments are required.

MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Significant Accounting Policies (Continued)

The Company held or has outstanding the following derivative financial instruments:

	Mar. 31,	Mar. 31,	Dec. 31,
	2004	2003	2003	Expiration
Derivatives issued:

Warrants, exercisable beginning February 5, 2005, to purchase the
Company's common stock issued to Chicago Investment Group, L.L.C.
at a purchase price of $10.572 per share	28,377	-	-	February 5, 2006

First Investment Right, exercisable beginning April 25, 2004, to
purchase the Company's common stock issued to Fletcher
International, Ltd. at a purchase price of $7.048 per share (1)	1,135,074	-	-	December 31, 2004

Second Investment Right, exercisable beginning immediately after
the full exercise of the First Investment Right, to purchase the
Company's common stock issued to Fletcher International, Ltd. at
a purchase price of $7.048 through December 31, 2005 or after
December 31, 2005 at the lower of $7.048 or the prevailing price
of the Company's common stock (1)	2,553,916	-	-	December 31, 2006

Plug Power Investment Right, exercisable at any time during the
month of June 2005 after the full exercise of the First Investment
Right, to purchase a number of the Company's shares of Plug
Power common stock (to the extent of the number of shares
remaining in escrow pursuant to the agreement) equal to
$10,000,000 divided by the prevailing price per share of Plug Power
common stock (1)	(2)	-	-	June 30, 2005

Warrants, immediately exercisable, to purchase the Company's
common stock issued to SatCon at a purchase price of $12.56 per
share	-	108,000	-	October 21, 2003

Warrants, immediately exercisable, to purchase the Company's
common stock issued to SatCon at a purchase price of $12.56 per
share	-	192,000	192,000	January 31, 2004

Derivatives held:
Warrants, immediately exercisable, to purchase SatCon common
stock at a purchase price of $7.84 per share	-	36,000	-	October 21, 2003

Warrants, immediately exercisable, to purchase SatCon common
stock at a purchase price of $7.84 per share	-	64,000	64,000	January 31, 2004

(1) - The Company and Fletcher International, Ltd. entered into an amended private placement agreement on May 4, 2004 (see Note 7 - Shareholders' Equity).

(2) - The exercise price for the Plug Power Investment Right is $10,000,000 less the positive difference between $18,000,000 and the product of the sum of 1,418,842 and the quantity of shares purchased in the exercise of the first $8 million additional investment right multiplied by the prevailing price per share of our common stock on the date Fletcher elects to exercise such right, all divided by the quotient obtained by dividing 10,000,000 by the prevailing price of Plug Power common stock on the date Fletcher elects to exercise such right (see Note 7- Shareholders' Equity).

Income Taxes

The Company accounts for taxes in accordance with SFAS No. 109, Accounting for Income Taxes, which requires the use of the asset and liability method of accounting for income taxes. Under the asset and liability method, deferred income taxes are recognized for the tax consequences of "temporary differences" by applying enacted statutory tax rates applicable for future years to differences between financial statement and tax bases of existing assets and liabilities. Under SFAS No. 109, the effect of tax rate changes on deferred taxes is

MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Significant Accounting Policies (Continued)

recognized in the income tax provision in the period that includes the enactment date. The provision for taxes is reduced by investment and other tax credits in the years such credits become available. A valuation allowance is recorded to reduce the carrying amounts of deferred tax assets unless it is more likely than not that such assets will be realized.

Reclassification

Certain 2003 amounts have been reclassified to conform to the 2004 presentation. The reclassifications have no effect on total revenues, total expenses, net loss or stockholders' equity as previously reported.

The reclassifications impact our consolidated statements of operations in the following way:

Selling, general and administrative expenses now include amortization of restricted stock compensation previously included in other expenses, net.

Contracts Receivable
Included in accounts receivable are the following at:

	Mar. 31,		Dec. 31,
(Dollars in thousands)		2004		2003
U.S. and State Government:
Amount billable		$ 105		$ 272
Amount billed		813		282
Retainage		70		65
		$ 988		$ 619

The balances billed but not paid by customers pursuant to retainage provisions in contracts are due upon completion of the contracts and acceptance by the customer. Based on the Company's experience, most retainage amounts are expected to be collected within the ensuing year.

Inventories

Inventories consist of the following at:

		Mar. 31,		Dec. 31,
(Dollars in thousands)	2004		2003
Finished goods	$ 311		$ 300
Work in process	275		316
Raw materials, components and assemblies, net	691		684
	$1,277		$1,300

Securities Available for Sale

Securities available for sale are classified as both current assets and long-term restricted assets and accumulated net unrealized gains are charged to Other Comprehensive Income. In connection with the Company's private placement consummated on January 29, 2004, the Company escrowed 3 million shares of Plug Power common stock. In connection with the amendment of the private placement agreement on May 4, 2004, the escrowed Plug Power common stock was reduced to 2.7 million shares (see Note 7 - Shareholders' Equity).

MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Securities Available for Sale (Continued)

The principal components of the Company's securities available for sale consist of the following:

(Dollars in thousands, except stock price and share data)

				Quoted
				Market
	Book	Unrealized	Recorded	Price
Security	Basis	Gain	Fair Value	Per NASDAQ	Ownership	Shares
March 31, 2004
Plug Power:
Current	$ 4,786	$16,006	$20,792	$ 7.72	3.70%	2,693,227
Restricted ⁽¹⁾	5,330	17,830	23,160	$ 7.72	4.11%	3,000,000
Total	$10,116	$33,836	$43,952		7.81%	5,693,227
December 31, 2003
Plug Power	$10,791	$33,240	$44,031	$ 7.25	8.36%	6,073,227

^{(1) - In connection with the amended private placement agreement, the Company has reduced the number of shares of Plug Power it has deposited into escrow to 2,700,000 shares, a reduction of 300,000 shares.

The book basis roll forward of Plug Power securities is as follows:

Plug Power - Current

(Dollars in thousands)

Mar. 31,

Dec. 31,

2004

2003

Securities available for sale, beginning of period

$10,791

$14,344

Sale of shares

(675)

(3,553)

Transfer 3,000,000 shares to restricted on 1/29/04

(5,330)

-

Securities book basis

4,786

10,791

Unrealized gain on securities available for sale

16,006

33,240

Securities available for sale, end of period

$20,792

$44,031

Plug Power - Restricted

(Dollars in thousands)

Mar. 31,

Dec. 31,

2004

2003

Securities available for sale, beginning of period

$ -

$ -

Transfer 3,000,000 shares from current on 1/29/04

5,330

-

Securities book basis

5,330

-

Unrealized gain on securities available for sale

17,830

-

Securities available for sale - restricted, end of period

$23,160

$ -

Accumulated unrealized gains related to securities available for sale are as follows:

Mar. 31,

Dec. 31,

(Dollars in thousands)

2004

2003

Accumulated unrealized gains

$ 33,836

$ 33,240

Accumulated deferred tax expense

on unrealized gains

(13,534)

(13,296)

Accumulated net unrealized gains

$ 20,302

$ 19,944

12
MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Income Taxes

The Company's effective income tax benefit rate from operations differed from the Federal statutory rate as follows:

Three months ended

Mar. 31,
2004

Mar. 31,
2003

Federal statutory tax rate

34.00%

34.00%

State taxes, net of federal tax effect

4.15

.58

Other benefit (expense), net

.39

(1.37)

Tax rate

38.54%

33.21%

Income tax benefit (expense) consists of the following:

Three months ended

(Dollars in thousands)

Mar. 31,

Mar. 31,

2004

2003

Operations before minority interest

Federal

$ 96

$ -

State

(23)

(22)

Deferred

243

111

Total

$ 316

$ 89

Items (charged) credited
directly to stockholders' equity:

Increase in unrealized gain on available for sale
securities - Deferred

$ (238)

$(1,005)

Expenses for employee stock options recognized
differently for financial reporting/tax purposes -
Federal

75

1

$ (163)

$(1,004)

13
MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Income Taxes (Continued)

Deferred tax assets and liabilities consist of the following tax effects relating to temporary differences and carryforwards:

(Dollars in thousands)

Mar. 31,

Dec. 31,

2004

2003

Current deferred tax assets (liabilities):

Bad debt reserve

$ 264

$ 264

Inventory valuation

17

3

Inventory capitalization

20

20

Securities available for sale

(7,286)

(15,289)

Vacation pay

194

181

Warranty and other sale obligations

13

11

Stock options

269

269

Other reserves and accruals

66

60

Net current deferred tax liabilities

$(6,443)

$(14,481)

Non-current deferred tax assets (liabilities):

Net operating loss

$ 5,528

$ 5,785

Property, plant and equipment

(145)

(145)

Securities available for sale - restricted

(8,117)

-

Derivatives

512

-

Other

239

239

Research and development tax credit

459

459

Alternative minimum tax credit

54

150

(1,470)

6,488

Valuation allowance

(1,836)

(1,836)

Net non-current deferred tax (liabilities) assets

$(3,306)

$ 4,652

Other Credits

$ (24)

$ (24)

The valuation allowance at March 31, 2004 and December 31, 2003 was $1.836 million. The valuation allowance reflects the estimate that it was more likely than not that certain net operating losses may be unavailable to offset future taxable income.

Shareholders' Equity

Common Shares
Changes in common shares are as follows:

Three

Months Ended

Year Ended

Mar. 31,

Dec. 31,

2004

2003

Balance, beginning

35,776,510

35,648,135

Issuance of shares for stock

option exercises

51,000

128,375

Issuance of shares for

private placement

1,418,842

-

Balance, ending

37,246,352

35,776,510

14

MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Shareholders' Equity (Continued)

Treasury Stock
Changes in treasury stock are as follows:

Three

Months Ended

Year Ended

Mar. 31,

Dec. 31,

2004

2003

Balance, beginning

8,035,974

8,020,250

Shares acquired for cash

4,762

15,724

Balance, ending

8,040,736

8,035,974

Warrants Issued
On February 5, 2004, the Company issued to Chicago Investment Group, L.L.C. a warrant to purchase 28,377 shares of the Company's common stock at an exercise price of $10.572 per share. The estimated fair value of this warrant at the date issued was $1.39 per share, using a Black Scholes Option Pricing Model and assumptions similar to those used for valuing the Company's stock options. The warrant may not be exercised until February 5, 2005 and expires on February 5, 2006.

Reservation of Shares
The Company has reserved common shares for future issuance as of March 31, 2004 as follows:

Stock options outstanding

2,825,650

Stock options available for issuance ⁽¹⁾

3,702,082

Additional Investment Rights as required by private placement agreement

4,131,988

Warrants outstanding

28,377

Number of common shares reserved

10,688,097

(1) - On December 22, 2003, the Company announced the successful completion of the first phase of its stock option exchange offer. A total of 757,000 options with an average exercise price of approximately $19 were tendered by employees and then cancelled by the Company in exchange for the future issuance of options at a one-for-two ratio. New options will be issued in the final phase of the exchange offer on or after June 23, 2004 at the then current market price to employees and directors who are employed by the Company or serve as directors of the Company from the acceptance date through the date that the new options are granted. As of May 11, 2004, the Company anticipates issuing 341,000 options associated with the exchange.

Private Placement

On January 29, 2004, we issued to Fletcher International, Ltd., or Fletcher, in a private placement (1) 1,418,842 shares of our common stock for an aggregate purchase price of $10 million, or $7.048 per share, and (2) rights to purchase up to an additional $26 million of our common stock and in certain instances up to 3,000,000 shares of Plug Power Inc. (NASDAQ:PLUG) common stock owned by us, which rights are referred to herein as the additional investment rights.

15
MECHANICAL TECHNOLOGY INCORPORATED AND SUBSIDIARIES
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

Shareholders' Equity (Continued)

We filed a registration statement with the SEC on February 3, 2004 for 6,384,790 shares, as required by our agreement with Fletcher, to permit Fletcher to re-sell the shares of our common stock issued to Fletcher and any shares of our common stock that Fletcher may acquire in the future upon exercise of its additional investment rights or upon the occurrence of certain other events.

On May 4, 2004, we amended our agreement with Fletcher. The agreement, as amended, includes a change in the exercise price for the rights to purchase additional shares of MTI common stock to a fixed price $6.34 per share from, in the original agreement, $7.048 per share until December 31, 2005 and the lesser of $7.048 per share or a variable price in 2006. The price remains subject to adjustment upon the occurrence of certain limited events. The agreement, as amended, also includes: (1) an increase in the rights to purchase additional shares of MTI common stock to $28 million from $26 million, (2) a reduction in Fletcher's right to purchase Plug Power common stock escrowed by the Company to a maximum of 2,700,000 shares from a maximum of 3,000,000 shares, (3) an extension of the exercise period for the right to purchase Plug Power common stock to one or more purchases between June 1, 2005 and December 31, 2006 from a one-time purchase in June of 2005, (4) an extension of MTI's ability to withdraw Plug
Power common stock from escrow through December 31, 2006 instead of through June 30, 2005, and (5) an extension of the exercise period for the right to invest the first $8 million in MTI's common stock to any time prior to December 31, 2004 from any time prior to ninety business days after the effective date of MTI's registration statement.

Additional Investment Rights - Prior to Amendment
The additional investment rights, prior to the amendment, provided Fletcher with the right, but not the obligation, to purchase up to an additional $8 million of our common stock at any time prior to ninety business days after the effective date of the registration statement, at a price per share equal to $7.048. In addition, in the event Fletcher exercised in full such $8 million investment right, Fletcher had the right, but not the obligation, to purchase, in a single purchase or multiple purchases, up to an additional $18 million of our common stock at any time prior to December 31, 2006, which date may have been extended in the event that we had not satisfied our contractual obligations with respect to the registration for resale of common stock issued or issuable to Fletcher. If Fletcher exercised such rights prior to December 31, 2005, the investment price per share was equal to $7.048.
After December 31, 2005 (including during any extension of the original investment term), the investment right was at a price per share equal to the lesser of $7.048 and the prevailing price of our common stock as of five business days prior to the delivery of the exercise notice. As used herein (both before and after the amendment), a prevailing price is the average of the daily volume-weighted average price per share of common stock during the sixty-business-day period ending three days prior to the date Fletcher elects to exercise such right, provided however that the price may not exceed the average of the daily volume-weighted average prices for any ten business days within such sixty-business-day period. Each of the above referenced per share exercise prices for the additional investment rights was subject to adjustment as described below under "Adjustment Provisions - Prior to A
mendment."

16}

	Three
	Months Ended	Year Ended
	Mar. 31,	Dec. 31,
	2004	2003
Balance, beginning	35,776,510	35,648,135
Issuance of shares for stock
option exercises	51,000	128,375
Issuance of shares for
private placement	1,418,842	-
Balance, ending	37,246,352	35,776,510

Stock options outstanding	2,825,650
Stock options available for issuance ⁽¹⁾	3,702,082
Additional Investment Rights as required by private placement agreement	4,131,988
Warrants outstanding	28,377
Number of common shares reserved	10,688,097