Back to GetFilings.com
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
(Mark One)
[X] Annual Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the Fiscal Year Ended December 31, 2001
[ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
Commission file number 0-23634
KFX INC.
(Exact Name of Registrant As Specified In Its Charter)
DELAWARE 84-1079971
(State or other jurisdiction of (I.R.S. Employer Identification
incorporation or organization) Number)
3300 EAST FIRST AVENUE, SUITE 290, DENVER, COLORADO USA 80206
(Address of Principal Executive Offices)
(303) 293-2992
(Registrant's Telephone Number Including Area Code)
Securities registered pursuant to Section 12(b) of the Act:
TITLE OF EACH CLASS NAME OF EXCHANGE ON WHICH REGISTERED
Common Stock, $.001 par value American Stock Exchange
Securities registered pursuant to Section 12(g) of the Act: None
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, and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
As of April 12, 2002, the aggregate market value of the Registrant's common
stock held by non-affiliates of the Registrant was approximately $66,488,000. At
April 12, 2002, 32,275,879 shares of common stock of the Registrant were
outstanding.
1
- --------------------------------------------------------------------------------
TABLE OF CONTENTS
- --------------------------------------------------------------------------------
Page No.
-------
PART I
Item 1. Business......................................................................
Item 2. Properties....................................................................
Item 3. Legal Proceedings.............................................................
Item 4. Submission of Matters to a Vote of Security Holders...........................
PART II
Item 5. Market for Common Stock and Related Stockholder Matters.......................
Item 6. Selected Financial Data.......................................................
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations.................................................................
Item 7A. Quantitative and Qualitative Disclosures About Market Risk....................
Item 8. Financial Statements and Supplementary Data...................................
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial
Disclosures...................................................................
PART III
Item 10. Directors and Executive Officers..............................................
Item 11. Executive Compensation........................................................
Item 12. Security Ownership of Certain Beneficial Owners and Management................
Item 13. Certain Relationships and Related Transactions................................
PART IV
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K..............
SIGNATURES ..............................................................................
2
PART I
- ------
ITEM 1. BUSINESS
OVERVIEW
KFX Inc. (the "Company" or "KFx"), a Delaware corporation formed in 1988, is
engaged in developing and delivering various technology and service solutions to
the electric power generation industry to facilitate the industry's (a)
compliance with various air quality emission standards on a domestic and
worldwide basis and (b) need to lower the cost of producing electricity,
particularly domestically as the United States power industry undergoes
deregulation and is transformed into a highly competitive business. Currently,
the Company sells and installs technology solutions that enhance the output of
coal, gas and oil-fired electric utility boilers while simultaneously reducing
the related environmental impacts and facilitating compliance with various
environmental standards, most importantly the Clean Air Act, as amended (the
"CAA"). The Company currently considers its business to be in two operating
segments, Pegasus Technologies, Inc. ("Pegasus") and K-Fuel(R) Technology ("K-
Fuel" segment), both of which serve the same industry and provide similar
benefits, but which have distinctly different technology bases. Prior to the
acquisition of Pegasus in 1998, the Company operated only in the K-Fuel segment.
Pegasus develops, markets, licenses and installs software that optimizes the
combustion performance of coal, gas and oil-fired electric utility boilers.
Pegasus currently has a suite of optimization products that include its
NeuSIGHT(R) ("NeuSIGHT") flagship product, Power Perfecter(TM) ("Power
Perfecter"), Software CEM(R) ("CEM") and Environmental Portfolio Manager(TM)
("EPM").
NeuSIGHT has been installed at 24 boiler units in the United States, Canada
and Poland. NeuSIGHT is currently under installation or scheduled to be
installed at 43 boiler units including two additional boiler units in Poland and
at one boiler unit in China. The NeuSIGHT installations underway or scheduled
are expected to be completed within approximately the next 12-24 months.
NeuSIGHT utilizes an artificial intelligence/neural network software platform
licensed from a wholly-owned subsidiary of Computer Associates, Inc. ("CA") to
interface with the process control system in electric utility boiler units. The
license agreement provides Pegasus perpetual, irrevocable, worldwide, exclusive
rights for process monitoring and control applications in the electric utilities
industry. NeuSIGHT collects real time operating data and builds a model of
optimal boiler combustion performance, taking into account various safety,
environmental and other constraints. NeuSIGHT can be set to optimize the
reduction of various emissions, such as nitrogen oxide ("NO\\x\\"), a boiler's
heat rate (a measure of boiler operating efficiency considering fuel consumed in
comparison to electricity generated), and/or other boiler performance measures.
NeuSIGHT provides the most benefit when operated in a closed loop mode, whereby
automatic adjustments are made to various controllable factors, such as oxygen
input.
Pegasus is continuously pursuing the development of improvements to NeuSIGHT
as well as complementary new products and services.
In July 2001, Pegasus entered into an Asset Purchase and License Agreement
with Pavilion Technologies, Inc. ("Pavilion"), under which Pegasus received the
exclusive right to license Pavilion's Power Perfecter, CEM and EPM software to
the electric utility industry. Power Perfecter is a universal, non-linear
control and optimization solution that uses model-predictive control to monitor
multiple variables and provide a proactive response. Pegasus is not currently
selling the CEM and EPM software, but is in the process of developing a
marketing plan for those two products.
Power Perfecter uses a different methodology to determine optimum performance
in boilers, but is considered to be a technology that is complementary to
NeuSIGHT. Power Perfecter has been installed at 43 boiler units in the United
States, Canada and Poland. Power Perfecter is currently under installation or
scheduled to be installed at 21 boiler units including an installation in
progress at one boiler unit in China. The Power Perfecter installations underway
or scheduled are expected to be completed within approximately the next 3-9
months. CEM applications are customized to meet state and federal emissions
monitoring using predictive emissions monitoring systems. These applications
return data identical to a hardware-based analyzer but with
3
less manual processing by the user. EPM simplifies the retrieval, collation,
processing and formatting of environmental monitoring data for submittal to
regulatory agencies and allows data from disparate sources to be reported in a
consistent manner.
The Company's K-Fuel segment continues to develop its patented K-Fuel
Technology, which is a process technology that uses heat and pressure to
physically and chemically transform high-moisture, low-energy value coal and
other organic feedstocks into a low-moisture, high-energy solid clean fuel ("K-
Fuel"). The K-Fuel Technology is generally referred to as a coal beneficiation
process, which refers to processes intended to produce, using run-of-mine coal
as feedstock, fuels with improved energy and environmental values. The principal
benefit of the K-Fuel Technology is that the fuel produced from the process can
facilitate the efforts of electric power producers and other large-scale users
of coal to meet the clean air standards imposed by the CAA. Based on various
analyses, the environmental benefits of burning K-Fuel versus most other coals
appear to include significant reductions in emissions of NO\\x\\, sulfur dioxide
("SO\\2\\"), carbon dioxide ("CO\\2\\"), mercury and chlorine. KFx plans to
license K-Fuel Technology domestically and internationally to various parties
wishing to construct and operate K-Fuel production facilities and, accordingly,
KFx plans to earn related license fee income and product sale or production
royalty income. In addition, KFx will consider negotiating for equity interests
in selected K-Fuel production facilities operated by K-Fuel licensees in
connection with its grant of a K-Fuel license. K-Fuel segment operations are
conducted through KFx and certain of its subsidiaries. The K-Fuel segment
recognized no revenues during 2001.
Summary financial information about each segment for 2001, 2000, and 1999
follows (for additional segment information see Note 19 to the consolidated
financial statements):
Pegasus K-Fuel
------- ------
2001
----
Operating Revenues $ 3,003,057 $ --
Operating Loss $ (3,489,709) $ (1,599,979)
Total Assets $ 10,661,823 $ 2,372,218
2000
----
Operating Revenues $ 1,894,994 $ 229,776
Operating Loss $ (4,131,294) $ (2,216,959)
Total Assets $ 3,242,295 $ 3,278,160
1999
----
Operating Revenues $ 1,536,884 $ 1,313,916
Operating Loss $ (3,266,584) $ (1,055,085)
Total Assets $ 3,457,574 $ 9,052,687
The Company will continue to consider various options to expand its business
by adding other solutions (including technologies, products and services) to
meet (a) the needs of the electric power industry as it is transformed by
deregulation into a highly competitive industry and (b) the increasingly
stringent environmental standards triggered by indications of global warming and
other environmental concerns.
Although the Company is pursuing various international opportunities in both
segments, during each of the three years ended December 31, 2001, most of the
Company's operating activities were conducted domestically. However, Pegasus
generated revenues from customers in Canada, China and Poland approximating
$833,000, $119,000, and $224,000 in 2001, 2000, and 1999, respectively.
4
PEGASUS
General
In March 1998, the Company purchased a 60% interest in Pegasus Technologies
Limited ("Pegasus Limited"), an Ohio limited liability company. Pegasus Limited
had developed a software technology that optimizes the performance of coal-fired
electric utility boilers. Pegasus' flagship product, NeuSIGHT, provides two
primary benefits: improved combustion performance and reduction in NO\\x\\
emissions. NO\\x\\ is a primary component of ground level smog. See "Market
Drivers--Domestic Market." Additional benefits of NeuSIGHT include (a)
improvements in boiler efficiency (heat rate), which translate into lower fuel
costs, as well as lower emissions of SO\\2\\ and CO\\2\\; (b) an increase in
gross generating capacity, providing more electricity for the power company to
sell; (c) lower carbon in the ash waste by-product, which can convert a related
waste product disposal cost into a marketable ash product; and (d) improvements
in opacity, which refers to the visible exhaust discharged from an emissions
stack.
NeuSIGHT dynamically models in real time the operating conditions of the
electric utility boiler combustion process and makes alterations to operating
variables, which improve boiler heat-rate performance, reduce harmful emissions
and lower fuel costs. Maximum benefits are achieved by allowing NeuSIGHT to
operate in closed loop mode wherein its alterations to operating variables are
automatically invoked.
In August 1998, the Company formed Net Power Solutions, LLC ("NPS"), a
Delaware limited liability company, primarily to provide marketing and sales
services to Pegasus Limited. From late 1998 through November 30, 1999, NPS hired
and trained a marketing and sales staff, developed marketing programs and
materials and generally performed the sales and marketing for Pegasus Limited.
Pursuant to an agreement dated December 13, 1999, the members of Pegasus Limited
and NPS including the Company, exchanged their membership interests in Pegasus
Limited and NPS for shares of common stock of a new company, Pegasus
Technologies, Inc., effective November 30, 1999. At November 30, 1999 and
December 31, 1999, KFx held 75% of the outstanding common stock of Pegasus
Technologies, Inc., with the 25% balance held by Pegasus management. Hereafter,
references to Pegasus include the activities of Pegasus Limited and NPS prior to
this exchange, as well as the subsequent activities of Pegasus Technologies,
Inc. and its subsidiaries.
On March 3, 2000, KFx and Pegasus closed a transaction with Kennecott Energy
Company ("Kennecott Energy") resulting in (a) the sale of 4% of the common stock
of Pegasus held by KFx ("Pegasus Common Stock") to Kennecott Energy for
$1,000,000, (b) the issuance by Pegasus to Kennecott Energy, in exchange for
$500,000, newly authorized Pegasus 6% cumulative convertible preferred stock
("Pegasus Preferred Stock") equivalent to an additional 2% interest in Pegasus
on an as converted basis, (c) the joint development by KFx, Pegasus and
Kennecott Energy of a work plan for enhancements to NeuSIGHT, new product
development and the completion of other tasks designed to improve the
performance of Pegasus and trigger additional purchases of Pegasus Preferred
Stock by Kennecott Energy of up to $3,500,000, for an additional interest in
Pegasus up to 14%, on an as converted basis, by December 31, 2004 or earlier and
(d) the conversion of secured debt owed by Pegasus to KFx, totaling $3,630,000,
into Pegasus Preferred Stock, at the same price as provided to Kennecott Energy.
Through December 31, 2001, Kennecott Energy had exercised its rights to purchase
additional Pegasus Preferred Stock for $2,500,000. In addition, during 2001,
KFx sold its Pegasus Preferred Stock equivalent to an approximate 16% interest
to several private investors. At December 31, 2001, the ownership of Pegasus on
an as converted basis was approximately as follows: KFx--51%, Pegasus founders-
- -16%, Kennecott Energy--17%, Evergreen Resources, Inc.--9% and other private
investors--7%. Through April 10, 2002, Kennecott Energy has exercised its
rights to purchase additional Pegasus Preferred Stock equivalent to a 1% as
converted interest in Pegasus, for $500,000. Kennecott Energy had the right to
sell the Pegasus Common Stock back to KFx at any time before March 3, 2001.
This right was not exercised and has expired.
5
In July 2001, Pegasus entered into an Asset Purchase and License Agreement
with Pavilion Technologies, Inc ("Pavilion"), under which Pegasus received the
exclusive right to license Pavilion's Power Perfecter, CEM and EPM software to
the electric utility industry. Power Perfecter is a universal, non-linear
control and optimization solution that uses model-predictive control to monitor
multiple variables and provide a proactive response. Power Perfecter uses a
different methodology to determine optimum performance in boilers, but is
considered to be a technology that is complementary to NeuSIGHT. CEM
applications are customized to meet state and federal emissions monitoring using
predictive emissions monitoring systems. These applications return data
identical to a hardware-based analyzer but with less manual processing by the
user. EPM simplifies the retrieval, collation, processing and formatting of
environmental monitoring data for submittal to regulatory agencies and allows
data from disparate sources to be reported in a consistent manner. Pegasus is
currently developing a marketing plan for the CEM and EPM software.
During 2001, KFx closed transactions with various parties pursuant to which
KFx sold all of its preferred stock investment in Pegasus for $2,722,330, which
represents an approximate 16% interest in Pegasus on an as converted basis.
Included in these sales of Pegasus preferred stock were sales to Evergreen
Resources, Inc. ("Evergreen"), whose Chairman is a director of KFx, for
$1,500,000, two directors of KFx and KFx's Chairman, Theodore Venners, for
$300,000 and a related party of KFx's Chairman for $100,000. These sales to
related parties represent an as converted interest in Pegasus of approximately
11.2%.
KFx is obligated to repurchase this preferred stock, or any other security
issued with respect to this preferred stock, at a premium of 33% over the
original purchase price, plus interest at an annual rate of 6% on the accreted
repurchase price, at dates varying from January 31, 2002 to November 20, 2002,
or earlier upon the occurrence of certain events, such as a change in control.
In certain circumstances, the parties can individually elect to exchange their
interest in Pegasus, with an aggregate maturity value of $3,847,562, for common
stock of KFx at $3.65 per share, subject to certain adjustments, including a
reduction to the then current market value upon the conversion or redemption of
the Company's 6% Convertible Debentures due July 31, 2002 ("Debentures"). In
addition, the parties were provided with warrants, expiring five years after
their issue, to purchase an aggregate amount of 1,814,887 shares of KFx common
stock at an exercise price of $3.65 per share, subject to certain adjustments
including a reduction to a weighted-average price of $2.52 per share upon the
conversion or redemption of the Company's Debentures. The terms of these
agreements are substantially the same except that Evergreen can elect to defer
the repurchase date to January 31, 2003, in which case it will receive the right
to purchase from KFx an additional interest in Pegasus on similar terms,
excluding additional warrants to purchase KFx common stock.
Subsequent to December 31, 2001 through April 10, 2002, Kennecott Energy has
exercised it right to purchase an additional $500,000 of Pegasus Preferred
Stock. Also during 2002, KFx received 919,416 shares of Pegasus Common Stock in
exchange for its guarantee of all of Pegasus' obligations relating to the
Pavilion acquisition and warrants issued in conjunction with the Cinergy advance
to Pegasus.
As a result of the additional investments of Kennecott Energy in
Pegasus Preferred Stock and the grant of Pegasus Common Stock to KFx subsequent
to December 31, 2001, the ownership of Pegasus at April 10, 2002 is
approximately as follows: KFx--52%, Pegasus founders--14%, Kennecott Energy--
18%, Evergreen Resources, Inc.--9% and other private investors--7%.
On March 28, 2002, the Company issued 2 million shares of KFx common stock and
warrants to purchase 2.25 million shares of KFx common stock. The common stock
issued is subject to redemption pursuant to a put option, in whole or in part,
at the option of the investors. The put option is exercisable upon the earlier
of July 31, 2002 or upon the redemption or conversion of all of the Company's 6%
Convertible Debentures due July 31, 2002. At the time the investors notify KFx
of their intent to exercise the put option, KFx must repurchase the common stock
at a price of $2.50 per share plus accrued interest within 100 days of
notification. If two-thirds or more of the investors notify KFx of their plan to
exercise their put option and KFx is unable to secure the necessary funding to
satisfy these exercised put options within 100 days of notification, then KFx
would be required to transfer its interests in Pegasus to the investors. The put
option expires on December 23, 2002. Until the put option
6
expires, the Company is precluded from issuing, selling, transferring or
pledging any of its interest in Pegasus and Pegasus is precluded from
transferring any rights with respect to its equity and assets without approval
of at least two-thirds of the investors.
In connection with the March 2000 transaction, Pegasus and Kennecott Energy
also formed a Colorado limited liability company, Net Power Solutions, LLC ("Net
Power Solutions"), to facilitate the combined marketing, on a non-exclusive
basis, of technologies, products and services that can be provided by KFx,
Pegasus, Kennecott Energy and other potential parties. Pegasus and Kennecott
Energy own Net Power Solutions equally. Since its formation, Net Power
Solutions has been involved in various joint marketing activities involving KFx,
Pegasus and Kennecott Energy, but has incurred no expenses nor generated any
revenues.
In the fourth quarter of 2000, Pegasus introduced the enhanced NeuSIGHT 2001
version of its flagship product. NeuSIGHT 2001 features simple installation and
configuration that lets the user drag and drop icons onto a design platform to
configure its own system. Pegasus is continually performing research and
development to enhance NeuSIGHT and improve the installation process. During
2001, 2000 and 1999 Pegasus research and development expenses were approximately
$655,000, $614,000 and $336,000, respectively.
As of April 10, 2002, Pegasus has firm unfilled sales commitments (backlog)
for software licenses and related installations at an estimated contract value
of $7,694,000, which are generally expected to be filled within approximately
the next 3-24 months. At April 13, 2001, such backlog approximated $2,522,000.
During 2001, the following individual Pegasus clients accounted for greater
than 10% each of consolidated revenues: Cinergy Corporation--39%, Ameren/Union
Electric--11% and BITCO Enterprises (China)--10%. During 2000, the following
individual Pegasus clients accounted for greater than 10% each of consolidated
revenues: Ameren/Union Electric--30%, Dairyland Power Cooperative--18% and
American Electric Power--12%. During 1999, two individual Pegasus clients
accounted for greater than 10% each of consolidated revenues: Carolina Power &
Light--19% and Houston Light & Power--11%.
Strategic Relationships
In March 1999, Pegasus executed an agreement with Science Applications
International Corporation ("SAIC") providing SAIC with certain exclusive rights
to install NeuSIGHT software in North America, as a subcontractor to Pegasus.
Under the terms of the agreement, SAIC has the right to perform NeuSIGHT
installations related to Pegasus license sales that Pegasus elects not to
perform with its own staff. Subject to certain termination provisions covering
performance and other matters, the agreement expires after SAIC completes 30
installations of NeuSIGHT or three years, whichever occurs first. In exchange
for certain services, investments and preferred billing rates by SAIC, the
agreement also provides for an equal sharing between Pegasus and SAIC of a
defined measure of Pegasus gross profits derived from the installation services
provided by SAIC to Pegasus customers under the agreement. Through December 31,
2001, no payments by Pegasus or related accruals have been required under the
profit sharing provisions of the agreement. On April 19, 2000, SAIC assigned
its rights and obligations under this agreement to one of its affiliates, Data
Systems & Solutions, LLC ("DS&S"), a joint venture between SAIC and Rolls
Royce. Pegasus and DS&S have mutually agreed that this agreement would stay in
effect after the expiration date, and Pegasus is currently utilizing the
experience of DS&S engineers to perform installations of the NeuSIGHT software
under time and material arrangements. Pegasus has included the costs of the
installation services performed by DS&S engineers in its cost of software and
services.
7
During the first quarter of 2000, Pegasus entered into value added reseller
agreements with Babcock & Wilcox ("B&W") and ABB Centrum ("ABB") providing for
certain minimum purchases of NeuSIGHT licenses from Pegasus and providing B&W
and ABB certain resale rights. Later in 2000, the B&W agreement was amended to
provide only for joint marketing activities and the provision of B&W
installation personnel at preferred rates. In addition, in connection with
the final testing of an installation for ABB at the Jawarzno power station in
Poland, various previous agreements with ABB were revised to provide ABB with
the exclusive resale rights in Poland and $500,000 of minimum purchases of
NeuSIGHT by February 27, 2002. No revenue has been recognized from these
agreements through December 31, 2001. In January 2002, a NeuSIGHT installation
project was sold by B&W under the amended agreement. This installation is in
progress and is expected to be completed during 2002.
Late in 2000, Pegasus took two steps to enter the market in the People's
Republic of China ("China"). During the third quarter of 2000, Pegasus signed a
letter of intent for the installation of its flagship NeuSIGHT product at four
coal-fired boiler units, with a total generating capacity of 1200 megawatts, at
the Xibaipo power station in China, near Beijing. In late November 2000, a firm
order was received for the first of these installations, which is expected to be
initiated in 2002. During the fourth quarter of 2000, Pegasus entered into a
license agreement with BITCO Enterprises ("BITCO"), providing BITCO and certain
affiliates with the exclusive right to market Pegasus' NeuSIGHT technology in
China in exchange for a nonrefundable $300,000 fee and future license fees.
Pegasus and BITCO finalized an exclusive agreement in 2001 for BITCO to license
NeuSIGHT in China, provided BITCO meets certain minimum license sales during
2001 and 2002. The agreement is expected to result in the sale of five NeuSIGHT
licenses during 2002 with the first order closing in the second quarter of 2002.
The $300,000 nonrefundable fee was recognized as revenue during 2001.
During 2001, Pegasus was selected as the neural network system provider for
the Department of Energy ("DOE") project awarded to Tampa Electric. The DOE's
funding will be from its "Power Plant Improvement Initiative", a
congressionally directed effort. This project is one of eight "showcase"
projects selected from 24 proposals submitted to the DOE in early 2001. The
intent of this project is to test and demonstrate a leading edge, artificial
intelligence based, sootblowing system in conjunction with state-of-the-art
controls and instrumentation, to reduce NOx and PM emissions while concurrently
optimizing the operation of a utility boiler. Pegasus' research and development
efforts with respect to developing this sootblowing system will be partially
reimbursed through this DOE initiative.
In September 2001, Pegasus entered into an agreement with Alstom Power
Customer Services China ("Alstom China") for Alstom China to have the exclusive
right to license Power Perfecter in China. In October 2001, Alstom China sold
the first Power Perfecter installation project under this agreement.
In December 2001, Pegasus entered into a two-year value-added reseller
agreement with ABB South Africa, part of the global power and automation
technology group, for ABB South Africa to be a reseller of Pegasus combustion
optimization products. This is the first such reseller agreement entered into
by Pegasus for the South African market.
In early 2002, Pegasus and ABB Inc. entered into a value-added reseller
agreement for Pegasus' combustion optimization solutions in the United States.
ABB Inc. will offer integrated Pegasus applications with ABB's Industrial IT(TM)
solutions for combustion management optimization, including carbon-in-ash
sensors, performance monitoring, coal flow monitoring, and ABB distributed
control systems.
Pegasus will pursue additional value-added reseller and similar arrangements
with appropriate parties as a means to quickly and cost effectively gain
access to potentialcustomers, particularly in foreign countries.
8
Intellectual Property
NeuSIGHT utilizes a neural network technology licensed from a wholly-owned
subsidiary of CA under an agreement which, among other terms, grants Pegasus a
perpetual, irrevocable, world-wide, exclusive right and license for use in
process monitoring and control applications in the electric utilities industry.
Payments are made to CA for each neural network license sold, one of which is
required for each NeuSIGHT installation. Through August 1999, CA was also a 15%
owner of Pegasus, at which time CA sold such interest to KFx in exchange for
527,000 common shares of KFx; see Note 13 to the consolidated financial
statements. The programming code that constitutes NeuSIGHT is a trade secret.
Power Perfecter is a universal, non-linear control and optimization solution
that uses model-predictive control to monitor multiple variables and provide a
proactive response. Power Perfecter uses a different methodology to determine
optimum performance in boilers, but is considered to be a technology that is
complementary to NeuSIGHT. Pegasus received the exclusive right to license
Pavilion's Power Perfecter under an Asset Purchase and License Agreement with
Pavilion dated July 31, 2001.
Competition
Pegasus faces direct competition from approximately three companies that offer
software products providing combustion optimization benefits to the electric
power industry. In addition, Pegasus faces indirect competition from a similar
number of companies that offer control systems used to operate utility boiler
units, which contain certain combustion optimization features. Management
believes the NeuSIGHT and Power Perfecter software solution offers several
competitive advantages over competitors' offerings. Most significantly, in a
survey completed in December 1998 by Resource Data International, a subsidiary
of the Financial Times, NeuSIGHT has been documented as providing greater
benefits than competing products in the areas of NO\\x\\ reduction and heat rate
improvement. In addition, NeuSIGHT and Power Perfecter have demonstrated an
ability to operate in closed-loop supervisory mode for extended time periods
without intervention.
NeuSIGHT's neural network model is considerably more extensive and therefore
more effective than competing products, through its ability to manage higher
volumes of input variables (up to 7 times the level of competing products).
While NeuSIGHT's neural network models are sophisticated and complex, the
software has a unique capability to retrain the model automatically as operating
conditions change in the plant. Competing product models are generally static
and require periodic retuning, making them more costly to maintain and less
effective over time. In management's opinion, these and other features provide
a much greater ability for the software to adapt to changing environmental
conditions, equipment degradation, instrument calibration drift, and operating
variances.
9
face increased or new competition from indirect competitors and other vendors to
the electric power generation industry, many of which have significantly greater
financial and other resources than Pegasus.
K-FUEL TECHNOLOGY
General
The K-Fuel Technology is comprised of three groups, or series, of patents, all
of which involve the use of heat and pressure to upgrade low rank coal and other
carbonaceous feedstocks into a boiler fuel. The Series "A" and Series "B"
Technology patents are based on hot gas and steam heat-transfer media,
respectively, in direct contact with the feedstock for heat transfer and
beneficiation. The Series "C" Technology patents are based on a nitrogen gas
atmosphere and an indirect hot-oil heat transfer system medium. The principal
difference between the Series "A" and "B" Technologies and the Series "C"
Technology is that Series "C" Technology is based on a more simplified design
with respect to the manufacturing equipment and facilities, resulting in lower
capital costs. Each of the three series of patents is regarded as having
improved operating efficiency and economics over the previous series. The K-
Fuel, LLC joint venture with Kennecott Energy has developed further improvements
in the Series "C" Technology, which are expected to be used in future K-Fuel
manufacturing facilities. See "Strategic Relationships--Kennecott Energy
Company" in this section. Further research may result in viable improvements to
one or more of the three patent series. The Company expects the Series "C"
Technology to be primarily used for coal fuel product-manufacturing facilities.
The Series "A" and "B" Technologies can be used for coal fuel product
facilities, as well as renewable resource fuel product manufacturing facilities
(e.g., bagasse, municipal solid waste, sludge and wood waste). The Series "A"
and "B" Technology patents were developed by Edward Koppelman and assigned to a
predecessor of the Company under a 1984 research and development contract (the
"R&D Contract") with the Company. The Company purchased the Series "C"
Technology patent directly from Mr. Koppelman after completion of the R&D
Contract in 1995 for $1.3 million. The Company is currently focusing its
commercialization efforts on the development of projects for the manufacture of
coal fuel product using the Series "C" Technology. The Series "A" and "B"
Technology patents are approaching expiration, but because these patents covered
earlier versions of the technology, management does not believe that expiration
of the patents will have a material adverse effect on the Company or the value
of the Series "C" Technology due to the superior performance observed by
employing the Series "C" Technology and the K-Fuel, LLC improvements. To date,
one commercial-scale K-Fuel manufacturing facility has been constructed, which
began operations in April 1998 and suspended operations in June 1999 (see
"Strategic Relationships--Thermo Ecotek Corporation and KFx Fuel Partners" in
this section). The development of future K-Fuel manufacturing facilities is
expected to result primarily from the K-Fuel, LLC joint venture with Kennecott
Energy. See "Strategic Relationships--Kennecott Energy Company" in this section.
In the Series "C" Technology process, raw coal is crushed and screened before
it is introduced into a steel alloy processing vessel that is then pressurized
and heated indirectly using vertical tube heat exchangers. Nitrogen, serving as
an inert, non-oxidizing heat-transfer medium, is admitted to the tube side of
the processing vessel at a pressure of approximately 125 pounds per square inch
("psi"). After the nitrogen is inserted, it picks up heat from the walls of the
tube and gradually expands to approximately 800 psi. Water is released from the
coal during this expansion period. When the temperature in the tubes reaches in
excess of 520 degrees Fahrenheit, any water remaining in the coal turns to steam
and continues to process the raw coal. When the temperature of the coal reaches
approximately 650 to 740 degrees Fahrenheit, the process is complete. The
process takes 30 to 40 minutes to complete from initial loading of the raw coal
into the processing vessels to final discharge of finished K-Fuel product.
The principal benefit of the K-Fuel Technology in the United States is that
the fuel produced from the process can facilitate the efforts of electric power
producers, manufacturers and other large-scale users of coal to meet the clean
air standards imposed by the CAA. Based on various independent and Company
10
analyses, the environmental benefits of burning K-Fuel versus most other coals
appear to include significant reductions in emissions of NO\\x\\, SO\\2\\,
CO\\2\\, mercury and chlorine. K-Fuel is the first beneficiated coal product
that has not exhibited significantly greater tendency for spontaneous combustion
than run-of-mine Powder River Basin ("PRB") coal. In addition, K-Fuel has been
demonstrated to increase gross power generation, reduce fuel-pulverizing
requirements, blend well with other coals and flow well through coal handling
systems. K-Fuel has exhibited a level of dustiness that requires the use of dust
suppression equipment on site at most domestic coal-fired power plants.
In May 1998, the Southern Research Institute conducted a test burn of
approximately 10 tons of K-Fuel, which was also overseen by a technical services
affiliate of Kennecott Energy. The results of this test burn are summarized in
the table below:
Emissions (ppm)
Btu (Corrected to 3% O2 Dry Basis)
------------------------------
(As Received) NO\\x\\ SO\\x\\
------------- ---------- ------------
K-Fuel...................... 11,703 142 173
Dry Fork Subbituminous...... 8,903 172 215
Lone Mountain Bituminous.... 13,315 265 530
In February 1999, the first commercial burn of K-Fuel was completed. A unit
train (approximately 12,000 tons of K-Fuel produced at the KFP Facility; see
"Strategic Relationships--Thermo Ecotek Corporation and KFx Fuel Partners" in
this section) was burned at Indiana-Kentucky Electric Corporation's Clifty Creek
generating station in southern Indiana. A fuel blend of approximately 60% K-
Fuel, with the balance consisting of a blend of high-Btu, high and low-sulfur
Eastern coals, replaced relatively low-Btu, low-sulfur southern PRB coal in one
of the station's boiler units. Results of the test burn indicate that K-Fuel
appeared to produce: a) a reduction in NOx emissions while maintaining full load
yet reducing auxiliary power, b) no unusual slagging or fouling of the boiler,
c) a reduction in the fuel pulverizing operations, d) no spontaneous combustion
and e) an improvement in boiler efficiency.
The results from this commercial scale burn at Clifty Creek generally confirm
the results of the test burn performed by the Southern Research Institute. The
Company believes that K-Fuel produced a reduction in SO\\2\\ and CO\\2\\
emissions but the plant instrumentation precluded clear quantification. The
handling characteristics of K-Fuel were acceptable with proper use of the power
station's existing dust suppressant system. Nevertheless, KFx continues to work
to improve the handling characteristics of K-Fuel.
The next step in product development is to build a demonstration plant for the
Series "C" Technology that is capable of producing test burn quantities of
K-Fuel. This will allow utilities to test burn the fuel. The Company is
currently soliciting industry partners for this demonstration project. The
Company is not obligated to find partners or build a test burn demonstration
plant, but considers this the next logical step in the development of a
commercial plant.
One of the Company's subsidiaries, KFx Technology, Inc., ("KFxT") has
performed research and development services related to the K-Fuel Technology
under a contract with Western Research Institute ("WRI"), a non-profit research
organization based in Laramie, Wyoming. Work under the most recent contract with
WRI has been completed and there is no commitment for an additional contract
from WRI or other potential customers of KFxT. Accordingly, the KFxT staff was
reduced in the first quarter of 2001, pending identification of other contracts
with WRI or other parties. As needs to research particular areas of the K-Fuel
Technology are developed, contracts are separately negotiated and performed with
WRI. This revenue is intermittent and a new project may not be done each year.
During 2001, no revenues were generated from such contracts. During 2000 and
1999, revenues from such contracts approximated $230,000 and $117,000,
respectively. Excluding depreciation, the costs under such contracts
approximated the related revenues and totaled $-0-, $230,000, and $117,000 in
2001, 2000, and 1999, respectively.
11
Strategic Relationships
Kennecott Energy Company and K-Fuel, LLC
In April 1996, the Company entered into a joint venture agreement (the
"Kennecott Agreement") with a wholly-owned subsidiary of Kennecott Energy. The
joint venture, a Delaware limited liability company named K-Fuel, L.L.C. ("K-
Fuel, LLC"), is intended to be the vehicle for further technical advancement and
the commercialization of business opportunities arising out of the K-Fuel
Technology, including research and development, sublicensing, marketing and
consulting, but not including the construction of facilities to produce K-Fuel
products on a commercial basis ("Commercial Projects"). Any Commercial Projects
will be constructed by separate entities in which Kennecott Energy, the Company,
both or third parties will have an equity interest and which will be granted a
sublicense from K-Fuel, LLC, for the K-Fuel Technology. In 1996, Kennecott
Energy paid a fee of $1,000,000 to the Company to enter into the K-Fuel, LLC
joint venture. In June 1999, in connection with certain amendments to the
Kennecott Agreement, Kennecott Energy purchased a K-Fuel license and paid KFx an
initial license fee of $1,000,000 for a minimum plant size of 666,667 tons of
annual capacity to be located at a site of its choice. This license is
expandable to a larger capacity plant, upon the payment of additional initial
license fees. In addition, Kennecott Energy paid to KFx an additional
$1,000,000, which KFx invested in K-Fuel, LLC to support the next phase of K-
Fuel commercialization, as required by the June 1999 amendments to the Kennecott
Agreement. Any technology, related to the Company's technology, developed
through the work plan funded by the $1,000,000 investment in K-Fuel, LLC, will
be owned by Kennecott Energy and licensed free of charge to K-Fuel, LLC. The
non-refundable payment related to the K-Fuel license accounted for 35% of the
Company's consolidated revenues in 1999. The Company has no future obligations
relating to this payment from Kennecott Energy or the construction of a K-Fuel
plant.
Under the work plan funded by the June 1999 investment in K-Fuel, LLC, an
improved K-Fuel process was demonstrated in late 2000, as announced in early
February 2001. The principal differences from the K-Fuel Series "C" Technology
process previously used are continuous operations, lower temperatures, and the
absence of superheat from the system. The resulting product, which in the tests
was produced from Powder River Basin ("PRB") coals, is low in SO\\2\\, NO\\x\\,
mercury and chlorine, similar to K-Fuel. Analysis from this work plan indicates
that an improved process can possibly be designed to produce the new fuel within
potentially attractive economic constraints and that the K-Fuel production
process proposed as a result of the project should be more reliable than was the
KFP Facility when operated by Thermo Ecotek Corporation (See "Strategic
Relationships--Thermo Ecotek Corporation and KFx Fuel Partners" in this section)
and have lower capital and operating costs than any previous K-Fuel plant
design.
The heating value of the new fuel as tested is approximately 11,200 to 11,600
Btu's per pound. Upon combustion, the new fuel produces approximately 20% lower
NO\\x\\ emissions and lower mercury emissions, as compared to the PRB feedstock
coal (already the lowest mercury content coal naturally available), and SO\\2\\
emissions well below the 1.0 lb per million Btu limit contained in Phase II of
the CAA.
In addition, K-Fuel, LLC is pursuing the possible advantages to blending the
new product and raw PRB coal. The dust and self-heating behaviors of a blend of
the new product and raw PRB coal appear to be similar to raw PRB coal, without
the need for oil or other treatment. The blend retains proportional NO\\x\\,
SO\\2\\ and mercury reduction benefits. Therefore a commercial plant for the new
product may be leveraged to provide considerably higher volumes of blended
product for the market place.
K-Fuel, LLC is conducting studies concerning appropriate means to further test
the new process and design facilities for production. As of March 29, 2002,
there were no commitments to construct any K-Fuel plants.
12
Initially, the Company has a 51% interest in K-Fuel, LLC and Kennecott Energy
has a 49% interest, except to the extent of certain research and development and
amortization expenses, which per the Agreement are allocated 100% to Kennecott
Energy. At the time that Kennecott Energy places into service Commercial
Projects with a collective design capacity equal to or in excess of 3 million
tons of K-Fuel product per annum, Kennecott Energy will obtain a 51% interest in
K-Fuel, LLC and the Company's interest will be reduced to 49%. In connection
with an amendment to the Agreement executed in June 1999, Kennecott Energy paid
to KFx a $1,000,000 K-Fuel license fee, which was recorded as license fee
revenue on the statement of operations, and an additional $1,000,000 that, in
accordance with the amendment, was invested in K-Fuel, LLC to fund future
development activities associated with the next phase of K-Fuel
commercialization. The additional $1,000,000 was recorded as an addition to
investment in K-Fuel, LLC and deferred income. During 2001, 2000, and 1999 K-
Fuel, LLC incurred related research and development costs totaling approximately
$347,000, $482,000 and $23,000, respectively.
In connection with the Kennecott Agreement, the Company granted K-Fuel, LLC,
an exclusive, worldwide, fully-paid, royalty-free right and license (including
the right to grant sublicenses) to and under the K-Fuel Technology, except to
the extent that it pertains to the beneficiation or restructuring of coal or
coal-related feedstocks and related improvements covered under the Heartland
Fuels Corporation License (as defined below) (the "KFx License"). In addition,
Heartland Fuels Corporation, an 85%-owned subsidiary of the Company, granted K-
Fuel, LLC, an exclusive, worldwide, fully-paid, royalty-free right and license
(including the right to grant sublicenses) to and under the Series "A" and
Series "B" K-Fuel Technology, as it pertains to the beneficiation or
restructuring of coal or coal-related feedstocks (the "HFC License"). Both the
KFx License and the HFC License specify minimum terms and provisions for any
sublicenses granted by K-Fuel, LLC, to third parties.
Under the Kennecott Agreement, as amended in June 1999, with respect to future
Commercial Projects to be licensed by K-Fuel, LLC to entities wholly or
partially owned by Kennecott Energy, the Company is entitled to a one-time
license fee approximating $3 per ton of annual design capacity of each project,
times Kennecott's percentage of beneficial ownership, to be paid one-half at the
time the license is granted, with the remaining one-half paid over a period of
three years beginning when the project begins commercial operations. The Company
will also receive a production royalty, to be paid each calendar quarter,
depending on certain levels of the project's selling price per ton of coal
product. With respect to the non-Kennecott Energy portion of production capacity
and production of Commercial Projects in which Kennecott Energy has less than
100% beneficial ownership, the Company is entitled to similar, but higher,
license fees and royalty payments. Such higher license fees and royalty payments
also apply to 100% of the production capacity and production of Commercial
Projects in which Kennecott Energy has no beneficial ownership. In addition, the
Company will be entitled to additional payments based on a percentage of the
excess of (1) annual cash revenue from each project, or (2) annual pre-tax cash
operating costs of each project plus an annual capital charge related to each
project. Kennecott Energy has the right to fund 100% of Commercial Projects that
it approves, subject, however, to the Company's right to fund up to 50% of such
projects on the same economic terms as Kennecott Energy. The Company has no
obligation to fund any Commercial Project.
Thermo Ecotek Corporation and KFx Fuel Partners
In August 1995, the Company entered into a Stock Purchase Agreement (the
"Stock Purchase Agreement"), with Thermo Ecotek Corporation ("TCK"), a
Massachusetts corporation. At that time the Company and TCK also entered into a
separate agreement to construct and operate a 500,000 TPY commercial-scale K-
Fuel production facility.
Under the Stock Purchase Agreement, in 1995 TCK purchased 3 million shares of
KFx Common Stock for $6 million, or approximately 14% of the outstanding KFx
Common Stock as of December 31, 1996, and in 1997 purchased an additional 1.25
million shares of KFx Common Stock for $2.5 million, increasing its ownership to
approximately 18% of the outstanding KFx Common Stock. As part of the
transaction TCK was also granted warrants to purchase the number of shares of
KFx Common Stock that, when added to all shares owned by TCK on the exercise
date, would be sufficient to give TCK 51% of the outstanding KFx Common Stock,
on a fully diluted basis. On May 9, 2000, TCK cancelled these warrants in
connection with certain other agreements, as discussed below.
13
In August 1995, the Company and TCK, acting through respective wholly-owned
subsidiaries, formed KFx Fuel Partners, L.P., a Delaware limited partnership
("KFP") and began construction of a 500,000 TPY K-Fuel production facility (the
"KFP Facility") near Gillette, Wyoming, using the Company's Series "C"
Technology. The Company owned a 5% interest in KFP, with the remaining 95% owned
by TCK. TCK was the managing general partner for KFP.
Construction of the KFP Facility was completed and KFP began operations at the
KFP Facility in April 1998 and completed a successful test burn in May 1998 and
a successful commercial burn in February 1999, as discussed above. The KFP
facility operated and produced commercially salable product in 1998 and 1999 and
KFP addressed certain problems previously encountered, including a 1996 fire at
the facility and certain construction problems, including issues relating to the
flow of materials within the facility and the design and operation of certain
pressure release equipment. Nevertheless, KFP continued to experience certain
problems relating to tar and fines residue build-up within the system during
production and product quality issues related to product dusting. On May 24,
1999, TCK announced that in connection with certain strategic restructuring
decisions made by TCK and its parent, Thermo Electron Corporation, it had
decided to hold for sale its investment in the KFP Facility and record charges
related thereto. Further, TCK in June 1999 suspended operations at the KFP
Facility and K-Fuel is not currently being produced.
As of May 9, 2000, the Company finalized a series of agreements with various
parties intended to initiate the redevelopment of the KFP Facility. Pursuant to
these agreements (a) a subsidiary of Black Hills Corporation ("BKH") purchased
the KFP Facility and received 2 million shares of KFx Common Stock previously
held by TCK in exchange for the assumption of the reclamation liability
associated with the KFP Facility, (b) BKH was given the right to one seat on
KFx's board of directors (which, through April 12, 2002, BKH has declined to
exercise), and KFx granted BKH a warrant to purchase 1,300,000 shares of KFx
Common Stock at $3.65 per share, subject to certain adjustments, (c) KFx
relinquished its 5% interest in KFP to TCK and provided certain releases to TCK
in exchange for $100,000 in cash, $150,000 in proceeds of an unsecured note
payable to TCK on June 10, 2000, and future cash payments estimated at
$1,400,000 (all of which were received by August 3, 2000), (d) KFx received
certain real and personal property from TCK, (e) TCK sold the remaining
2,250,000 shares of KFx Common Stock it owned to private investors and canceled
the warrants it held to purchase a control position in KFx's Common Stock. The
carrying value of the Company's investment in KFP was written down effective
December 31, 1999 by $1,800,000, to the $1,500,000 expected cash proceeds to
KFx. In addition, the estimated $2,200,000 value of the warrants issued to BKH
at the closing on May 9, 2000 was charged to expense effective December 31,
1999. These amounts were recorded as non-operating impairment losses in the
statement of operations in 1999 based on the fact that the assets sold were no
longer in operation, but instead were held for disposal.
The Company has no ownership interest in the KFP Facility and has no
obligation to fund any capital or other costs necessary for its restart. The
Company would, however, be entitled to royalty payments upon the successful
restart of the plant and production of K-Fuel.
14
Patents, Licenses, and Royalty Agreements
The Company has patents or patent applications for the K-Fuel Technology
registered in the United States and over 40 foreign countries, including all
major industrialized countries that either have significant reserves of high-
moisture lignite or subbituminous coal, or that are readily accessible to such
reserves via large-scale transportation infrastructure (primarily ocean barge
vessels). Included in the patent collection are applications for patents
developed by the Company and seven patents and patent applications developed by
K-Fuel, LLC, which were originally assigned by the inventors to the Company.
The Company has assigned the United States counterparts to K-Fuel, LLC. The
assignment has no effect on the sharing of license fees and royalties for these
seven patents and patent applications.
The only licenses the Company has granted for use of the K-Fuel Technology are
to the KFP Facility (Series "C" Technology), K-Fuel, LLC (Series "C"
Technology), and Heartland Fuels Corporation ("HFC") (Series "A" and "B"
Technologies). The Company owns 85% of the common stock of HFC, and as a
condition of the Kennecott Agreement, the Company caused HFC to grant to K-Fuel,
LLC an exclusive sublicense to the Series "A" and "B" Technologies.
A predecessor entity of the Company acquired the Series "A" and "B"
Technologies from Edward Koppelman and other investors (the "Koppelman Group")
in 1984 for $10 million in cash and a royalty agreement. In June 1996, the
Company entered into a royalty amendment agreement with Edward Koppelman, the
inventor of the K-Fuel Technology. As a result of the amended agreement, Mr.
Koppelman's royalty is now 25 percent of the Company's worldwide royalty and
license fee revenue. The royalty to Mr. Koppelman will cease when the cumulative
payments to him reach the sum of approximately $75,222,000. As consideration for
the royalty amendment agreement, in June 1996, the Company paid Mr. Koppelman
$300,000 cash and issued a promissory note for $200,000; see Note 8 to the
consolidated financial statements. The resulting $500,000 prepaid royalty is
amortized as licenses to K-Fuel Technology are sold. Also as part of the royalty
agreement, Mr. Koppelman indemnified the Company for any claims made by the
Koppelman Group. During 2001, the Company reacquired the 12% patent interest
held by the State of Wyoming for a cash payment approximating $1,162,000.
The following table summarizes the Company's royalty obligations to various
third parties:
Expiration Date or
Royalty Obligation United States International Maximum Amount
------------------ ------------- ------------- --------------
Estate of Edward Koppelman....... 25 Percent 25 Percent $75,222,000
Fort Union Ltd................... 20 Percent/(1)/ Canada, Mexico Earlier of cumulative
royalties paid of
$ 1,500,000 or
September 15, 2015
Ohio Valley Electric............. 0.5 Percent/(2)/ NA--None None
/(1)/ Applies to royalties only and is also applicable to any production in
Canada or Mexico.
/(2)/ Applies to revenues derived from the sale of K-Fuel only, excluding the
KFP Facility.
15
Competition
To the best of the Company's knowledge, there are currently no competitors
producing significant commercial quantities of beneficiated clean coal fuel
products either in the United States or in international markets. However, there
are other clean coal technology ("CCT") companies, primarily in the United
States, that are developing fuel combustion and product technologies that would
reduce emission pollutants and/or increase the heating value of coal feedstock
fuel sources. Many of these CCT competitors have greater financial, technical
and operational resources than the Company. To the best of management's
knowledge, however, none of these other efforts have yet resulted in an
economically viable and commercially acceptable beneficiated coal product with
the economic and commercial potential of K-Fuel.
In the United States market, the Company must also compete with other
naturally low-sulfur coals. Also, SO\\2\\ emission credits ("emission credits")
allow non-compliance users of higher sulfur coal to bundle coal purchases with
these emission credits to meet the CAA requirements. During Phase I of the CAA,
which began January 1, 1995, the majority of affected boiler units achieved
compliance by switching to lower sulfur fuels rather than installing flue gas
desulfurization equipment ("FGDs" or "scrubbers"). An over-compliance
situation developed in Phase I of the CAA, resulting in an abundant supply of
emission credits in the U.S. market. Similarly, during the first two years of
Phase II of the CAA, which began January 1, 2000, utilities have largely chosen
to rely on banked emission credits obtained during Phase I, as well as
additional fuel switching. As a result of fuel switching, existing supplies of
naturally low-sulfur coal are continually being depleted. The extent of the use
of scrubbers, versus additional fuel switching, including the impact on the
demand for K-Fuel and NeuSIGHT, will depend on a number of factors, including
final EPA rulings on small particulates ("PM2.5") and regional haze and the
outcome of a number of pending lawsuits regarding certain aspects of the CAA.
The ultimate impact of these factors on the demand for K-Fuel, NeuSIGHT and
other related technologies, products and services that the Company may offer in
the future is not clearly determinable.
The Company is not able to predict the impact that competing coal
beneficiation technologies, the availability and pricing of low-sulfur coal
reserves or the availability and pricing of emission credits will have on the
future competitive position of the Company. To the best of the Company's
knowledge however, none of its competitors have been able to demonstrate as many
quantifiable and potential benefits in a commercial setting as K-Fuel achieved
in February 1999 at Indiana-Kentucky Electric Corporation's Clifty Creek
generating station in southern Indiana. Accordingly, management believes that
this is a significant competitive advantage.
16
MARKET DRIVERS
Domestic Market
There are two primary market drivers for the Pegasus software and K-Fuel
Technology solutions offered by the Company. For a number of years various
regulations and other requirements have placed increasingly stringent standards
on the air emissions generated by the electric power generation industry and
others. In addition, as the power industry undergoes the rigors of deregulation
and is transformed into a market-driven highly competitive industry, there will
be increasing pressure to meet such air emission standards in more cost
effective ways as well as to improve the overall cost efficiency of electric
power generation.
Air Emission Standards
The CAA has been the primary historical stimulus for the developing United
States market for beneficiated clean coal fuel products, such as K-Fuel, and for
combustion optimization products, such as NeuSIGHT and Power Perfecter.
Specifically, Title IV of the CAA requires electric utilities to reduce
emissions of NO\\x\\ and SO\\2\\.
In September 1998, the United States Environmental Protection Agency ("EPA")
issued a rule requiring 22 Midwestern and Southern states and the District of
Columbia to prepare implementation plans to reduce current allowed levels of
NO\\x\\ by approximately 85% (the "SIP Call"). NO\\x\\ is a primary component in
ground-level smog and is also a contributor to acid rain. Coal-fired electric
utility power plants are widely considered to be the most likely targets to
achieve the required reductions in NO\\x\\. Challenges to the EPA's SIP Call
resulted in a May 1999 federal appeals court action that effectively suspended
the SIP Call pending further review. Subsequently, a March 3, 2000 federal
appeals court mostly affirmed EPA's SIP Call, although the number of states
included has been reduced to 19. Implementation of the SIP Call will commence in
the 2004 ozone season (May through December), which will include a regional
NO\\x\\ trading program, in essence an expansion of the Ozone Transport
Commission ("OTC") trading program already in place in 11 northeastern states.
While early compliance with the OTC trading program, which commenced in 1999,
was achieved largely through a combination of environmental dispatch of natural
gas-fired power generating stations (and a consequent reduction in the
operations of coal-fired stations), compliance with the more stringent 2003
reduction requirements is generally expected to require a significant investment
in emission control technologies. Additionally in February 2001, the US Supreme
Court affirmed the constitutionality of Congress' delegation of authority to the
EPA to impose certain air quality standards and
17
regulations, which had previously been under legal challenge. Although the
ultimate impact of the SIP Call and other air quality regulations on the demand
for K-Fuel and Pegasus software is not clearly determinable, management believes
it will create demand for these and other related technologies, as well as
related products and services that the Company may offer in the future.
Pegasus software has been demonstrated to typically reduce NO\\x\\ by 10% to
40%. K-Fuel Technology can also reduce NO\\x\\ emissions (when using PRB coal as
the feedstock) as compared to typical eastern coals by levels approximating 25%,
as indicated in the February 1999 commercial burn. Through the combination of
Pegasus software and K-Fuel, management believes that the Company is in a unique
position to assist the electric power generation industry in achieving required
reductions in NO\\x\\ more cost effectively than various other solutions, some
of which are highly capital intensive and also can add significant operating
costs.
Title IV of the CAA specifies a two-phase implementation schedule that
primarily targets electric utility companies with annual generating capacities
in excess of 25 megawatts ("MW"). Phase I implementation began on January 1,
1995, and affected 110 large, high-emission generating plants in 21 states
(primarily in the industrial Midwest). The emissions limit for these plants
during Phase I was 2.5 lbs. SO\\2\\ per million Btu ("MMBtu") of heat output.
Phase II, which began January 1, 2000, is more broadly sweeping than Phase I,
generally expected to impact more than 2,000 fossil fuel-fired electric
generating units in 48 states. The effective SO\\2\\ emission rate limitation
under Phase II is reduced to 1.2 lbs. SO\\2\\ per MMBtu. When using Wyoming PRB
coal as feedstock material, the K-Fuel Technology produces a fuel product that
has an SO\\2\\ emission rate of approximately 0.7 to 1.0 lbs. SO\\2\\ per MMBtu.
NeuSIGHT also produces reductions in SO\\2\\ as a byproduct of heat rate
improvements and combustion optimization. Although the ultimate impact of the
implementation of Phase II of the CAA on the demand for K-Fuel, NeuSIGHT and
Power Perfecter is not clearly determinable, management believes it will create
demand for these and other related technologies, as well as products and
services that the Company may offer in the future.
The Company's United States marketing emphasis is directed primarily at
electric utilities located in the industrial Midwest and eastern states, more
specifically those under EPA scrutiny. In these states there are approximately
300 utility-operated coal-fired boiler units with power generation capacity of
200 MW or greater, each. The entire U. S. contains approximately 500 of such
utility-operated coal-fired boiler units.
The combustion characteristics of cyclone furnace boilers, a common boiler
type of Midwestern utilities originally designed to burn high-sulfur Midwestern
coal, are particularly well suited to the K-Fuel product manufactured from PRB
coal. As reported by the U.S. Department of Energy, the total domestic market
for coal fuel is approximately 1 billion TPY, of which electric utility
companies use the majority of the tonnage (approximately 85%). Coal-fired
electricity generation currently accounts for approximately 54% of the nation's
total electricity supply. The Company has estimated, based on published utility
coal consumption data and responses to Phase I and Phase II requirements of the
CAA, that a market of approximately 100 to 150 million TPY of clean coal fuel
products will develop over approximately the next ten years. Any amendments to
the CAA that reduce the specified limits on industrial SO\\2\\ emissions would
likely negatively impact the potential size of the market and the domestic
growth prospects of the Company.
In addition to the electric utility industry, the Company believes there is
potential for a market for K-Fuel and Pegasus software with manufacturers and
other large-scale industrial coal users that are either subject to the NO\\x\\
and SO\\2\\ provisions of the CAA or that desire to improve their fuel
combustion performance. Fuel combustion performance is becoming more important
to electric utilities and others because of the need to cut costs and become
more efficient in an increasingly competitive market environment.
CO\\2\\ is widely considered to be a primary component of greenhouse gases
that have given rise to worldwide concerns of global warming. The December 1997
Kyoto Protocol to the United Nations
18
Framework Convention on Climate Change ("Kyoto Protocol") targets CO2 and
certain other greenhouse gas emissions for aggressive reduction in the years
2008 to 2012. In addition, the Kyoto Protocol notes electric power generation as
one of the specific industry sectors that should be reviewed to achieve the
targeted reductions. A very important by-product of the efficiency gains at
electric power generation boiler units achievable through the use of Pegasus
software and/or K-Fuel is a corresponding reduction in the level of CO\\2\\.
Management believes that the level of CO\\2\\ reduction available through the
use of Pegasus software and K-Fuel approximates up to 5% and 6%, respectively.
As of April 13, 2002, approximately 84 countries, including the European
Community, have signed the Kyoto Protocol and approximately 51 have ratified or
acceded it. Although the United States signed the Kyoto Protocol in December
1998, it has not been ratified by the United States Senate, as would be required
to be applicable in the United States. In addition, the Bush Administration has
indicated that it does not support signing the Kyoto Protocol or the regulation
of emissions of CO\\2\\ in the near term. The Company is not able to predict the
impact that such United States ratification of the Kyoto Protocol, or lack
thereof, could have on the demand for K-Fuel, NeuSIGHT and Power Perfecter.
Nevertheless, initiatives such as the Kyoto Protocol, targeted at reducing
CO\\2\\ and other greenhouse gases, are expected to continue to progress and
create additional demand for alternatives to achieve significant reductions in
such emissions.
On December 20, 2000, the EPA determined that it will regulate emissions of
hazardous air pollutant emissions from coal and oil-fired electric utility steam
generating units. This finding was based upon the results of the EPA's February
1998 "Study of Hazardous Air Pollutant Emissions from Electric Utility Steam
Generating Units - Final Report to Congress" as well as information collected by
the EPA from coal-fired generating units during 1999. Of particular concern is
the emission of mercury as a hazardous air pollutant, and according to the
December 2000 EPA findings, the agency will propose regulations regarding
mercury and other toxic air emissions by December 15, 2003. Final regulations
will be released by December 15, 2004. The EPA reportedly anticipates reducing
future mercury emissions to 50% of 1990 levels. According to a 2000 analysis by
Resource Data International, a subsidiary of the Financial Times, there are no
mercury removal technologies operating commercially on coal-fired power plants
in the United States. Activated carbon injection and carbon bed technologies
were identified by RDI as likely, but high cost, remedies. RDI identified other
mercury reduction techniques including the use of low or zero mercury fuels,
such as K-Fuel. According to independent research, a significant level of
mercury is removed from run-of-mine coal during the K-Fuel production process.
These tests indicate any mercury contained in K-Fuel is below detectable levels
of .05 parts per million (ppm), compared to mercury levels of typical Eastern
bituminous coals of .15 ppm to .20 ppm. Based on these test results, if the EPA
adopts regulations to restrict the level of mercury emissions, K-Fuel may offer
significant competitive advantages over other high-energy value coals. In
addition, the mercury tests of K-Fuel indicate that the chlorine content of K-
Fuel is also below the detectable levels of .05 ppm. Although the Company is not
aware of any initiatives underway to regulate emissions of chlorine, it is
commonly considered to be a hazardous material that is regulated in various
settings, and emissions of chlorine are generally considered to be undesirable.
Accordingly, regulation of chlorine emissions could develop in the future, which
could create another competitive advantage for K-Fuel.
Deregulation of the United States Power Industry
In the United States the retail power industry is regulated primarily by
various state authorities. With the passage of the Energy Policy Act of 1992,
deregulation of the power industry began approximately nine years ago in an
effort to introduce market discipline in a manner similar to the deregulation of
the telecommunications industry, both of which had previously been considered to
be monopolies requiring a high degree of regulation in order to protect retail
consumers. Approximately 24 of the states and the District of Columbia have
deregulated or are in the process of deregulating their power industry with 17
additional states considering deregulation. With the exception of California,
deregulation has generally proceeded without significant disruptions of supply
or unfavorable impacts on power rates.
19
Significant disruptions in the supply of power and very high power rates
experienced in California have been widely attributed to the State of
California's deregulation of its power industry. A certain level of resulting
negative public sentiment toward deregulation of the domestic power industry may
slow the deregulation process in certain states. Nevertheless, the difficulties
in California have been mostly attributed to a poorly designed deregulation
process. Accordingly, management believes that the deregulation of the domestic
power industry will continue.
Deregulation of the electric power industry is expected to result in
intensified price competition, increased price volatility, shorter-term
wholesale electricity transactions and industry consolidation and structural
changes. The electric power industry is moving toward retail competition while
the wholesale market has already been established as full-scale open
competition. While the electric power industry is experiencing consolidation
through mergers and acquisitions, the industry is concurrently unbundling
generation, transmission and distribution services from the traditionally
integrated structure.
This restructuring is expected to cause some electricity generators to operate
as merchant plants without a guaranteed market for their production output. In
such an environment these businesses will be under constant competition for the
sales of their products and services. As a result, plant operators will be
expected to look to cut costs and improve operating efficiencies wherever
possible.
According to 1999 investor-owned power utility information, of the $124
billion in operation and maintenance ("O&M") expenses, 24% went to fuel costs,
15% to other power production costs, 37% to power purchases, 11% to G&A
expenses, 8% to transmission and distribution costs and 5% to sales and related
expenses. Although the cost of power generation has been reduced overall to an
average cost of 3.8 cents per kilowatt-hour ("kWh") in 1999, from 4.6 cents per
kWh in 1986, much of this reduction has been attributed to reductions in force.
Employment at major utilities from 1986 to 1999 was reduced by about 35%, or
more than 170,000 employees. In the opinion of management, competition in a
deregulated power industry will require further reductions in the cost of power
generation. To further reduce the cost of power generation, savings must begin
to come from areas other than personnel reductions, such as more effective fuel
purchase practices and efficiency gains in the core processes in the generation
of power.
The need for these expense reductions by power generating companies to remain
competitive in the deregulated market comes at a time when EPA regulations are
causing the power generation industry to consider further capital investment in
plants to achieve emissions compliance. Management believes that power-
generating companies will look for solutions, such as Pegasus software and K-
Fuel, to reduce these capital investments, cut operating costs and run their
plants more efficiently.
These developments are expected to produce a strong incentive for electricity
generators to become low cost producers and expand market share in order to
remain profitable in the deregulated environment. In a fully competitive retail
electricity market, only those generators with costs low enough to produce
electricity at market acceptable prices, not simply low enough to meet
regulatory oversight, will be able to sell electricity profitably and remain
viable.
FOREIGN MARKETS
The international coal-fired power generation industry is approximately four
times the size of the United States coal-fired power generation industry. The
Company's objective, with respect to international opportunities for K-Fuel, is
to concentrate on markets where there is either a significant need for more
energy efficient and environmentally responsible fuel products, or where
abundant coal reserves can be utilized in conjunction with the K-Fuel Technology
to develop a value-added export product. The principal benefit of the K-Fuel
Technology in foreign markets is that low-rank indigenous coal reserves can be
upgraded to provide a more cost effective and less environmentally damaging fuel
source for power producers, manufacturers and households, either in internal
markets or for export. The Company has
20
international commercialization opportunities related to K-Fuel in Indonesia and
Turkey, although they are not currently active.
In addition, although management expects to initially concentrate its
marketing and sales efforts with respect to Pegasus domestically, for reasons
similar to those cited above relative to K-Fuel and certain of the United States
market drivers, management believes there is significant market potential for
Pegasus software and related products internationally. Pegasus currently derives
certain revenues from Canada, China and Poland and has a value-added reseller
agreement in place for sales into South Africa. See "Pegasus--Strategic
Relationships" above.
CHARCO REDONDO, LLC
In December 1997, the Company purchased a 12.6% interest in Charco Redondo,
LLC, a Texas limited liability company ("Charco"), for $629,000.
Charco was formed to develop and complete a project intended to demonstrate
the effectiveness of Synthetic Energy Corporation's ("Synthetic") patented
process, which uses mining techniques in connection with superheated steam and
moderate pressure to mobilize crude oil that otherwise cannot be produced by
conventional techniques. The technology licensed to Charco is based on patents
held by John A. Masek (the "Masek Technology"). Charco has an exclusive
sublicense to use the Masek Technology in a four-county area of Texas (the
"AMI"), which is believed to have reservoirs containing approximately 1 billion
barrels of crude oil, which would be appropriate targets for application of the
Masek Technology. The pilot project (the "Charco Pilot Project") has been
conducted on a mineral lease covering approximately 1800 acres in southern Texas
(the "Charco Redondo Lease"). Drilling, completion and start-up activities were
completed late in the second quarter of 1998 and injection operations were
conducted for five months until December 1998, when the pilot project was shut
down because of depressed crude oil prices even though daily oil production was
increasing. The Charco Pilot Project achieved its initial objectives of
demonstrating the technical and operational feasibility of the Masek Technology.
Charco is pursuing further improvements to the technology. KFx and Charco have
undertaken efforts to obtain approximately $5 million of outside financing to
further develop the Charco Redondo Lease. The Company has no obligations to
provide any funding for the development of the Charco Redondo Lease. Although
the Company believes the Charco Redondo Lease has significant potential, based
on (a) the need for the Company to focus its efforts and limited financial
resources on its K-Fuel and Pegasus business segments and (b) the inability to
obtain the necessary outside financing to date, the Company recorded a permanent
impairment write-off for its investment in Charco Redondo as of December 31,
2000. Efforts to obtain financing will continue and the Company will consider
alternatives to dispose of its investment.
The Company also entered into an option agreement with Synthetic with respect
to the use of the Masek Technology outside the AMI. The option agreement
provides that the Company and Synthetic will form a joint venture to be owned
55% by the Company and 45% by Synthetic. The option will expire when commercial
production, defined as 1,500 barrels of oil per day, is attained in 60 out of 70
consecutive days. During that time, the Company has the right to exercise its
option by paying Synthetic $1,900,000. As noted above, the initial objectives
were attained during the pilot phase; however, the production levels were
significantly below the commercial level of 1,500 barrels per day, which we
believe will not be attained without additional investments in the project.
GOVERNMENT AND ENVIRONMENTAL REGULATION
Generally, environmental permitting and operating regulations in countries
outside the United States that the Company is currently pursuing for
international development are not as stringent as those are within the United
States. Nevertheless, international initiatives, such as the Kyoto Protocol, are
expected to create increasing pressures on the electric power generation
industry on a world-wide basis to reduce emissions of various pollutants, which
management expects will create additional demand for its products and services.
21
Pegasus
The operations of Pegasus are not significantly impacted by governmental
regulation with respect to the development and delivery of NeuSIGHT, Power
Perfecter, CEM, EPM and related software products and services.
K-Fuel
In the United States, the K-Fuel product is not expected to be subject to
unusual levels of local, state or federal regulation with respect to its
transportation and distribution. However, any future United States production
plants will require numerous permits, approvals and certificates from
appropriate federal, state and local governmental agencies before construction
of each facility can begin, and will be subject to periodic maintenance and
review requirements once facilities begin production. Typically, state laws
govern most permitting requirements, but the EPA has the authority to overrule
certain state permitting decisions. The types of permits that are typically
required for commercial production facilities include air quality, wastewater
discharge, land use, and hazardous waste treatment, storage and disposal. KFP
has in place all permits for the operation of the KFP Facility. The K-Fuel
Technology process generates only waste gas, waste discharge water, and a small
amount of fuel liquid as by-products of the process. The KFP Facility has waste
gas and water treatment facilities to treat and dispose of the waste by-
products.
Future international K-Fuel production plants will also be subject to various
permitting and operational regulations specific to each country.
EMPLOYEES
The Company currently has approximately 42 full-time employees, six of whom
work in the areas of corporate and K-Fuel marketing, finance, and
administration, and the operation of the K-Fuel demonstration plant and
laboratory and 36 of whom work at Pegasus in the areas of sales and marketing,
software development, software implementation, finance, and administration. The
Company considers its relations with all employees to be good.
RISK FACTORS
Our Historical Financial Performance and Current Financial Condition Raise
Substantial Doubt About Our Ability to Continue as a Going-Concern. We Need
Additional Capital to Fund Our Business, to Make Installment Payments Due on the
Acquisition of the Pavilion Power Optimization Division, to Pay Interest,
Premium and Principal, at Maturity on July 31, 2002, on Our 6% Convertible
Debentures and to Repurchase Pegasus Preferred Stock Sold to Private Investors
During 2001
We require substantial working capital to fund our business. At December 31,
2001, we had a working capital deficit of $17,402,398, an accumulated deficit of
approximately $86,268,000 and a stockholders' deficit of approximately
$14,103,000. We have incurred losses approximating $15,177,000, $12,290,000 and
$12,730,000 in 2001, 2000 and 1999, respectively. We have experienced negative
operating cash flow approximating $6,738,000, $5,151,000 and $3,458,000 in 2001,
2000 and 1999, respectively. We expect to incur net losses and negative
operating cash flows in 2002. We cannot assure you that we will ever achieve
profitability, or be able to generate earnings sufficient to meet our interest
and principal payment obligations. As a result, we have been and continue to be
very dependent on strategic relationships, sales of our debt and equity
securities and short-term loans from our directors and third parties to fund the
operating costs associated with our businesses.
22
The opinion to our consolidated financial statements contains an explanatory
paragraph regarding our ability to continue as a going concern. Accordingly, the
accompanying financial statements have been prepared on a going concern basis,
which contemplates the realization of assets and the satisfaction of liabilities
in the normal course of business. Our historical financial performance,
obligations coming due over the next 12 months and the need for additional
financing to fund planned growth in the business raise substantial doubt about
whether the Company can continue as a going concern.
By selling our 6% convertible debentures in July 1997, we incurred $17,000,000
in principal amount of indebtedness. Through April 10, 2002, holders of
$12,990,000 in principal amount of these debentures have exercised their
conversion rights and converted their debentures into 4,134,089 shares of KFx
Common Stock. At April 10, 2002, the outstanding principal amount of these
debentures totaled $4,010,000. If the debentures are not converted into common
stock before they mature on July 31, 2002, interest at an annual rate of 6% plus
a maturity premium of 12%, for a total of $601,500 will also be due at that
time. Due to our need for cash and the current restraints on our ability to
raise capital, it is currently unlikely that these obligations will be
satisfied.
As of December 31, 2001, a total of $5,000,000 was due to Pavilion during 2002
for installment payments on the purchase of the Power Optimization Division. In
March 2002, the Asset Purchase and License Agreement was amended to reduce total
remaining purchase price payments to $4,500,000, with the entire payment due by
March 28, 2002. On March 28, 2002, the Company issued 2 million shares of common
stock at a price of $2.50 per share and a warrant, expiring eight years after
the date of issuance, exercisable for 2.25 million shares of KFx common stock,
at a price of $2.75 per share, subject to certain adjustments, to an
institutional investor, resulting in proceeds to the Company of $5 million. The
common stock issued is subject to redemption pursuant to a put option, in whole
or in part, at the option of the investors. The put option is exercisable upon
the earlier of July 31, 2002 or upon the redemption or conversion of all of the
Convertible Debentures. At the time the investors notify KFx of their intent to
exercise the put option, KFx must repurchase the common stock at a price of
$2.50 per share plus accrued interest ("Redemption Value") within 100 days of
notification. Interest for purposes of redemption accrues at the rate of 9% per
annum, beginning upon the original issuance date and ceases on the date on which
the common stock is repurchased. If two-thirds or more of the investors notify
KFx of their plan to exercise their put option and KFx is unable to secure the
necessary funding to satisfy these exercised put options within 100 days of
notification, then KFx would be required to transfer its interests in Pegasus to
the investors. The put option expires on December 23, 2002. As a result of the
put option, the common stock issued to the investors will be classified as
redeemable common stock in the mezzanine level of the consolidated balance
sheet. Until the put option expires, the Company is precluded from issuing,
selling, transferring or pledging any of its interest in Pegasus and Pegasus is
precluded from transferring any rights with respect to its equity and assets
without approval of at least two-thirds of the investors. Per the terms of the
investment agreement the proceeds of this investment were first used to complete
the payments of the remaining purchase price for the Pavilion Power Optimization
Division acquisition.
During 2001, the Company closed transactions with various parties pursuant to
which KFx sold all of its Pegasus Preferred Stock, which represents an
approximate 16.0% interest in Pegasus on an as converted basis. KFx is
obligated to repurchase these shares one year after the sale. Based on the
terms of these sales of Pegasus Preferred Stock the obligation to repurchase has
been classified as debt in the December 31, 2001 balance sheet. The total
amount needed to repurchase these shares during 2002 is $3,847,562.
We will require substantial amounts of cash to fund scheduled payments of
principal, interest and maturity premium on our 6% convertible debentures and to
satisfy the obligations to repurchase the Pegasus Preferred Stock that was sold
to private investors in 2001. In addition, substantial cash will be required to
fund working capital requirements and capital expenditures. We may also need
substantial amounts of cash to repurchase redeemable common stock and the common
shares that could be put back to the Company under the terms of the March 28,
2002 agreement to sell common stock. We will be required to raise additional
funds through public or private financings, strategic relationships or other
arrangements. We currently do not have any commitments with respect to any
funding. We cannot be assured that such additional funding will be available at
all or on terms satisfactory to us. A lack of adequate financing may adversely
affect our ability to:
. make necessary interest and principal payments on our indebtedness;
. satisfy our obligation to repurchase Pegasus Preferred Stock;
. respond to changing business and economic conditions and competitive
pressures;
. absorb negative operating results; or
. fund capital expenditures or increased working capital requirements.
The Company intends to seek further capital through various means which may
include the sale of a portion of its interest in Pegasus, additional sales of
debt or equity securities, a business combination, or other means and to further
reduce expenditures as necessary. Should the Company not be successful in
achieving one or more of these actions, it is possible that the Company may not
be able to continue as a going concern.
23
We may be required to sell our interest in Pegasus if more than two-thirds of
the outstanding put options held by some of our investors are exercised at one
time and we are unable to secure the necessary funding to satisfy those options
within the time permitted.
On March 28, 2002, we issued 2 million shares of our common stock and warrants
to purchase 2.25 million shares of our common stock. The common stock issued is
subject to redemption pursuant to a put option, in whole or in part, at the
option of the investors. The put option is exercisable upon the earlier of July
31, 2002 or upon the redemption or conversion of all of the Company's 6%
Convertible Debentures due July 31, 2002. At the time the investors notify us of
their intent to exercise the put option, we must repurchase the common stock at
a price of $2.50 per share plus accrued interest within 100 days of
notification. If two-thirds or more of the investors notify us of their plan to
exercise their put option and we are unable to secure the necessary funding to
satisfy these exercised put options within 100 days of notification, then we
would be required to transfer our interests in Pegasus to the investors. The put
option expires on December 23, 2002. Until the put option expires, we are
precluded from issuing, selling, transferring or pledging any of our interests
in Pegasus and Pegasus is precluded from transferring any rights with respect to
its equity and assets without approval of at least two-thirds of the investors.
We Have Not Consistently Achieved Significant K-Fuel-related Revenue Since Our
Inception
We have not consistently achieved material K-Fuel licensing, royalty or
product sales revenues since we were formed in 1988. In addition, no significant
K-Fuel related revenue was earned prior to our formation when similar operations
to our K-Fuel segment were conducted by various predecessor entities.
We Have Contractual Limitations on Our Ability to Secure Additional Funding
Our ability to secure additional financing is limited by the terms of the
indenture related to our 6% convertible debentures, which precludes secured
borrowings, except in limited circumstances, limits unsecured borrowings, causes
additional dilution to our shareholders if we sell our own equity securities at
prices below the $2.50 per share conversion price of the debentures, limits our
ability to sell assets and enter into merger agreements and places various other
restrictions on our ability to raise debt or equity capital. Our ability to
secure additional financing is also limited by the fact that, until the put
option relating to the March 28, 2002 sale of common stock expires, we are
precluded from issuing, selling, transferring or pledging any of our interest in
Pegasus and Pegasus is precluded from transferring any rights with respect to
its equity and assets without approval of at least two-thirds of the investors
who purchased KFx common stock on March 28, 2002, as stated above.
We Rely on Strategic Partners
Kennecott Energy has been a strategic partner in the development of K-Fuel
technology since early 1996 and also became a strategic partner in Pegasus in
early 2000. Our success will depend upon our ability to maintain existing
strategic relationships with Kennecott Energy and others and develope and
maintain additional relationships for the further development of our
technologies. We are and will continue to be dependent upon our strategic
partners to, among other things, fund the operations of the partnerships or the
joint venture entities in which we own interests and to provide necessary
technical, operational, personnel and other resources. While each of our
strategic partners has an economic motivation to further the development of
their respective joint ventures or projects with us, the amount of time and
resources devoted to such joint ventures or projects will be controlled by our
strategic partners and not by us. A decline in the financial prospects of a
particular strategic partner could adversely affect such partner's commitment to
a joint venture, which could materially harm us. Moreover, joint ventures or
similar arrangements require us to have financial and other arrangements to meet
our commitments to the joint ventures. We cannot assure you that we will be able
to maintain existing strategic relationships, develope or maintain additional
strategic relationships, meet our commitments with respect to our joint ventures
or that our strategic partners will meet their commitments to any respective
joint venture or project.
24
It Is Difficult to Evaluate Our Business and Prospects Because We Added the
Development of Pegasus to Our Strategic Focus, Which Until 1998, Had Been on the
Development of K-Fuel
In August 1995, we commenced the initial application of our K-Fuel technology
and began construction of a facility near Gillette, Wyoming, to produce K-Fuel.
Until early 1998, our primary business was developing, licensing and
commercializing a patented technology that, in general, uses heat and pressure
to physically and chemically transform high-moisture, low-energy per pound coal
and other organic feedstocks into a low-moisture, high-energy solid fuel known
as K-Fuel. Operations at the KFP Facility began in the second quarter of 1998,
but were suspended in the second quarter of 1999. In March 1998 we acquired,
through our purchase of a controlling ownership interest in Pegasus, the
software product NeuSIGHT. Accordingly, we have a limited operating history upon
which an evaluation of our prospects and future performance can be made.
Although we continue to believe that K-Fuel technology has significant long-term
value, we believe that the software business of Pegasus offers more near term
growth opportunity. Our prospects must be considered in light of the risks,
expenses and difficulties frequently encountered in the operation of a new
business based on innovative technologies in a highly competitive and evolving
industry.
The Market for Software in Connection with the Efficiency of the Combustion of
Coal Is New and Uncertain
Combustion and other optimization software relating to the production of coal
or other similar products has only been used by the electric power business for
a few years. We believe that market pressures caused by the developing
deregulation of the electric power industry and the CAA will accelerate demand
for and market acceptance of combustion optimization and related software
products being developed at Pegasus. There can be no assurance, however, that
these software products will experience growth or market acceptance.
The Market for NeuSIGHT and Related Software Depends on Successful Sales and
Marketing Strategies and Product Improvement Strategies
The market for Pegasus combustion optimization and related software is
uncertain. In our opinion, realization of near term value from the software
business of Pegasus requires, among other things, the successful implementation
of new sales and marketing programs. We cannot assure you that our sales and
marketing strategies for Pegasus combustion optimization and related software
will continue to be successful.
Additionally, we believe that increased market acceptance of Pegasus software
is dependent, in part, on our ability to simplify and streamline its
installation process. Product improvements directed at this objective have been
made and new versions of NeuSIGHT were released to the market in late 1999 and
again in late 2000. We will continue to evaluate additional improvements for
development. We cannot assure you that our efforts to further improve Pegasus
software products to more fully meet our objectives will be successful.
No Established Market for Beneficiated Fuel Products Exists
Although we believe that a substantial market will develop both domestically
and internationally for clean coal fuel products, an established market does not
currently exist. As a result, the availability of accurate and reliable pricing
information and transportation alternatives is not fully known. The future
25
success of our K-Fuel technology will depend on our ability to establish a
market for clean coal fuel products among potential customers such as electrical
utility companies and industrial coal users. Further, potential users of our
fuel products may be able to choose among alternative fuel supplies. The market
viability of the K-Fuel technology will not be known until we complete
construction of one or more commercial-scale production facilities, either in
the United States or internationally, that produce, on a consistent basis,
commercial quantities of fuel and meet certain minimum performance
specifications. We face the risk that commercial-scale production facilities
when completed will be unable to generate sufficient market interest to continue
in business. Further, we cannot assure you that any commercial-scale K-Fuel
facility will be successful.
Deregulation in the United States Power Industry May Result in Increased
Competition for Our Products
We expect that deregulation in the United States power industry will result in
utilities and other power generators placing a high emphasis on reducing costs
in their operations. This situation may, in turn, result in increased
competition from other producers of beneficiated coal products, other clean fuel
sources, other developers of combustion optimization software and other
products, services and technologies designed to provide environmental and
operating cost benefits similar to those which we believe are available from our
K-Fuel technology and Pegasus' combustion optimization technology and related
software.
Our Markets Are Competitive
We face competition from other companies in the clean coal and alternative
fuel technology industries as well as the emission control equipment industry.
Many of these companies have financial and managerial resources much greater
than ours and, therefore, may be able to offer products more competitively
priced and more widely available than ours. Also, competitors' products may make
our technology and products obsolete or non-competitive. Our future success may
depend on our ability to adapt to such changing technologies and competition.
We Are Subject to Risks of Changing Laws
A significant factor driving the creation of the United States market for K-
Fuel, other beneficiated coal products, Pegasus combustion optimization and
related software products is the CAA, which specifies various air emission
requirements for electrical utility companies and industrial coal users. We
believe that compliance with the air emission regulations by these coal users
can be fully or partially met through the use of clean-burning fuel
technologies, like K-Fuel, and combustion optimization software, like NeuSIGHT
and Power Perfecter. We are unable to predict future regulatory changes and
their impact on the demand for our products. A full or partial repeal or
revision of the CAA would have a material adverse effect on our prospects.
26
Our Inability to Adequately Protect Our Proprietary Technology Could Harm Our
Business
Our success depends upon our proprietary technology. We rely on a combination
of patent, copyright, trademark and trade secret rights to establish and protect
our proprietary rights. We currently have a series of patents on our K-Fuel
technology, however, competitors may successfully challenge the validity or
scope of one or more of our patents or any future allowed patents. These patents
alone, our trade secret rights with respect to NeuSIGHT and indemnification by
the licensors of various Pegasus software products may not provide us with any
significant competitive advantage.
Third parties could copy or otherwise obtain and use our products or
technology without authorization or develop similar technology independently. We
cannot easily police unauthorized use of our technologies. The protection of our
proprietary rights may be inadequate and our competitors could independently
develop similar technology, duplicate our solutions or design around any patents
or other intellectual property rights we hold.
As is common in the software industry, we may, from time to time receive
notices from third parties claiming infringement by our NeuSIGHT product or
similar software of third party patent and other property rights.
We Rely on Key Personnel and Must Be Able to Retain or Attract Qualified
Personnel
We believe that our performance is substantially dependent on the performance
of a small group of senior managers and key technical personnel. The inability
to retain key managerial and technical personnel or attract and retain
additional highly qualified managerial or technical personnel in the future
could harm our business or financial condition.
Technical and Operational Problems May Adversely Impact Our Ability to Develop
K-Fuel Projects or Facilities
We cannot assure you that any K-Fuel facilities under consideration by
Kennecott Energy will not experience technical or operational problems similar
or in addition to those experienced at the KFP Facility. To the extent that
other technical or operational problems materialize, our ability to develop
other K-Fuel projects or facilities would be jeopardized.
Local Opposition to K-Fuel Projects Could Substantially Delay or Prevent
Development of New K-Fuel Facilities
Development, construction and operation of K-Fuel production facilities
require numerous environmental and other permits. The process of obtaining these
permits can be lengthy and expensive. In addition, local opposition to a
particular project can substantially increase the cost and time associated with
developing a project, and can, potentially, render a project unfeasible or
uneconomical. Kennecott Energy or others that may consider the development of K-
Fuel facilities may incur substantial costs or delays or may be unsuccessful in
developing K-Fuel production facilities as a result of such opposition.
27
Our General Project Development Is Uncertain
The process of developing, permitting, financing and constructing K-Fuel
production facilities is complex, lengthy and costly and subject to numerous
risks, uncertainties and factors beyond our control, including cost overruns,
delays, damage and technical delays. Only a small percentage of the projects
that are considered and pursued, by us, Kennecott Energy or other third parties,
may ultimately result in operating projects, that are sufficiently successful to
provide us with license fee income, royalty fee income and/or equity
participation income. As a result, we may not be able to recover any expenses
that we incur in the evaluation and development of certain projects.
A Significant Portion of the Potential of the K-Fuel and Pegasus Businesses Is
Subject to International Risks
Although our current operations are primarily in the United States, we believe
a significant portion of the growth opportunity for both our Pegasus and K-Fuel
businesses lies outside the United States. Doing business in foreign countries
exposes us to many risks that are not present in the United States and with
which we lack significant experience, including political, military,
privatization, technology piracy, currency exchange and repatriation risks, and
higher credit risks associated with customers. In addition, it may be more
difficult for us to enforce legal obligations in foreign countries and we may be
at a disadvantage in any legal proceeding within the local jurisdiction. Local
laws may also limit our ability to hold a majority interest in the projects that
we develop.
Our Ability to Take Advantage of Net Operating Losses if We Achieve
Profitability Could be Limited
Under Section 382 of the Internal Revenue Code ("IRC"), the use of prior net
operating losses is limited after an "ownership change," as defined in Section
382. The limitation, if applicable, is equal to the value of the loss
corporation's outstanding stock immediately before the date of the ownership
change multiplied by a long-term interest rate specified by the IRC. The quoted
market value of a stock is a factor to consider, but not necessarily a
conclusive factor, in determining the fair value of a corporation's stock.
Additional issuances of equity interests by us, including the issuance of shares
of common stock upon the conversion of our 6% convertible debentures or on the
exercise of outstanding warrants or options to purchase our common stock may
result in an ownership change that is large enough to trigger the Section 382
limitations. In the event we achieve profitable operations and taxable income,
any significant limitation on the use of our net operating losses to offset
taxable income would have the effect of increasing our tax liability and
reducing net income and available cash resources.
We Are Required to Pay Third Parties a Significant Portion of Licensing and
Royalty Revenues
We anticipate that a significant portion of our future revenues with respect
to K-Fuel will be in the form of licensing and royalty payments from third party
licensees operating commercial-scale production facilities of K-Fuel. Pursuant
to various agreements we have executed, we are required to pay third parties a
substantial portion of licensing and royalty revenues that we receive. Amounts
due under these agreements may restrict or limit our ability to pursue other
commercialization opportunities with respect to K-Fuel because such payments
will decrease cash flow from operations.
Our common stock could be delisted from the American Stock Exchange ("Amex") if
we do not comply with the Amex continued listing standards.
Our common stock is listed on the Amex and to maintain our listing we must
meet certain continued listing standards. Specifically, pursuant to Section
1003(a)(ii) of the Amex Company Guide, the Amex will consider delisting a
company that has stockholders' equity of less than $4 million if such company
has sustained losses from continuing operations and/or net losses in three of
its four most recent fiscal years. At December 31, 2001, our stockholders'
deficit was $16 million and we sustained net losses for three consecutive fiscal
years. If we do not increase our stockholders' equity to meet this continued
listing standard, our common stock may be delisted. Although we will develop and
pursue a plan to meet the continued listing requirements, there can be no
assurance that our common stock will remain listed on the Amex. If our common
stock were delisted from the Amex for any reason, it could seriously reduce the
value of our common stock and its liquidity, reduce our ability to raise
additional financing, limit our use of equity instruments to satisfy outstanding
obligations and limit our ability to attract qualified employees.
28
We Do Not Pay Cash Dividends
We have never paid any cash dividends and do not anticipate paying cash
dividends in the foreseeable future. In addition, we are prohibited from paying
dividends as long as any of our 6% convertible debentures are outstanding.
ITEM 2. PROPERTIES
Effective October 1, 2000, the Company's principal executive offices consist
of approximately 2,100 square feet of office space leased under a sublease
through August 31, 2004, located at 3300 East First Avenue, Suite 290, Denver,
Colorado 80206. The current base rent under the lease is $3,367 per month,
escalating to $3,540 per month by the final year of the lease. The Company is
also obligated to pay, as additional rent, allocable operating costs.
Until September 30, 2000, the Company's principal executive offices consisted
of approximately 5,900 square feet of office space leased through September
2004, located at 1999 Broadway, Suite 3200, Denver, Colorado 80202. The current
base rent under the lease is $10,607 per month, escalating gradually to $11,593
per month by the final year of the lease. Effective October 1, 2000 to
September 30, 2004, this space was subleased to a third party for $11,100 per
month. The Company is also obligated to pay, as additional rent, allocable
operating costs, most of which will also trigger additional rental income from
the sublessee. During 1998 and 1999, the Pegasus and K-Fuel segments used a
portion of this office space.
The Company has leased approximately 2,300 square feet of office space through
June 30, 2003, located at 2300 Clarendon Boulevard, Suite 401, Arlington,
Virginia 22201. The base rent under the lease is approximately $4,999 per month,
with escalations of 2.5 percent for each subsequent year of the lease term. The
Company is also obligated to pay, as additional rent, an allocable share of
increases in certain operating costs. The Company has the option to renew the
lease for one additional five-year term. A portion of this office space is
sublet under short-term leases to third parties.
Pegasus has leased approximately 7,600 square feet of office space through
October 2004, located at 5970 Heisley Road, Suite 300, Mentor, Ohio 44060. The
current base rent under the lease is approximately $8,515 per month, escalating
gradually to $9,146 per month by the final year of the lease. Pegasus is also
obligated to pay, as additional rent, allocable operating costs. Pegasus has
options to renew the lease for two additional 3-year terms, at a base rent
escalated by the Consumer Price Index from the final base rent in the current
term.
The Company, through its KFx Technology, Inc. ("KFxT") subsidiary, owns a
demonstration plant and leases from a subsidiary of Black Hills Corporation (for
nominal rental payments) a research and development laboratory adjacent to the
KFP Facility (the "Gillette Facility"). The Gillette Facility is located on
approximately 80 acres of land, inside the rail loop of Fort Union Mine, in
Campbell County, Wyoming, approximately 5 miles northeast of Gillette, Wyoming.
The Gillette Facility is comprised of three buildings totaling approximately
7,100 square feet.
ITEM 3. LEGAL PROCEEDINGS
On August 14, 2000, Pavilion Technologies, Inc. ("Pavilion"), a competitor of
Pegasus, filed a complaint in the United States District Court for the Southern
District of Texas asserting that Pegasus infringed 26 patents allegedly issued
to or licensed by Pavilion (the "Pavilion Lawsuit"). The Pavilion Lawsuit was
subsequently transferred to the United States District Court for the Northern
District of Ohio. The Pavilion Lawsuit sought injunctive relief, compensatory
and treble damages, as well as attorney's fees, costs and expenses. On April
11, 2001, Pegasus and Pavilion agreed to dismiss the Pavilion Lawsuit, the
Pegasus
29
Answer and the Pegasus Counterclaims, without prejudice, in order to
explore possible business combinations, cooperative relationships and other
alternatives. On July 31, 2001, Pegasus purchased certain assets and
liabilities of the Power Optimization Division of Pavilion, which effectively
resolved the complaints alleged in the Pavilion Lawsuit.
On November 4, 1999, Link Resources, Inc., a Georgia corporation, ("Link") and
its two shareholders, Linda E. Kobel ("Kobel") and Gary A. Sanden ("Sanden")
filed a complaint against the Company in US District Court for the District of
Colorado. The complaint alleged that KFx, Link, Kobel and Sanden had entered
into an agreement requiring KFx to acquire Link and that KFx breached such
agreement. The complaint sought damages in excess of $5.3 million. This
litigation was settled in February 2002 with the costs of the settlement borne
by the Company's insurance carrier.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
PART II
- -------
ITEM 5. MARKET FOR COMMON STOCK AND RELATED STOCKHOLDER MATTERS
The Common Stock trades on the American Stock Exchange (under the trading
symbol "KFX"). The following table presents the reported sales prices on the
American Stock Exchange for the two-year period ended December 31, 2001:
Year Period High Low
---- ------ ---- ---
2001 First Quarter $ 2.90 $ 1.375
Second Quarter 3.25 1.80
Third Quarter 3.85 2.40
Fourth Quarter 3.25 2.50
2000 First Quarter $4.9375 $1.6875
Second Quarter 3.6250 1.5000
Third Quarter 3.1875 2.1875
Fourth Quarter 2.9375 1.1875
As of April 12, 2002, the Company had 215 holders of record of the Common
Stock. This does not include holdings in street or nominee names. On April 12,
2002, the closing price of the Common Stock on the American Stock Exchange was
$2.06 per share.
The Company has never paid cash dividends and does not anticipate paying
dividends in the foreseeable future. The Company is also prohibited from paying
dividends pursuant to the terms of the Convertible Debenture Indenture.
During 2001, KFx issued or granted the following securities in private
transactions pursuant to an exemption from the registration requirements of the
Securities Act of 1933, as amended ("Securities Act") under Section 4(2) of the
Securities Act:
Purchaser/ Number
30
Recipient of Terms of Exercise, if Title of Security Sold or Consideration
Securities Date Convertible ----------------- Granted Received
---------- ---- ----------- ------- --------
Reisert Group January 2001 N/A Common Stock 56,250 Professional services
valued at $205,313
J. P. Venners January 2001 N/A Common Stock 50,000 Professional services
& Co. valued at $182,500
Reisert Group April 2001 N/A Common Stock 56,250 Professional services