UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

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

OR

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

COMMISSION FILE NUMBER 000-31687

EVERGREEN SOLAR, INC.

138 Bartlett Street
Marlboro, Massachusetts 01752
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)

(508) 357-2221
(REGISTRANT’S TELEPHONE NUMBER, INCLUDING AREA CODE)

259 Cedar Hill Street
Marlboro, Massachusetts 01752
(FORMER NAME, FORMER ADDRESS AND FORMER FISCAL YEAR, IF CHANGED SINCE LAST REPORT)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [  ]

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes [  ] No [X]

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: As of April 16, 2004 there were 16,086,604 shares of common stock outstanding.

EVERGREEN SOLAR, INC.
QUARTERLY REPORT ON FORM 10-Q
FOR THE QUARTER ENDED MARCH 31, 2004

TABLE OF CONTENTS

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PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

Evergreen Solar, Inc.

The accompanying notes are an integral part of these financial statements.

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Evergreen Solar, Inc.

The accompanying notes are an integral part of these financial statements.

4

Evergreen Solar, Inc.

The accompanying notes are an integral part of these financial statements.

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EVERGREEN SOLAR, INC.

1.

Basis of Presentation

The accompanying condensed consolidated interim financial statements of Evergreen Solar, Inc. (“Evergreen Solar” or the “Company”) are unaudited and have been prepared on a basis substantially consistent with the Company’s audited financial statements for the year ended December 31, 2003. The condensed consolidated interim financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information. Consequently, these statements do not include all disclosures normally required by generally accepted accounting principles for annual financial statements. These condensed consolidated interim financial statements should be read in conjunction with the Company’s audited financial statements for the year ended December 31, 2003, which are contained in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2003, which was filed with the Securities and Exchange Commission on March 23, 2004. The unaudited condensed consolidated interim financial statements, in the opinion of management, reflect all adjustments (consisting only of normal recurring accruals) necessary for a fair presentation of the financial position at March 31, 2004, the results of operations for the three month periods ended March 31, 2004 and 2003, and the cash flows for the three month periods ended March 31, 2004 and 2003. The balance sheet at December 31, 2003 has been derived from audited financial statements as of that date. The results of operations for the interim periods are not necessarily indicative of the results of operations to be expected for any other interim period or for the full fiscal year ending December 31, 2004.

The Company’s preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosures of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenue and expenses during the reported periods. Estimates are used when accounting for the collectibility of receivables, valuing deferred tax assets, provisions for warranty claims and inventory obsolescence.

The Company applies the accounting provisions of Accounting Principles Board (“APB”) Opinion 25 and related interpretations and has elected the disclosure-only alternative permitted under Statement of Financial Accounting Standards Board (“SFAS”) No. 123, “Accounting for Stock-Based Compensation.” The Company has disclosed herein pro forma net loss using the fair value based method. All stock-based awards to non-employees are accounted for at their fair market value, as calculated using the Black-Scholes model in accordance with SFAS No. 123.

Had compensation expense for the employee stock option plan been determined based on the fair value at the grant dates for options granted under the plan consistent with the method of SFAS No. 123, the Company’s net loss would have been as follows (in thousands, except per share data):

The Company has historically financed operations and met capital expenditures requirements primarily through sales of capital stock and, to a lesser extent, research and product revenues. On May 15, 2003, the Company consummated a private placement transaction with certain investors to raise $29.5 million through the issuance of 26,227,668 shares of Series A convertible preferred stock and the sale of a warrant to purchase 2,400,000 shares of common stock. The proceeds to the Company, net of financing expenses of approximately $849,000, were approximately $28.6 million. The Company expects to use the net proceeds from this transaction to fund the construction of the second manufacturing line and other operations of the Company.

The Company needs additional financing to execute its business plan and to respond to business contingencies such as the need to enhance its operating infrastructure, respond to competitive pressures and acquire complementary businesses or necessary technologies. For example, in addition to capital commitments as of March 31, 2004, substantial further capital expenditures will be required over the next eight to ten months to increase the capacity at the Company’s manufacturing facility to its target level of 10 to 14 megawatts for both manufacturing lines. The Company does not know whether it will be able to raise additional financing on favorable financing terms. If

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adequate funds are not available or are not available on acceptable terms, the Company’s ability to fund its operations, develop and expand its manufacturing operations and distribution network, or otherwise respond to competitive pressures would be significantly limited. In such a situation, the Company would need to implement fundamental changes to its business and operations which would likely include substantially reducing, suspending, or terminating the Company’s capacity expansion and substantially reducing daily operating expenditures from current levels, in which case the Company believes its cash, cash equivalents and short-term investments will then be sufficient to fund operations through the end of fiscal year 2004.

The Company is subject to risks common to companies in the high technology and energy industries including, but not limited to, development by the Company or its competitors of new technological innovations, dependence on key personnel, protection of proprietary technology and compliance with government regulations. Any delay in the Company’s plan to scale up to full capacity may result in increased costs and could impair business operations.

2.

Net Loss per Common Share

The Company computes net loss per common share in accordance with SFAS No. 128, “Earnings Per Share” (“SFAS 128”), and SEC Staff Accounting Bulletin No. 98 (“SAB 98”). Under the provisions of SFAS 128 and SAB 98, basic net loss per common share is computed by dividing net loss attributable to common stockholders by the weighted average number of common shares outstanding during the period. The calculation of diluted net loss per common share for the three month period ended March 31, 2004 and 2003 does not include 31,489,151 and 1,160,225 potential shares of common stock equivalents outstanding at March 31, 2004 and 2003, respectively, as their inclusion would be antidilutive.

3.

Inventory

Inventory consisted of the following at December 31, 2003 and March 31, 2004 (in thousands):

4.

Fixed Assets

Fixed assets consisted of the following at December 31, 2003 and March 31, 2004 (in thousands):

As of March 31, 2004, the Company’s outstanding commitments for capital expenditures were approximately $1.5 million. Nearly all of its commitments for capital expenditures are associated with infrastructure improvements and equipment purchases for its manufacturing facility. In addition to the current capital commitments, substantial further capital expenditures will be required over the next eight to ten months to increase the capacity at our manufacturing facility to our target level of 10 to 14 megawatts for both lines.

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5.

Guarantor Arrangements

The following is a summary of the Company’s agreements that are within the scope of FIN 45.

Product Warranty

The Company provides for the estimated cost of product warranties at the time revenue is recognized. Given the Company’s limited operating history, the Company uses historical industry solar panel failure rates as the basis for the accrued warranty costs during the period. While the Company engages in product quality programs and processes, including monitoring and evaluating the quality of component suppliers, its warranty obligation is affected by product failure rates and material usage and service delivery costs incurred in correcting a product failure. If the Company’s actual product failure rates, material usage or service delivery costs differ from these estimates, accrued warranty costs would be adjusted in the period that such events or costs become known. Since the Company has a limited operating history and its manufacturing process differs from industry standards, its experience may be different from the industry data used as a basis for its estimate. While the Company’s methodology takes into account these uncertainties, adjustments in future periods may be required as its products mature. The following table summarizes the activity regarding the Company’s warranty accrual during the first three months of 2004:

Indemnification Agreements

The Company enters into standard indemnification agreements in its ordinary course of business. Pursuant to these agreements, the Company indemnifies, holds harmless, and agrees to reimburse the indemnified party for losses suffered or incurred by the indemnified party, generally our business partners, directors and officers. The term of these indemnification agreements is generally perpetual any time after execution of the agreement. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements under certain circumstances may be unlimited. However, the Company has never incurred costs to defend lawsuits or settle claims related to these indemnification agreements. Furthermore, the Company has a director and officer insurance policy pursuant to which the Company may recover all or a portion of amounts it pays to directors and officers under their indemnification agreements. As a result of the Company’s insurance policy coverage, the Company believes the estimated fair value of these indemnification agreements is minimal. The Company believes the estimated fair value of agreements with parties other than its directors and officers is minimal as well.

The Company agreed to indemnify, defend and hold harmless each of the purchasers participating in the Company’s Series A private placement financing transaction, their affiliates and their respective officers, directors, agents, employees, subsidiaries, partners, members and controlling persons to the fullest extent permitted by law from and against any and all losses, claims or written threats thereof, damages, expenses (including reasonable fees, disbursements and other charges of counsel) resulting from or arising out of the Company’s breach of any representation or warranty, covenant or agreement in the purchase agreement. The Company believes the estimated fair value of this indemnification agreement is minimal.

6.

Deferred Compensation

Prior to December 31, 2000, the Company recorded total cumulative deferred compensation of approximately $1.3 million, representing the difference between the fair market value of the Company’s common stock and the exercise price on the option grant date. These amounts were presented as a reduction of stockholders’ equity and are being amortized ratably over the vesting period of the options, which is generally four years. The amortization resulted in charges to operations of $69,000 and $31,000 for the three months ended March 31, 2003 and 2004, respectively.

7.

Segment Information

The Company operates as one operating segment. The following table summarizes the Company’s concentration of total revenue:

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8.

Stockholders’ Equity

At March 31, 2004, 7,650,000 shares of common stock were authorized for issuance under the Company’s 2000 Stock Option Plan and 40,000,000 shares were reserved for issuance upon conversion of Series A convertible preferred stock sold to several purchasers and upon exercise of a warrant issued to Beacon Power Corporation.

Dividend Rights of Series A Convertible Preferred Stock

Shares of Series A convertible preferred stock pay a compounding dividend of 10% per annum, paid quarterly, in cash, or at the Company’s election, to be added to the liquidation preference of the Series A convertible preferred stock on a quarterly basis, which would result in an increase in the number of shares of common stock issuable upon conversion of the Series A convertible preferred stock. To date, a total of $2.5 million in dividends has accrued on the outstanding Series A convertible preferred stock, which the Company elected to add to the liquidation preference of the Series A convertible preferred stock. Subject to changes in business conditions, the Company presently anticipates that the dividend will be added to the liquidation preference for the foreseeable future.

9.

Subsequent Event

On April 21, 2004, the Company’s Board of Directors approved a resolution increasing the number of authorized shares of common stock from 70,000,000 to 100,000,000 and correspondingly increasing the total number of authorized shares of capital stock from 97,227,668 to 127,227,668. The increase in the total number of authorized shares of capital stock is subject to approval by the Company’s shareholders. The Company’s shareholder meeting is currently scheduled for June 15, 2004.

10.

Other Comprehensive Income

Other comprehensive income (loss) consists of unrealized gains and losses on marketable securities. For the three months ended March 31, 2004, the Company recorded other comprehensive income of $37,000, which, when added to net loss, results in comprehensive loss of $3.9 million. For the three months ended March 31, 2003, the Company recorded other comprehensive loss of $6,000, which, when added to net loss, results in comprehensive loss of $3.2 million.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

CAUTION CONCERNING FORWARD-LOOKING STATEMENTS

We caution readers that statements in this Quarterly Report on Form 10-Q that are not strictly historical statements, including, but not limited to: statements reflecting our expectations regarding the timing, cost, and success of our manufacturing scale-up at our facility in Marlboro, Massachusetts and future manufacturing expansion and production, as well as related financing requirements; future financial performance; our technology and product development, cost and performance; our current and future strategic relationships and future market opportunities; and our other business and technology strategies and objectives, constitute forward-looking statements which are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These

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statements may be identified with such words as “we expect”, “we believe”, “we anticipate” or similar indications of future expectations. These statements are neither promises nor guarantees and involve risks and uncertainties, which could cause our actual results to differ materially from such forward-looking statements. Such risks and uncertainties may include, among other things, those risks and uncertainties described in this Quarterly Report and in our other filings with the Securities and Exchange Commission, copies of which may be accessed through the SEC’s Web Site at http://www.sec.gov. We caution readers not to place undue reliance on any forward-looking statements contained in this Quarterly Report, which speak only as of the date of this Quarterly Report. We disclaim any obligation to publicly update or revise any such statements to reflect any change in our expectations, or events, conditions, or circumstances on which any such statements may be based, or that may affect the likelihood that actual results will differ from those set forth in such forward-looking statements.

EXECUTIVE OVERVIEW

We develop, manufacture and market solar power products for the global marketplace. Solar cells are semiconductor devices that convert sunlight into electricity and form the building block for all solar power products. To date, our product sales have been primarily solar panels, which have been used to generate electricity for on-grid and off-grid applications. Off-grid applications have included the electrification of rural homes, lighting for small, rural schools and power supplies for water pumping. More recently, the substantial majority of our products have been used by on-grid customers as a clean, renewable source of alternative or supplemental electricity.

We made significant progress on our capital expansion program aimed at roughly quadrupling our production capacity by adding a second manufacturing line, which we expect to be completed by the end of 2004.During the first quarter of 2004, our product sales were constrained by our manufacturing capacity despite the fact that in April 2004, we doubled our manufacturing capacity over 2003. The factory now has an installed capacity of 6 MW (megawatts, or million watts) per year, up from the 3 MW capacity of Line 1 and has operated at a run rate of 4.5 MW per year. Since product revenue has been capacity limited, the planned expansion should enable significant revenue growth during 2004 and should also further improve our product gross margins.

Implementation of our dual-ribbon growth technology, increased production volume, adding key positions to staff across the organization, expanding and establishing key customer relationships, and consummating the Series A convertible preferred stock and warrant financing were the key factors in determining our performance. We continue to demonstrate our dual-ribbon growth technology (pulling two string ribbons out of one furnace) on an increasing production basis, which we expect to substantially lower the manufacturing cost of growing silicon wafers and roughly double the capacity of one string ribbon furnace. We expect the new crystal growth furnaces we will be installing throughout 2004 will all be dual-ribbon growth furnaces. During the first quarter, we had about 100 crystal growth furnaces in production, 40 of which were new, double-ribbon growth furnaces delivered during the first quarter. We added several key staff in sales, administration, manufacturing and research and development to better position ourselves for the anticipated growth of the company during the year. Most notably, we hired Richard M. Feldt as our new President and CEO in December 2003.

The cash raised as a result of the Series A convertible preferred stock and warrant financing in May 2003 provided us with the resources necessary to increase our capital spending program. However, our current cash, cash equivalents and short-term investments will not be sufficient to fund this capacity expansion and our expected increased level of operations through fiscal year 2004 and, as a result, we will need to raise significant additional financing or secure a working capital line of credit in order to successfully fund such expanded operations. If we are not able to complete a financing or secure a working capital line of credit in a timely manner, we will need to implement fundamental changes to our business and operations which will likely include substantially reducing, suspending, or terminating our capacity expansion and substantially reducing our daily operating expenditures from current levels, in which case we believe our cash, cash equivalents and short-term investments will then be sufficient to fund our operations through the end of fiscal year 2004.

We may need additional financing to execute our business plan sooner if we need to respond to business contingencies such as the need to enhance our operating infrastructure, respond to competitive pressures and acquire complementary businesses or necessary technologies. We do not know whether we will be able to raise additional financing or financing on terms favorable to us. If adequate funds are not available or are not available on acceptable terms, our ability to fund our operations, develop and expand our manufacturing operations and distribution network, or otherwise respond to competitive pressures would be significantly limited.

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CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The preparation of consolidated financial statements in accordance with generally accepted accounting principals requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements:

Revenue Recognition and Allowance for Doubtful Accounts

We recognize product revenue if persuasive evidence of an arrangement exists, shipment has occurred, risk of loss has transferred to the customer, sales price is fixed or determinable, and collectibility is reasonably assured. The market for solar power products is emerging and rapidly evolving. We currently sell our solar power products primarily to distributors, system integrators and other value-added resellers within and outside of North America, which typically resell our products to end users throughout the world. For new customers requesting credit, we evaluate creditworthiness based on credit applications, feedback from provided references, and credit reports from independent agencies. For existing customers, we evaluate creditworthiness based on payment history and known changes in their financial condition.

We also evaluate the facts and circumstances related to each sales transaction and consider whether risk of loss has not passed to the customer upon shipment. We consider whether our customer is purchasing our product for stock, and whether contractual or implied rights to return the product exist or whether our customer has an end user contractually committed. To date, we have not offered rights to return our products other than for normal warranty conditions.

We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. If the financial condition of our customers were to deteriorate, such that their ability to make payments was impaired, additional allowances could be required.

Revenue from research grants is recognized as services are rendered to the extent of allowable costs incurred.

Inventory

Inventory is valued at the lower of cost or market. Certain factors may impact the realizable value of our inventory including, but not limited to, technological changes, market demand, changes in product mix strategy, new product introductions and significant changes to our cost structure. Given our current production levels and the market value of our products, we currently sell our finished goods inventory at prices that are below the sum of our fixed and variable costs per unit. Accordingly, we write down our finished goods inventory to realizable value equal to the difference between the cost of inventory and the estimated market value. In addition, estimates of reserves are made for obsolescence based on the current product mix on hand and its expected net realizability. If actual market conditions are less favorable or other factors arise that are significantly different than those anticipated by management, additional inventory write-downs or increases in obsolescence reserves may be required. We treat lower of cost or market adjustments and inventory reserves as an adjustment to the cost basis of the underlying inventory. Accordingly, favorable changes in market conditions are not recorded to inventory in subsequent periods.

Warranty

We provide for the estimated cost of product warranties at the time revenue is recognized. Given our limited operating history, we use historical industry solar panel failure rates as the basis for our warranty provision calculation. While we engage in product quality programs and processes, including monitoring and evaluating the quality of our component suppliers, our warranty obligation is affected by product failure rates and material usage and service delivery costs incurred in correcting a product failure. If our actual product failure rates, material usage or service delivery costs differ from our estimates, revisions to the estimated warranty liability would be required. Since we have a limited operating history and our manufacturing process differs from industry standards, our experience may be different from the industry data used as a basis for our estimate. While our methodology takes into account these uncertainties, adjustments in future periods may be required as our products mature.

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Long-lived Assets

Our policy regarding long-lived assets is to evaluate the recoverability or usefulness of these assets when the facts and circumstances suggest that these assets may be impaired. This analysis relies on a number of factors, including changes in strategic direction, business plans, regulatory developments, economic and budget projections, technological improvements, and operating results. The test of recoverability or usefulness is a comparison of the asset value to the undiscounted cash flow of its expected cumulative net operating cash flow over the asset’s remaining useful life. If such a test indicates that an impairment is required, then the asset is written down to its estimated fair value. Any write-downs would be treated as permanent reductions in the carrying amounts of the assets and an operating loss would be recognized. To date, we have had recurring operating losses and the recoverability of our long-lived assets is contingent upon executing our business plan that includes further reducing our manufacturing costs and significantly increasing sales. If we are unable to execute our business plan, we may be required to write down the value of our long-lived assets in future periods.

Income Taxes

We are required to estimate our income taxes in each of the jurisdictions in which we operate as part of our consolidated financial statements. This involves estimating the actual current tax in addition to assessing temporary differences resulting from differing treatments for tax and financial accounting purposes. These differences together with net operating loss carryforwards and tax credits may be recorded as deferred tax assets or liabilities on the balance sheet. A judgment must then be made of the likelihood that any deferred tax assets will be recovered from future taxable income. To the extent that we determine that it is more likely than not that deferred tax assets will not be utilized, a valuation allowance is established. Taxable income in future periods significantly different from that projected may cause adjustments to the valuation allowance that could materially increase or decrease future income tax expense.

Results of Operations

Revenues. Total revenues for the Company consist of revenues from the sale of products and research revenues. Product revenues consist of revenues from the sale of solar cells, panels and systems. Research revenues consist of revenues from various state and federal government agencies to fund our ongoing research, development, testing and enhancement of our products and manufacturing technology. Our current intention is not to pursue contracts that are not part of our ongoing research activities. We recognize research revenues as services are rendered.

Cost of product revenues. Cost of product revenues consists primarily of salaries and related personnel costs, materials expenses, depreciation expenses, maintenance, rent, royalties on licensed technology, warranty costs, and other support expenses associated with the manufacture of our solar power products. We expect to continue to experience costs in excess of product revenues unless we are able to achieve greater manufacturing efficiencies, higher yields, and higher production levels.

Research and development expenses, including cost of research revenues. Research and development expenses, including cost of research revenues, consist primarily of salaries and related personnel costs, consulting expenses, and prototype costs related to the design, development, testing and enhancement of our products and manufacturing technology. We expense our research and development costs as incurred. We believe that research and development is critical to our strategic objectives of enhancing our technology, reducing manufacturing costs and meeting the changing requirements of our customers. As a result, we expect that our total research and development expenses will increase in the future.

Selling, general and administrative expenses. Selling, general and administrative expenses consist primarily of salaries and related personnel costs, professional fees, rent, insurance and other sales expenses. We expect that selling expenses will increase substantially in absolute dollars as we increase our sales efforts, hire additional sales personnel and initiate additional marketing programs. We expect that general and administrative expenses will increase as we add personnel and incur additional costs related to the growth of our business.

Stock-based compensation expense, related to the issuance of stock options to employees. Prior to December 31, 2000, we recorded total cumulative deferred compensation of approximately $1.3 million representing the difference between the estimated fair market value of the common stock and the exercise price of the option at the grant date. These amounts were presented as a reduction of stockholders’ equity and are being amortized ratably over the vesting period of the options, which is generally four years.

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Other income. Other income consists of net interest income primarily from interest earned on the holding of short-term, high quality commercial paper, corporate bonds and United States government-backed securities, less any bond premium amortization, and foreign currency gains and losses.

Dividends on preferred stock. On May 15, 2003, we issued 26,227,668 shares of Series A convertible preferred stock at a per share purchase price of $1.12 to several purchasers. Shares of Series A convertible preferred stock pay a compounding dividend of 10% per annum, paid quarterly, in cash, or at our election to be added to the liquidation preference of the Series A convertible preferred stock on a quarterly basis, which would result in an increase in the number of shares of common stock issuable upon conversion of the Series A convertible preferred stock. Subject to changes in business conditions, we presently anticipate that the dividend will be added to the liquidation preference for the foreseeable future.

Net loss attributable to common stockholders. Net loss attributable to common stockholders consists of net losses and dividends earned by the Series A preferred stockholders.

Other comprehensive income (loss). Our other comprehensive income consists of net unrealized gains and losses on marketable securities, as well as foreign currency gains and losses.

Comparison of Three Months Ended March 31, 2004 and 2003

Revenues. Our product revenues for the three months ended March 31, 2004 were $2.8 million, an increase of $1.7 million, or 165%, from $1.1 million for the same period in 2003. The increase in product revenues was due to the increased production capacity of our new manufacturing facility in Marlboro, Massachusetts, and our increased marketing and sales activities. Research revenues for the three months ended March 31, 2004 were $262,000, a decrease of $119,000, or 31%, from $381,000 for the same period in 2003. Research revenue decreased since during the first quarter of 2004 we had one active research contract versus two during the same period in 2003.

Product revenues represented 92% of total revenues for the three- month period ended March 31, 2004 and 74% of total revenues for the three- month period ended March 31, 2003. The share of total revenues represented by product revenues in the first quarter of 2004 increased from previous quarters due to an increase in product revenues from increased production capacity and a decrease in research revenues. International product sales accounted for approximately 61% of total revenues for the three-month period ended March 31, 2004, and 43% for the three-month period ended March 31, 2003. The increased share of total revenues represented by international product sales for the three-month period ended March 31, 2004 resulted from an expanded focus on international sales channels. We anticipate that international sales will continue to account for a significant portion of our product revenues for the foreseeable future. Currently, all European sales are denominated in Euros, which increases our risk of incurring foreign exchange gains or losses. As we expand our manufacturing operations and distribution network internationally, our exposure to fluctuations in currency exchange rates may increase.

The following table summarizes our concentration of total revenue:

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Cost of product revenues. Our cost of product revenues for the three months ended March 31, 2004 was $4.6 million, an increase of $1.9 million, or 71%, from $2.7 million for the same period in 2003. Most of the increase was due to an increase in materials consumption and labor costs due to increased product sales. Product gross margin for the three months ended March 31, 2004 was -61% versus -150% for the same period in 2003. Product gross margin improved due primarily to yield and efficiency improvements associated with the scale-up of our second manufacturing line and increased sales volume. Due to the relatively large component of fixed costs, product gross margins will still be highly dependent on sales volumes. Therefore, we do not expect substantial improvements in product gross margin until we realize production capacity increases associated with the ramp up of our second manufacturing line, expected by the end of 2004.

Research and development expenses, including cost of research revenues. Our research and development expenses, including cost of research revenues, for the three months ended March 31, 2004 were $902,000, an increase of $189,000, or 27%, from $713,000 for the same period in 2003. The increase was due mainly to increased activity associated with other internal research and development programs.

Selling, general and administrative expenses. Our selling, general and administrative expenses for the three months ended March 31, 2004 were $1.7 million, an increase of $356,000, or 27%, from $1.3 million for the same period in 2003. The increase was primarily due to increased legal costs, increased compensation costs associated with added personnel and increased costs associated with sales and marketing initiatives.

Stock-based compensation expense, related to the issuance of stock options to employees. The amortization of total cumulative deferred compensation of approximately $1.3 million recorded prior to December 31, 2000, representing the difference between the estimated fair market value of the common stock and the exercise price of the option at the grant date resulted in charges to operations of $31,000 and $69,000 for the three month periods ended March 31, 2004 and 2003, respectively.

Other income. Our other income for the three months ended March 31, 2004 was $73,000, an increase of $50,000, or 217%, from $23,000 for the same period in 2003. The increase in other income was primarily due to an increase in net interest income resulting from higher cash and investment balances resulting from our May 2003 Series A preferred stock and warrant financing.

Dividends on preferred stock. On May 15, 2003, we issued 26,227,668 shares of Series A convertible preferred stock at a per share purchase price of $1.12 to several purchasers. Shares of Series A convertible preferred stock pay a compounding dividend of 10% per annum, paid quarterly, in cash, or at our election to be added to the liquidation preference of the Series A convertible preferred stock on a quarterly basis, which would result in an increase in the number of shares of common stock issuable upon conversion of the Series A convertible preferred stock. For the quarter ended March 31, 2004, $665,000 in dividends accrued on the outstanding Series A convertible preferred stock, which we elected to add to the liquidation preference of the Series A convertible preferred stock. Subject to changes in business conditions, we presently anticipate that the dividend will continue to be added to the liquidation preference for the foreseeable future.

Net loss attributable to common stockholders. Net loss attributable to common stockholders was $4.6 million and $3.2 million for the period ended March 31, 2004 and March 31, 2003, respectively. The increase in net loss attributable to common stockholders was due to the overall increase in net operating losses associated with the scale-up of our operations combined with the dividend charges associated with the Series A convertible preferred stock financing, which was consummated on May 15, 2003.

Other comprehensive income (loss). Our other comprehensive income for the three months ended March 31, 2004 was $37,000, compared to a loss of $6,000 for the same period in 2003, consisting of net unrealized gains and losses on marketable securities.

Liquidity and Capital Resources

We have historically financed our operations and met our capital expenditures requirements primarily through sales of our capital stock and, to a lesser extent, product revenues. Research and development expenditures have historically been partially funded by government research contracts. At March 31, 2004, we had working capital of $16.4 million, including cash, cash equivalents and short-term investments of $14.7 million.

Net cash used in operating activities was $3.1 million for the three months ended March 31, 2004, as compared to $2.1 million for the three months ended March 31, 2003. The increase in net cash used in operating activities was primarily due to an increase in our operating loss and accounts associated with an increase in sales volume towards

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the end of the quarter. For the first quarter in 2004, Days Sales Outstanding (DSO) was approximately 59 days, versus approximately 38 days as of December 31, 2003. The increase in DSO was due mainly to increased sales volume towards the later part of the first quarter of 2004. Product sales to customers can fluctuate widely month-to-month, and depending on when sales occur during the quarter, DSO can fluctuate significant