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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 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
or
[_] Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 for the transition period from to
.
Commission File No. 0-20966
CATALYTICA ENERGY SYSTEMS, INC.
(Exact name of Registrant as specified in its charter)
Delaware 77-0410420
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification Number)
430 Ferguson Drive
Mountain View, CA 94043
(Address of principal executive offices)
(650) 960-3000
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $0.001 par value
(Title of Class)
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. [X] Yes [_] 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 March 20, 2002, there were outstanding 11,606,135 shares of the
registrant's common stock, par value $0.001, which is the only class of common
stock of the registrant registered under Section 12(g) of the Securities Act of
1933. As of that date, the aggregate market value of the shares of common stock
held by nonaffiliates of the registrant (based on the closing price for the
common stock on The Nasdaq National Market on March 20, 2002) was $42,246,331.
For purposes of this disclosure, shares of common stock held by each officer
and director of the Registrant and by each person who owns 5% or more of the
outstanding voting stock have been excluded in that such persons may be deemed
to be affiliates. This determination of affiliate status is not necessarily a
conclusive determination for other purposes.
DOCUMENTS INCORPORATED BY REFERENCE
The information called for by Part III is incorporated by reference to the
definitive Proxy Statement for the Annual Meeting of Stockholders of the
Company, which will be filed with the Securities and Exchange Commission no
later than 120 days after December 31, 2001.
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CATALYTICA ENERGY SYSTEMS, INC.
Annual Report on Form 10-K
Table of Contents
December 31, 2001
Page No.
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PART I
Item 1. Business............................................................................. 2
Item 2. Properties........................................................................... 17
Item 3. Legal Proceedings.................................................................... 17
Item 4. Submission of Matters to a Vote of Security Holders.................................. 17
PART II
Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters............ 18
Item 6. Selected Financial Data.............................................................. 20
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 21
Item 7A. Quantitative and Qualitative Disclosures about Market Risk........................... 40
Item 8. Financial Statements and Supplementary Data.......................................... 40
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. 40
PART III
Item 10. Directors and Executive Officers of the Registrant................................... 41
Item 11. Executive Compensation............................................................... 41
Item 12. Security Ownership of Certain Beneficial Owners and Management....................... 41
Item 13. Certain Relationships and Related Transactions....................................... 41
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K...................... 42
1
PART I
Item 1. BUSINESS
Overview
We are responding to a growing demand in the energy industry for
cost-effective solutions for cleaner power through our commitment to the
discovery, development, and manufacture of advanced products that ease the
environmental impact of power production. Our first product, Xonon(R) Cool
Combustion, prevents the formation of nitrogen oxides (NOx) in stationary gas
turbines that are used primarily for electric power generation. Additionally,
we believe that our proprietary catalytic technology has significant market
opportunities in energy production applications outside of gas turbines. In
order to pursue these opportunities, we are currently conducting several
technology development efforts including early stage development work on fuel
processing for fuel cells in automotive applications and adaptation of our
Xonon technology to microturbines, hybrid gas turbine fuel cells and diesel
applications.
Our Xonon system is the only commercially available pollution prevention
technology proven to achieve ultra-low emissions (less than 5 parts per million
("ppm")) during combustion. We believe that our Xonon system achieves ultra-low
emissions of NOx more efficiently and cost-effectively than current systems
that remove this pollutant from the turbine exhaust. In addition, we believe
that our Xonon system can be broadly deployed across turbine applications where
current systems may not be economically or technically viable. Further, we
believe that the environmental and operational benefits offered by Xonon will
expand the use and broaden the application of gas turbines.
For over 24 months, we have been using a Xonon-equipped 1.4 MW gas turbine
to successfully generate power with ultra-low emissions for Silicon Valley
residents and to test our technology in field conditions. The turbine, which
functions as part of the Silicon Valley Power grid, has served alternately as a
demonstration of Xonon's performance and reliability during unattended
full-load operation, and as a development and test engine in support of
commercial program initiatives for customers. Since its installation, the
Xonon-equipped turbine has run for over 8,600 hours. The system has satisfied
federal Environmental Protection Agency, or EPA, guidelines for an emissions
control technology that is "achieved in practice" and has demonstrated
emissions levels that would satisfy the California and South Coast Air Quality
Management District, or SCAQMD, guidelines for gas turbines. We believe that
Xonon is the only gas turbine combustion system demonstrated to meet these
guidelines without requiring a costly exhaust cleanup system. Furthermore, in
February 2001, we successfully completed an evaluation process by the EPA
through its Environmental Technology Verification program, which confirmed the
ultra-low emissions performance of our turbine.
We have been working actively with gas turbine original equipment
manufacturers, or OEMs, to adapt our technology as part of their stationary gas
turbine product lines. We currently have collaborative commercialization
agreements in place with General Electric Power Systems, or GE, and Kawasaki
Motors Corp., U.S.A., or Kawasaki. Both companies have already received initial
orders for Xonon-equipped gas turbines, and in the third quarter of 2001, we
shipped our first three commercial Xonon units to Kawasaki. We also have
development work underway with Solar Turbines, or Solar, to incorporate the
Xonon system into its turbines. Our development of the Xonon technology has
been supported by government agencies and research institutions, including the
Federal Department of Energy, the EPA, the California Energy Commission Public
Interest Energy Research program, the California Air Resources Board and others.
The Market Opportunity
Three major factors are reshaping today's electric power generation industry:
. An ongoing need for new generating capacity in the United States to avoid
supply/demand imbalances;
. A continued focus on the environmental consequences associated with the
generation of electric power; and
2
. An increased demand for distributed power sources due to growing
transmission and distribution constraints and to assure very high levels
of power reliability and quality to support the requirements of our
digital economy.
Together, these forces are creating a significant need for more
environmentally friendly power generation sources. We believe that our Xonon
Cool Combustion system is an enabling technology that addresses this growing
market need.
Need for Increased Generating Capacity
Driven by an economic boom and population growth, the demand for electricity
in the United States grew dramatically during the 1990s. However, growth in the
supply of electricity failed to keep pace. Over the ten-year period from 1990
to 1999, the increase in the peak demand for power was approximately four times
as large as the increase in generation capacity. Consequently, several regions
of the country suffered significant supply/demand imbalances.
For example, in California, residents were subjected to repeated rolling
blackouts and significant increases in retail electric rates during 2000 and
2001. Fortunately, mild weather conditions, newly installed capacity, and
economic factors across the country in the latter half of 2001 avoided a more
widespread problem. Nevertheless, the President's National Energy Policy
Development Group, or NEPDG, projects that the demand for electricity in the
United States will rise 45% from 2000 to 2020. Accordingly, the Department of
Energy, or DOE, estimates that the United States will need 355,000 MW of new
generating capacity, or the equivalent of 1,300 new large power plants, to meet
growing demand and to replace retiring units. According to the DOE, 88% of this
growth in capacity will come from gas-fired generation, and a large percentage
of these capacity additions will be in densely populated areas where air
quality and environmental concerns are the most severe.
Gas turbines are increasingly the choice for new power generation, due
primarily to their inherent operating flexibility, high efficiency, relatively
low capital investment, shorter installation time, lower operating costs, and
lower emissions. Gas-fueled generation, which includes gas turbines and other
generation technologies, as a percent of total installed capacity is expected
to rise significantly over the next two decades. The DOE estimates that
gas-fired generation, which accounted for 16% of total United States
electricity generation in 2000, will represent 32% of total generation by 2020.
We believe that the environmental and operational benefits of our Xonon
technology will expand the use and broaden the applicability of gas turbines,
thereby enabling a more rapid and comprehensive response to the need for
additional generation capacity.
Continued Environmental Awareness
One barrier to adding this additional generation capacity is the continued
public focus on environmental issues. Electricity production can result in
emissions of certain environmentally harmful pollutants, including NOx, carbon
monoxide, volatile organic compounds and particulate matter. In the United
States, the Clean Air Act creates the National Ambient Air Quality Standards,
or NAAQS, which are the basis for regulations that limit these emissions. The
NAAQS encourage the use of more effective emissions control technology in two
ways. First, they require the use of the best available control technology, or
BACT. Second, they provide an economic incentive by requiring that emissions
from new sources be offset by emissions reductions from existing sources in
areas that do not meet air quality standards. Although permits are issued on a
facility-by-facility basis, regulators often issue regulatory guidance setting
forth permissible emissions for new and upgraded facilities. These emission
standards vary geographically and are most stringent in areas where existing
pollution levels are high, including California, the Northeastern states, East
Texas, and other urban areas.
3
A representative sample of high population density areas and their
corresponding permissible emissions includes:
. California (California Air Resource Board)--2.5 ppm, for all units
regardless of size;
. Los Angeles Basin (SCAQMD)--2.5 ppm for units greater than 3 MW;
. Eastern Texas, including Dallas, Austin and San Antonio (Texas Natural
Resources Conservation Commission)--3 ppm for units greater than 10 MW
(and will apply to smaller units after 2004);
. Connecticut, Massachusetts, New York and New Jersey--no specific guidance
has been issued, however several permits have been issued in the past
three years requiring less than 2.5 ppm.
The increased permitting requirements associated with meeting more stringent
emissions requirements, as well as community concerns surrounding construction
of new plants near population centers, have significantly increased the time
and cost associated with siting and permitting new power plants. These
difficulties, combined with other uncertainties surrounding deregulation, have
resulted in a situation where only a fraction of planned generation additions
have actually been brought on-line. For example, according to the NEPDG, of the
approximately 43,000 MW of new generating capacity that power companies planned
in 1994 for construction from 1995 to 1999, only about 18,000 MW of capacity
were actually built. Completion statistics are even lower in areas with more
severe environmental problems and more stringent emissions regulations. The
NEPDG found that, in California where emissions restrictions are the strictest
in the nation, lengthy and costly siting and permitting issues had prevented
the addition of even one single major new power plant between 1991 and 2000.
Significant capacity additions, however, have finally been completed since the
beginning of 2001and more additions are expected in the next few years.
Currently available emissions control technologies fail to cost-effectively
satisfy the most stringent environmental requirements in gas turbine
applications. In order to reduce emissions, gas turbine manufacturers have
developed improved flame-based combustion systems. These measures have, in some
cases, contributed to shorter component lives. Furthermore, even the most
effective of these systems has been unable to achieve ultra-low emissions
levels that are required today without add-on exhaust gas cleanup systems. For
baseload, or nearly continuous operation, virtually all new gas turbine
generating plants that operate in combined cycle (with a heat recovery system)
require exhaust cleanup systems to achieve ultra-low emissions. The most common
conventional exhaust cleanup system is selective catalytic reduction, or SCR.
While this technology has become commonplace, it adds significant capital and
operating costs, reduces overall project performance and efficiency, and
creates incremental health risks through secondary emissions and through the
transportation and storage of hazardous and toxic reagents. In addition,
exhaust cleanup systems cannot be used in all gas turbine applications. For
small gas turbines with heat recovery systems used in distributed generation
applications, the addition of SCR can be cost-prohibitive. Gas turbines that
operate in simple cycle (without a heat recovery system), such as peaking
turbines and gas pipeline compressors, have exhaust temperatures that are too
hot for conventional exhaust cleanup systems. However, there is an emerging
technology generically called high-temperature SCR that can be used in some
simple cycle applications. At least one high-temperature application has been
demonstrated to meet the EPA definition of "achieved in practice" with 8 ppm
NOx, and some units are now operating at less than 5 ppm. However, these
systems are even more expensive to acquire and operate than traditional SCRs
and carry the same attendant risks.
We believe that the role that environmental protection requirements have
played and may continue to play in delaying or ultimately limiting the supply
of new generation capacity highlights the need for a cost-effective,
widely-applicable emissions technology, like Xonon, that permits turbines to
meet the most stringent existing emissions guidelines. We believe that Xonon
will not only reduce the operating costs associated with complying with
environmental standards, but may create additional value by enabling rapid
siting and permitting of projects that otherwise may not have been possible.
4
Increased Demand for Distributed Power Sources
The third factor impacting the electric power industry is the emerging
demand for distributed power sources, or distributed generation. The DOE
projects that about 19,000 megawatts of gas-fired distributed generation
capacity will be added by 2020. Two market drivers are contributing to the
increased demand for on-site power generation:
1. Growing transmission and distribution constraints, and
2. The digital economy's need for high-quality, highly reliable power.
The electric utility grid in the U.S. is faced with growing transmission and
distribution constraints as the result of a lack of investment in an aging,
outdated infrastructure. While net generation of electricity has grown 26% over
the past decade, the number of transmission miles has remained virtually
constant. This lack of investment is creating an electricity bottleneck, which
is impacting transmission grid reliability. A recent report published by the
North American Electric Reliability Council, or NERC, highlights this growing
problem:
"In the near term, transmission congestion is expected to continue. Demand
growth, new generation additions, and the increasing number of energy
transactions continue to outstrip the proposed expansion of transmission
systems The reliability of the interconnected transmission systems in the
long term will be highly dependent upon the location of new generating
resources. Unless mechanisms are developed to encourage investment in new
transmission facilities and siting issues are addressed, few new
transmission facilities and reinforcements will be constructed. This lack of
additional transmission facilities and reinforcements will require either
that new technologies be developed to alleviate transmission congestion or
that generating facilities be located and dispatched in a manner to minimize
the use of constrained transmission corridors."(1)
At the same time, the new digital economy is faced with a need for reliable,
high-quality power. The rapid growth in the use of computers, the Internet and
telecommunications products has significantly increased the demand for highly
reliable power. The electric power grid in the United States was designed to
achieve reliability targets for delivery to traditional electric loads, such as
lights and motor-operated equipment. Sophisticated digital devices require
higher levels of reliability. In addition, brief and sustained outages exact
high costs on all types of businesses in terms of lost data, materials and
productivity. Sandia National Laboratories, a DOE national security laboratory,
estimates that power quality and reliability problems cost U.S. businesses
approximately $150 billion annually. Several businesses have sought to avoid
the costs associated with poor grid quality and reliability by placing
generation sources at or near their point of demand.
To date, power producers have been unable to offer distributed generation
solutions on a wide scale because technologies that can achieve ultra-low
emissions, such as fuel cells, remain prohibitively expensive while
cost-effective alternatives, such as gas turbines, produce unacceptable levels
of emissions that limit their use in densely populated areas requiring
distributed applications. We believe that the low-cost, ultra-low emissions
solution offered by our Xonon technology will enable the widespread use of
distributed generation.
Our Solution
How Xonon Cool Combustion Is Unique
A gas turbine operates by compressing incoming air, combining it with fuel
and combusting the mixture. The combustion process releases the fuel's energy,
forming hot gases that power the turbine. In conventional combustion systems, a
flame is used to combust the fuel. The temperature required to sustain a stable
flame is significantly higher than the temperature at which the gas turbine is
designed to operate, so most of the air is used to cool the combustion process
to the level the turbine requires. The high temperature required for a stable
flame causes the nitrogen and oxygen in the air to react, forming NOx, a major
contributor to air pollution.
- --------
(1) Reliability Assessment 2001-2010: The Reliability of Bulk Electric Systems
in North America; NERC--October 16, 2001
5
We have developed Xonon Cool Combustion, a catalytic technology that
combusts fuel flamelessly. This system provides the same amount of output
energy as flame-based combustion systems at a lower peak temperature.
Importantly, this lower temperature is below the threshold at which significant
amounts of NOx are formed. The Xonon combustion system is the only commercially
available gas turbine combustion system demonstrated to achieve ultra-low
emissions without add-on exhaust gas cleanup systems.
How Xonon Cool Combustion Is Integrated into the Gas Turbine
We collaborate with gas turbine OEMs, to adapt their combustion systems to
incorporate our Xonon technology. We believe that, together with the OEMs, we
can design the Xonon combustion system to suit essentially all sizes and types
of gas turbines in land-based applications. For each turbine model that an OEM
agrees to pursue, we design a catalytic Xonon module, the key component of the
Xonon system, to be incorporated into the design of the turbine combustors.
We then manufacture the custom-designed Xonon modules and sell the Xonon
modules to the OEM to incorporate as an integral part of its product. At
present, the Xonon modules have an expected life of 8,000 hours (equivalent to
approximately one year of continuous operation) and are designed to be replaced
during regular, scheduled maintenance over the 15- to 20-year life of the
turbine. We expect to derive revenue from the sale of both new and replacement
Xonon modules.
Key Benefits of Xonon Cool Combustion
We believe that Xonon can achieve ultra-low NOx emissions levels more
efficiently and cost-effectively than current emissions control technologies
across a broader range of gas turbine applications. As a result, we believe
Xonon will enable the power generation industry to address the significant need
for additional, high-quality power supply while simultaneously protecting the
environment and mitigating community concerns about air quality, the
environment, aesthetics and public safety. In addition, our Xonon system is
designed to operate with low carbon monoxide and volatile organic compound
emissions, which are other pollutants associated with power generation. Xonon's
role as an enabling technology is the product of several key benefits that it
offers relative to current emissions control technologies. Xonon:
. Significantly Reduces the Formation of NOx. High temperatures in
conventional gas turbine combustion systems result in the formation of
NOx. The Xonon Cool Combustion system allows combustion to occur at lower
temperatures, which significantly reduces the formation of NOx without
affecting turbine performance.
. Avoids Costly and Burdensome Exhaust Cleanup. Gas turbines using
flame-based combustion can achieve ultra-low emissions only in some
applications and only through the combination of lean pre-mix combustion
and exhaust cleanup systems. Gas turbine exhaust cleanup systems,
however, add significant capital and operating costs, reduce system
efficiency, require considerable additional space, and in many cases
require the use of hazardous and toxic reagents. Xonon enables gas
turbines in essentially all applications to achieve ultra-low emissions,
without the use of exhaust cleanup systems.
. Maintains Combustion Efficiency. Flame-based combustion and the Xonon
Cool Combustion system release the same energy from the fuel and
therefore achieve the same combustion efficiency required for optimal
operation of the turbine.
. Broadens Gas Turbine Applicability. To date, conventional exhaust
cleanup systems cannot be applied cost-effectively to all applications
and sizes of gas turbines. For example, simple cycle turbines cannot use
conventional exhaust cleanup systems except for high temperature SCRs,
which are not yet proven at ultra-low emissions levels and which are more
costly than conventional SCRs. In addition, it can be cost-prohibitive
for smaller gas turbines to use any exhaust cleanup systems. As a result,
these facilities cannot in some cases achieve ultra-low emissions. We
believe Xonon will enable almost all applications and sizes of gas
turbines to achieve ultra-low emissions, thus broadening their range of
use.
6
. Expands Gas Turbine Use in Urban Areas. Xonon-equipped turbines can be
put into service in densely populated areas where community,
environmental, health, and safety concerns may have previously prevented
gas turbines from being used.
Market for Xonon
We believe that Xonon combustion systems offer distinct advantages in all
gas turbine markets. We divide our potential market into three sectors based on
gas turbine size: small, medium and large gas turbines.
Small Gas Turbines
Market Description. The small gas turbine sector includes turbines that
generate between 1 and 15 MW of electric power. Turbines in this sector serve
industrial, commercial and institutional loads in power only and combined heat
and power, or cogeneration, applications. The desire to site generation
facilities near users for quality and reliability reasons has driven demand for
these turbines. Units sited at or near the point of use can enhance power
quality and reliability while avoiding the need to expand transmission and
distribution capacity.
We believe that the small gas turbine market sector is poised for growth.
According to Diesel & Gas Turbine Worldwide, 327 power generation gas turbines
between 1 and 15 MW were ordered during the year ended May 2001. According to
the DOE's Strategic Plan for Distributed Energy Resources, its goal for
distributed generation, which includes small gas turbines in this size range
and other technologies, is to reach 20% of the total power generation capacity
additions by 2010. Gas turbine OEMs in this sector include Alstom Power,
Kawasaki Heavy Industries, Ltd., GE's Nuovo Pignone subsidiary, Pratt & Whitney
Canada Corp., Rolls Royce Allison, and Caterpillar Inc.'s Solar Turbines unit.
Products. Due to their earlier shipping dates, we expect that Xonon modules
for small gas turbines will comprise a majority of our product revenue through
2005. We are currently engaged with OEMs in adapting Xonon for gas turbines
they manufacture in this size range.
. Kawasaki M1A-13X Turbine (1.4 MW). In May 2000, Kawasaki and Enron
Energy Services jointly agreed to furnish three Xonon-equipped 1.4 MW
Kawasaki gas turbines for a distributed power generation project at a
United States government agency healthcare facility located in
Massachusetts. Following the receipt of this order, in December 2000, we
entered into a collaborative commercialization agreement enabling
Kawasaki to market and sell a generator package comprised of a 1.4 MW
Kawasaki gas turbine outfitted with the Xonon Cool Combustion system.
Kawasaki is currently accepting commercial orders for this generator
package. We shipped our first commercial Xonon modules to Kawasaki in the
third quarter of 2001.
. GE-10 Turbine (11 MW). In May 2000, Alliance Power Inc. entered into a
preliminary agreement with GE for the purchase of up to six 11 MW GE gas
turbines equipped with the Xonon Cool Combustion system. Pre-delivery
testing of Xonon-equipped GE turbines began in the second quarter of
2001, with the shipment of two pre-commercial Xonon modules to GE.
Subject to successful completion of the development work on this Xonon
system, we expect that GE could begin accepting commercial orders for
Xonon-equipped GE turbines in the second half of 2002, for delivery
commencing in the first half of 2003.
. Taurus 60 (5 MW). In October 2001, we entered into an agreement with
Solar, a wholly owned subsidiary of Caterpillar, for the development and
adaptation of the Xonon Cool Combustion system to Solar's Taurus 60, a 5
MW turbine. The 24-month development effort commenced in the first
quarter of 2002, and will culminate in full-scale testing on a
demonstration engine at Solar's facility.
. Small, multi-can development ((less than)15 MW). In September 2001, the
California Energy Commission, or CEC, notified us that it would award us
$3.0 million to help fund application of the Xonon Cool Combustion system
to a multi-combustor gas turbine. The development effort for this program
commenced in the first quarter of 2002. We expect to partner with an OEM
in this effort, with the objective of completing an engine test under
full-scale operating conditions, followed by commercialization.
7
Medium Gas Turbines
Market Description. The medium gas turbine sector includes turbines that
generate between 15 and 60 MW of electric power. These units are generally used
for meeting power requirements during periods of peak demand and in energy
intensive industrial facilities for power generation and cogeneration.
According to Diesel & Gas Turbine Worldwide, 401 power generation gas
turbines between 15 and 60 MW were ordered during the year ended May 2001. A
February 2002 forecast by Forecast International estimates that the global
market for this class of unit will remain in excess of 400 units per year over
the next ten years. The majority of these units are expected to be used for
peaking applications, with the bulk of the remainder used for base load duty.
Alstom Power, GE and Rolls Royce Allison manufacture turbines for this market.
Products. We are in active discussions with OEMs to incorporate the Xonon
system into medium-sized gas turbines. However, we expect our revenues from
this sector to be smaller than from the small and large gas turbine sectors.
Large Gas Turbines
Market Description. The large gas turbine sector is comprised of turbines
that generate more than 60 MW of electric power. These turbines are used by
public utilities and wholesale generating companies to provide large quantities
of power to serve utility loads or for resale in wholesale markets.
In the last couple of years, the market for large gas turbines has
demonstrated very high growth, with turbine manufacturers reporting significant
sales increases and backlogs. According to Diesel & Gas Turbine Worldwide,
there were 629 global orders for gas turbines greater than 60 MW during the
year ended May 2001. While the market for large gas turbines has experienced a
recent slowdown, due largely to economic factors in the U.S. in the second half
of 2001, a February 2002 forecast by Forecast International estimates that the
global market will remain in excess of 600 units per year between 2002 and
2011, suggesting continued long-term demand. The continuation of these high
order levels is predicated on several factors including the need to replace
aging generating plants, continued growth in the U.S. economy, and the
environmental attractiveness of natural gas as a fuel when utilized to power
highly efficient and clean gas turbine combined-cycle power plants. According
to PowerData Group, Alstom Power, GE and Siemens Westinghouse together
represent nearly all of this market on a unit basis.
Products. Due to longer lead times required to apply Xonon to large gas
turbines, we expect that Xonon modules for large gas turbines will not comprise
a significant portion of our revenue until after 2005. We are working with GE
to adapt Xonon for gas turbines it manufactures in this size range.
. GE 7FA Turbine (170 MW). In November 1998, we signed a collaborative
agreement with GE to develop the Xonon Cool Combustion system components
for incorporation into GE's model 7EA and 7FA gas turbines. In December
1999, GE accepted an order from Enron specifying Xonon as the preferred
emissions control system for three GE 7FA gas turbines intended for the
Pastoria project in central California. Concurrent with this order, GE
agreed to use commercially reasonable efforts to complete development,
design and testing of the Xonon Cool Combustion system for GE 7FA
turbines. As part of this order, Enron and GE had the right to substitute
alternative emissions controls for any reason. In January 2001, we
shipped Xonon modules to GE for rig testing in support of our 7FA program
effort. Initial tests were promising and confirmed Xonon's ability to
reduce NOx to ultra low levels in a high-firing temperature environment.
Despite the positive test results, in the spring of 2001, we and GE
decided that the delivery date of January 2003 selected for these
turbines was too early to ensure that Xonon could be ready to meet the
strict commercial warranties required under this contract, and GE
exercised the option to substitute alternative emissions control
technology. Since this substitution, we have continued Xonon development
for the GE 7FA gas turbine.
8
Our Strategy
Our goal is to make Xonon an industry standard as the preferred combustion
system for all gas turbines and for similar applications. Our strategy for
achieving this goal is as follows:
. Continue to Develop Our OEM Relationships. We develop and sell Xonon
combustion modules to gas turbine OEMs. We have entered into
collaborative development and commercialization agreements with leading
turbine manufacturers for the joint design and application of Xonon Cool
Combustion technology to their turbines.
We believe offering Xonon on their gas turbines gives OEMs a competitive
advantage in new equipment sales. We also believe that Xonon module
replacement services and the availability of Xonon as an upgrade for
existing gas turbines will enhance the OEMs' service businesses. Once an
OEM adopts Xonon combustion technology on one of its gas turbines, we
will work to extend the Xonon combustion technology to other gas turbines
in its product lines. We believe our existing collaborative relationships
with OEMs place us at a considerable competitive advantage over other
potential developers of catalytic combustion and competing technologies.
. Market Currently Offered Xonon-Equipped Gas Turbines. During the early
stages of commercialization, we work with our OEM partners and actively
seek prospective users of Xonon-equipped gas turbines. We participate in
the initial stages of discussions relating to their gas turbine orders.
We also work with OEMs to identify situations where project circumstances
are well suited for early adoption of Xonon.
. Establish and Promote Xonon Brand Awareness. We believe that increased
awareness of our Xonon Cool Combustion technology and its benefits among
end-users will increase OEMs' incorporation of Xonon combustion systems
across their product lines. We actively promote awareness of Xonon
combustion systems among a broad audience through peer-reviewed technical
articles, advertisements in trade journals, presentations at trade shows
and other promotional activities. We establish brand awareness by
targeting our marketing and product development activities to demonstrate
the range of Xonon's benefits. We expect that the OEMs will market the
Xonon combustion system under our Xonon brand.
. Develop and Defend Our Intellectual Property and Broaden Our Technology
Base. Our Xonon Cool Combustion technology is a proprietary technology
protected by patents. We believe our intellectual property base and our
accumulated experience in applying catalytic combustion to operating
systems place us at a considerable advantage relative to other potential
developers of catalytic combustion and competing technologies. We intend
to continue technological development of Xonon to further extend catalyst
life, gain experience with a wider set of gas turbine operating
conditions and develop component design approaches for gas turbines under
different operating conditions and combustion configurations.
. Expand the Applications of Our Technology. We believe our technology is
applicable to other types of gas turbines, such as microturbines and
turbines incorporated in fuel cell-gas turbine hybrid power systems. We
also believe our technology can be used in combustion systems other than
gas turbines, such as diesel engines. We expect to continue research and
development in these areas where technical and commercial factors appear
encouraging.
. Participate in the Development of Regulations. Federal, state and local
air agencies are continually developing regulations and guidance
affecting the permitting and operation of gas turbines. We participate in
these development efforts by attending workshops and hearings, providing
written comments to draft documents and participating in public forums,
such as trade associations, as well as meeting with key individuals in
regulatory agencies. We do this to ensure that the agencies are aware of
Xonon's capabilities and limitations when creating regulations.
9
Recent Milestones Achieved
The following is a summary of milestones that we have recently achieved.
Date Recent Milestones
---- -----------------
Q1 2000 Announced satisfaction of all EPA guidelines for an "achieved in practice" technology
Q2 2000 Agreed to pursue an amendment to our collaborative commercialization and license agreement with
GE in order to commercialize the Xonon--equipped GE-10 gas turbine (formerly the Nuovo
Pignone PGT10 turbine)
Q2 2000 Alliance Power signed preliminary agreement with GE to order up to six Xonon-equipped GE-10 gas
turbines
Q2 2000 Enron Energy Services ordered three Xonon-equipped Kawasaki M1A-13X gas turbines
Q3 2000 Received distributed power generation research award from the DOE, which provided for additional
R&D funding
Q3 2000 Received the EPA's first Clean Air Excellence Award in the Clean Air Technology category for
impact, innovation and replicability
Q4 2000 Catalytica Energy Systems spun off as a new public entity from Catalytica, Inc.
Q4 2000 Entered into commercialization agreement with Kawasaki to supply Xonon-equipped Kawasaki
turbines to the distributed generation market
Q1 2001 Received third party confirmation of Xonon's ultra-low emissions capabilities from the EPA's
Environmental Technology Verification Program
Q2 2001 Achieved 8,000 hours of power production with a Xonon-equipped gas turbine operating at Silicon
Valley Power
Q2 2001 Awarded a research and development cost sharing contract by the DOE to fund development of fuel
reforming and fuel processing technology for use in transportation applications, which was increased
to an aggregate $11.7 million
Q3 2001 Shipped first commercial Xonon units for incorporation into Kawasaki M1A-13X
Q3 2001 Completed follow-on public offering, raising $47.6 million in net proceeds to us through sale of
4,250,000 shares
Q3 2001 Received notification of $3.0 million award from the CEC for expanded application of Xonon to a
small, multi-can gas turbine
Q4 2001 Finalized agreement with Solar Turbines to develop Xonon-Equipped Taurus 60 gas turbines
Q4 2001 Opened new facility in Arizona to house dedicated commercial manufacturing operations
Manufacturing
We currently manufacture both prototype and production Xonon modules at our
facility in Mountain View, California. We believe that, with modest capital
expenditures, we can expand our capabilities in Mountain View to supply a
sufficient number of both development and production Xonon modules to satisfy
our short-term needs. We plan to retain all proprietary manufacturing within
our facilities and outsource the manufacturing of non-critical components to
third party suppliers.
We plan to use manufacturing cells for internal production. Our
manufacturing cells consist of a sequence of manufacturing equipment arranged
in a manner to allow the simultaneous production of three different varieties
of Xonon modules on three separate coating lines. Certain equipment is common
to all coating lines, such as ovens, rollers and other support equipment. Our
cells are designed to produce all varieties of Xonon modules. Our first
manufacturing cell located at our Mountain View facility was developed in 1999
with a single coating
10
line, and has demonstrated initial production of commercial-quality modules.
Since we are able to manufacture our Xonon modules much more quickly than gas
turbines are manufactured, we anticipate that we will be able to accommodate
demand for our modules.
Based on our commercialization plan, we anticipate that our existing
facilities will provide sufficient capacity through 2002. We anticipate
achieving production efficiencies as commercial production volume increases
over the next three years. In addition, we will expand our production
capabilities at our new facility in the Phoenix metropolitan area, which is
expected to come on-line by the end of 2002. Upon initiation of production in
our new facility, our focus will be manufacturing commercial modules at our
Phoenix area facility, with the Mountain View facility serving primarily for
the manufacture of prototype and development modules, and as a back-up site for
commercial manufacturing. Over the long term, we intend to manufacture our
modules in high commercial volumes at our production facility in Arizona.
We manage our supply of critical materials through dual-sourcing
procurement, strategic inventory control and identification of substitute
materials. We purchase metal fabrication components from suppliers already
supplying similar components to the turbine OEMs. Other materials required for
Xonon module production are sourced from the specialty chemicals and specialty
metals industries. We expect these components and materials to have lead times
of under four months at full production quantities. In the case of all of our
components and materials, with the exception of one, a high temperature steel
alloy, we have identified either alternative suppliers or substitute materials.
The alloy's primary use is in the jet aircraft and turbine industries, and we
believe that at full production levels our requirements would represent less
than 5% of our supplier's present demand. We believe the continuing supply of
this material will be ensured by its demand in its primary market. We are also
evaluating substitute materials for this alloy.
We expect the Xonon modules to be returned to us at the end of their useful
life. We expect to reclaim, reuse or recycle most components of the module,
particularly the precious metals palladium and platinum, in order to reduce our
costs and protect ourselves against the volatility of precious metal prices.
In the fourth quarter of 1999, we earned ISO 9001 Registration from
Underwriters Laboratories, Inc. for the design and manufacture of Xonon
modules. The ISO series standards are internationally recognized quality
management system requirements developed by the International Organization of
Standardization, or ISO. ISO 9001 is the most comprehensive standard in the ISO
9000 series.
In addition to our manufacturing facilities, we operate facilities used for
testing and developing our technologies. We have catalyst test facilities,
including two combustion test rigs, at our site in Mountain View, California.
These facilities are capable of testing catalysts at a range of gas turbine
operating conditions representative of most gas turbines that are presently
manufactured. We have additional facilities for the testing of critical
combustor components such as preburners and mixers.
Technology
In a gas turbine system, a fuel, often natural gas but also other
hydrocarbons, is burned in a chamber with air compressed by the gas turbine's
compressor. This heat energy is then converted to mechanical energy in the
turbine section to drive an electric generator or other device.
In a conventional gas turbine combustion system, fuel is injected into a
combustion chamber that is filled with compressed air. The fuel-air mixture
burns at a high temperature. NOx is formed when the nitrogen present in the air
is exposed to very high temperatures, such as those in a flame. As a result,
NOx concentrations reach over 100 ppm in the gas turbine exhaust. Over the past
twenty years systems have been developed which reduce the temperature at which
the fuel is burned by altering the composition of the fuel; most often by using
water, steam or air to dilute the concentration of fuel in the combustor before
it is mixed with the compressed air and burned. As the fuel-air mixture becomes
leaner, the combustion temperature lowers, thus reducing the NOx
11
emissions. These systems are generically called "lean pre-mix" combustion
systems. Today most gas turbines are manufactured with a version of this type
of system that uses air to dilute the mixture and are known as "dry low NOx"
systems.
However, the combustion temperature must be sufficiently hot to prevent the
flame from flickering or being extinguished. In practice this has limited the
lean pre-mix systems to operating at NOx levels no lower than approximately 9
ppm for the very best commercial systems using air and approximately 25 ppm for
those using steam or water.
The Xonon system combusts the fuel using a different principle. Instead of
heating the fuel-air mixture in a flame until it is hot enough to burn, Xonon
passes this mixture over a chemical catalyst that causes the combustion
reaction to take place at much lower temperatures. About half the fuel is
combusted in the catalyst. The remaining fuel is combusted downstream of the
catalyst in a homogeneous reaction, also at a temperature low enough to prevent
formation of significant amounts of NOx. The resulting concentration of NOx in
the gas turbine exhaust will be in the range of 1 to 5 ppm and below 3 ppm in
most gas turbines built today.
Competition
We expect Xonon-equipped gas turbines to compete with turbines outfitted
with current emissions reduction technologies, including lean pre-mix
combustion and conventional exhaust cleanup systems. Lean pre-mix combustion
systems are manufactured and provided by gas turbine OEMs as part of their
turbine product line. These gas turbine OEMs represent the potential customer
base for our Xonon modules, and we expect to rely upon them to distribute
Xonon-equipped turbines to end-users. We expect that OEMs will continue to
develop technologies that may compete with ours.
Third parties, including Cormatech, Engelhard, EmeraChem, Mitsubishi and
Siemens, manufacture conventional exhaust cleanup systems. End-users generally
purchase these systems directly from the manufacturers, through packagers, or
from vendors of heat recovery steam generation equipment. Gas turbine OEMs do
not function as intermediaries in these transactions and do not receive any
economic value from the sale of exhaust systems.
We expect that gas turbine OEMs will choose to purchase Xonon modules and
distribute Xonon-equipped turbines despite the fact that Xonon represents a
direct competitive challenge to their existing emissions control products. We
believe this will be the case for two reasons. First, Xonon combustion systems
achieve ultra-low emissions at lower costs than competing technologies. Based
on this cost differential, turbines that incorporate Xonon Cool Combustion
technology should offer a significant competitive advantage over turbines
equipped with conventional emissions control technology. Incorporation of Xonon
Cool Combustion technology, therefore, enhances the OEM's product line and
offers the potential for the turbine OEM to gain market share from competitors
whose turbines do not incorporate Xonon Cool Combustion technology. Second,
incorporating Xonon into its turbines should allow the OEM to capture a larger
portion of the economics associated with pollution control. Currently, most
OEMs do not capture the portion of economics associated with exhaust cleanup
systems. Because Xonon replaces lean pre-mix technology and eliminates the need
for exhaust cleanup systems, its incorporation in the turbine allows OEMs to
capture a larger portion of the economic value associated with emissions
reduction.
Over time, the Xonon combustion system may also face competition from new
entrants to the market for emissions reduction. New entrants may eventually
develop competing technologies, catalytic or otherwise, that also achieve
ultra-low emissions on a cost-effective basis. For example, Precision
Combustion, Inc., or PCI, has indicated on its web site that it is working with
Siemens Westinghouse, Honeywell and Solar Turbines.
12
New Technology Development
We believe that our proprietary catalytic technology has significant market
opportunities in energy production applications outside of gas turbines. As a
result, we are pursuing new product development efforts, which leverage our
proprietary Xonon catalyst technology.
In July 2001, we were selected by the DOE for an $11.2 million cost-shared
contract to help fund the development of a compact fuel processor capable of
operating on multiple fuels for use with fuel cells in transportation
applications. In September 2001, this contract amount was increased to $11.7
million. The 48-month development effort commenced in October 2001 in
association with the National Fuel Cell Research Center, whom we have engaged
as a sub-contractor. The program will focus on delivering a compact
fuel-flexible fuel processor prototype to be used with Proton Exchange Membrane
("PEM") fuel cells in an automotive application. The availability of a
cost-effective, compact system that can convert conventional fuels, such as
gasoline, to hydrogen to power fuel cells remains one of the barriers to
widespread commercialization of fuel cell use in automobiles. We believe that
the low volume and weight enabled by our technology, combined with our
technology's high efficiencies and rapid transient response, could provide a
solution to this problem.
We are also pursuing the application of our Xonon technology for diesel
engines. In 2001, we commenced development of a prototype reductant generator
designed to enable over-the-road diesel trucks to meet the stringent 2007 EPA
emission requirements by significantly improving NOx storage and release
technology. While current NOx trap technology has been proven to reduce NOx
emissions in diesel engines, certain operating constraints persist. These
operating issues include significant performance limitations and a negative
impact on fuel economy. We believe that the use of our technology will solve
these issues by enabling enhanced regeneration of NOx traps for improved
performance and fuel efficiency. The goal of the combined system is to reduce
NOx by 90 to 95%.
In 2001, we spent $14.6 million on research and development activities of
which approximately $11.7 million was related to customer and government
sponsored programs in which we received $5.5 million of cost reimbursement.
Intellectual Property
We rely on a combination of patents, trade secrets, trademarks, copyrights
and contracts to protect our proprietary technology, including the Xonon Cool
Combustion system. Our intellectual property strategy is to identify key
intellectual property developed by us in order to protect it in a timely and
effective manner, and to use and assert such intellectual property to our
competitive advantage in the catalytic combustion business. Intellectual
property includes proprietary technology, know-how, business strategies and
market information. An objective of our intellectual property strategy is to
enable us to be first to market with proprietary technology and to sustain a
long-term technological lead in the market.
We use patents as the primary means of protecting our technological advances
and innovations. We have adopted a proactive approach to identifying patentable
inventions and securing patent protection through the timely filing and
aggressive prosecution of patent applications. Our employees participate in a
comprehensive invention disclosure program involving preparation of written
invention memoranda and preservation of supporting laboratory records. Patent
applications are filed in various jurisdictions internationally, which are
carefully chosen based on the likely value and enforceability of intellectual
property rights in those jurisdictions, and to strategically reflect our
anticipated major markets.
As of December 31, 2001, we either owned (exclusively or jointly), held
exclusive license rights from third parties for, or held license rights from
affiliates for 24 U.S. patents and 49 international registered patents.
Additional domestic and international patent applications are currently in
preparation. Among other things, our patents cover our proprietary Xonon Cool
Combustion system designs, catalyst compositions, new materials,
13
manufacturing processes, operating techniques, methods of control, combustor
components and combustor system designs.
We believe that we have developed a significant international patent
portfolio. We have filed an increasing number of patent applications each year,
and we anticipate that this trend will continue. We actively monitor the patent
position, technical developments and market activities of our competitors. We
expect that our growing patent portfolio, especially when coupled with a strong
enforcement program, will provide us with a significant advantage over our
competitors. We plan to vigorously defend our intellectual property.
Portions of our know-how are also protected as trade secrets and supported
through contractual agreements with our employees, suppliers, partners and
customers. We aggressively protect our intellectual property rights in our
collaboration agreements with a view to capturing maximum value from our
products in our markets and ensuring a competitive advantage.
Other Businesses
NovoDynamics, Inc.
In July 2000, we formed Catalytica NovoTec Inc. ("NovoTec") as a wholly
owned subsidiary. NovoTec was formed to develop improved catalytic processes
employing proprietary high speed testing and computer learning technologies. In
January 2001, all operations in NovoTec were ceased and assets contributed to
NovoTec were used to purchase equity in NovoDynamics, Inc. ("NovoDynamics"). We
currently own approximately 34.4% of NovoDynamics' outstanding equity.
Sud-Chemie Catalytica, L.L.C.
In 1998, Catalytica Advanced Technologies, which was merged into us in
December 2000, formed a joint venture with United Catalysts, Inc., a division
of Sud-Chemie Group, to form Sud-Chemie Catalytica. The joint venture was
formed to custom manufacture organometallic catalysts. Formerly named
Single-Site Catalysts, the name was changed to Sud-Chemie Catalytica in March
2000 to more closely identify the company with the parents of the joint
venture. This joint venture is currently winding down. The operating agreement
for this joint venture does not require any further capital contributions by
Catalytica Advanced Technologies or us beyond the initial $0.15 million
contribution. We do not expect to incur further losses as we do not intend to
make any additional capital contributions.
Facilities
We lease approximately 85,000 square feet in Mountain View, California
pursuant to a lease that expires in December 2003, with a five-year option for
renewal. We currently sublease approximately 20,000 square feet at this site.
In 2001, we expanded our manufacturing facilities and initiated relocation
of our headquarters to Gilbert, Arizona under a lease for approximately 43,000
square feet. In December 2001, we entered into an option agreement to purchase
this site. In March 2002, we completed the purchase of this facility.
We lease an additional 5,300 square foot facility in Scottsdale, Arizona,
which is entirely subleased. This lease expires in August 2003.
Human Resources
As of December 31, 2001, we employed 96 persons. None of our employees is
represented by a labor union. We believe our relations with our employees are
good.
14
Directors, Executive Officers and Key Employees
Our directors, executive officers and key employees are as follows:
Name Age Position with Catalytica Energy Systems
- ---- --- ---------------------------------------
Ricardo B. Levy..... 57 Chairman of the Board and Director
Craig N. Kitchen.... 51 President and Chief Executive Officer and Director
Ralph A. Dalla Betta 57 Chief Technology Officer and Vice President, Technology
Dennis S. Riebe..... 59 Chief Financial Officer
Patrick T. Conroy... 56 Senior Vice President, Product Development
William B. Ellis.... 61 Director
Frederick M. O'Such. 64 Director
John A. Urquhart.... 73 Director
Ernest Mario........ 63 Director
Howard I. Hoffen.... 38 Director
Susan F. Tierney.... 50 Director
Peter Cartwright.... 72 Director
Ricardo B. Levy, Ph.D. joined our board of directors in June 1995 as
chairman of the board. He was a founder of Catalytica, Inc., and was a director
of Catalytica, Inc. from 1974 to December 2000. He served as chief operating
officer from Catalytica, Inc.'s inception in 1974 until August 1991. He served
as president and chief executive officer of Catalytica, Inc. from August 1991
until December 2000. Before founding Catalytica, Inc., Dr. Levy was a founding
member of Exxon's chemical physics research team. Dr. Levy also serves on the
board of directors of the public companies, Pharmacopeia, Inc. and StemCells,
Inc., and is a director of a privately held company. Dr. Levy has an M.S. from
Princeton University and a Ph.D. in chemical engineering from Stanford
University. Dr. Levy is an alumnus of Princeton and Harvard University's
Executive Management Program.
Craig N. Kitchen has served as our president, chief executive officer, and
director since July 2000. Prior to that Mr. Kitchen was a corporate vice
president at Triumph Group, a manufacturer of major airframe, structural and
aircraft engine components, where he most recently directed business for the
aerospace companies. From October 1994 to July 1997, Mr. Kitchen was a partner
at Stolper-Fabralloy, a supplier of combustors for aerospace and industrial gas
turbines, and led the business development efforts for new combustors such as
GE Aircraft Engines, Rolls Royce, Allison Engine and Solar Gas Turbines. From
1982 to 1994, Mr. Kitchen served in several senior management positions and was
vice president, repairs and overhaul/business development for AlliedSignal. Mr.
Kitchen holds a B.S.M.E. from the U.S. Air Force Academy and an M.B.A. from the
University of Northern Colorado.
Ralph A. Dalla Betta, Ph.D. has served as our chief technology officer and
vice president, technology since June 1995. From 1976 until the spin-off of
Catalytica Energy Systems, Inc., Dr. Dalla Betta was employed by Catalytica,
Inc. most recently as chief scientist. Prior to joining Catalytica, Inc., Dr.
Dalla Betta was a senior scientist at the Ford Motor Company. He has authored
over 40 scientific papers, holds 12 patents and is co-author of one book. He
holds a B.S. degree from the Colorado College and a Ph.D. in physical chemistry
from Stanford University.
Dennis S. Riebe has served as our chief financial officer since September
2000. Prior to that, Mr. Riebe spent 34 years with AlliedSignal (now
Honeywell), in a variety of positions including both Finance and Operations. He
served as the CFO for an AlliedSignal Engines acquisition in Stratford,
Connecticut, and has been the Director of Cost Management and Director of
Financial Planning and Analysis for the AlliedSignal Engine business. Prior to
that he was the Corporate Controller for The Garrett Corporation, and served as
an officer and member of the Board of Directors for an international joint
venture with the Republic of China (Taiwan). Mr. Riebe is a graduate of Purdue
University and has completed graduate studies in business administration at
Arizona State University.
15
Patrick T. Conroy has served as our senior vice president, product
development since September 1998. Since October 1997, Mr. Conroy has served as
president and chief executive officer of GENXON Power Systems LLC. From 1971
until February 1997, Mr. Conroy was employed by Westinghouse Electric
Corporation in the nuclear energy and power generation businesses. Significant
positions during his tenure at Westinghouse included four years as operations
manager of the nuclear service business and six years as general manager of the
power generation service business. He was also the senior sales executive for
Westinghouse's power generation business in Europe, the Middle East and Africa
and president of a joint venture with Rolls Royce Industrial Power. Mr. Conroy
holds a B.S. in marine engineering from the US Merchant Marine Academy (Kings
Point) and has completed graduate work in business administration at Widener
University.
William B. Ellis joined our board of directors in September 1995. Mr. Ellis
is a senior fellow of the Yale University School of Forestry and Environmental
Studies. Mr. Ellis retired as chairman of Northeast Utilities in 1995, where he
also served as chief executive officer from 1983 to 1993. Mr. Ellis joined
Northeast Utilities in 1976 as its chief financial officer. Mr. Ellis was a
consultant with McKinsey & Co. from 1969 to 1976 and was a principal in that
firm from 1975 to 1976. Mr. Ellis serves on the board of directors of the
Massachusetts Mutual Life Insurance Company and on the Pew Center on Global
Climate Change. He has a Ph.D. in chemical engineering from the University of
Maryland.
Frederick M. O'Such joined our board of directors in 1995. From 1986 until
2001, Mr. O'Such served as president and chief executive officer of Xertex
Capital. From 1981 to 1986, Mr. O'Such served as chief executive officer of
Xertex Corporation. From 1970 to 1981, Mr. O'Such served as group president and
vice president, corporate development with Envirotech Corporation. He served as
group vice president with Gulton Industries, Inc. from 1963 to 1970. Mr. O'Such
is a member of several boards of directors, including Herrick-Pacific
Corporation. Mr. O'Such holds a B.S. in chemical engineering from Lehigh
University and an M.B.A. from Harvard University.
John A. Urquhart joined our board of directors in April 1997. Mr. Urquhart
serves on a number of other boards of directors, including those of the
following public companies: Hubbell Incorporated, TECO Energy, Inc., and Tampa
Electric Co. He served as a senior advisor to the chairman of Enron Corp. from
1998 until 2001, and also served as the vice chairman of Enron from 1990 to
1998. He previously served as the senior vice president/executive vice
president of industrial and power systems at General Electric. In addition, he
served five years as a committee member on the board of the United States
Council for Energy Awareness. Mr. Urquhart holds a B.S. in engineering from the
Virginia Polytechnic Institute.
Ernest Mario, Ph.D. joined our board of directors in September 2000. Dr.
Mario is currently Chairman and Chief Executive Officer of Apothogen, Inc.
Prior to joining Apothogen, Inc. in January 2002, Dr. Mario was Chairman and
Chief Executive Officer of ALZA Corp. until July 1993. From July 1993 Dr. Mario
served as deputy chairman and chief executive officer of Glaxo Holding p.l.c.,
having served in a variety of executive positions with Glaxo, Inc. beginning in
1986. From 1977 to 1984, he held various executive level positions with Squibb
Corporation, ending as president and chief executive officer of Squibb Medical
Products. Dr. Mario is a member of the board of directors of several companies,
including the following public companies: SonoSite, COR Therapeutics, Orchid
BioSciences, Inc. and Pharmaceutical Product Development Co. Dr. Mario has a
Ph.D. and an M.S. in physical sciences from the University of Rhode Island and
a B.S. in pharmacy from Rutgers University.
Howard I. Hoffen joined our board of directors in September 2000. Mr. Hoffen
is currently the Chairman and Chief Executive Officer of Morgan Stanley Private
Equity, and has been a Managing Director of Morgan Stanley & Co., Incorporated
since 1997. He joined Morgan Stanley & Co., Incorporated in 1985 and Morgan
Stanley Private Equity in 1986. Mr. Hoffen also serves on a number of boards of
directors, including the boards of the public companies, Allegiance Telecom,
Inc. and Choice One Communications, Inc., and is a director of several
privately held companies. Mr. Hoffen has a B.S. from Columbia University and an
M.B.A. from the Harvard Business School.
16
Susan F. Tierney, Ph.D. joined our board of directors in December 2000. Dr.
Tierney is currently the Senior Vice President of Lexecon Inc. Dr. Tierney is
chairman of the board of directors of The Energy Foundation and the Energy
Innovations Institute, non-profit organizations. Additionally, she is a
director of the following non-profit organizations: Electric Power Research
Institute, Clean Air-Cool Planet, and the Northeast States Clean Air
Foundation. Before joining Lexecon (and its predecessor company, the Economics
Resource Group) in November 1995, Dr. Tierney served in senior positions in
federal and state government from 1983 until 1995. Previously, she was an
assistant professor at the University of California, Irvine from 1978 until
1982. Dr. Tierney has a Ph.D. in public policy and planning, a Masters degree
in regional planning from Cornell University, and a bachelor's degree from
Scripps College.
Peter Cartwright joined our board of directors in December 2001. Mr.
Cartwright currently serves as a director as well as the President and Chief
Executive Officer of Calpine, Inc., which he founded in 1984. From 1979 to
1984, Mr. Cartwright was Vice President and General Manager of Gibbs & Hill,
Inc.'s Western Regional Office. From 1960 to 1979, Mr. Cartwright worked for
General Electric Corporation's Nuclear Energy Division. Mr. Cartwright obtained
a Master of Science Degree in Civil Engineering from Columbia University in
1953 and a Bachelor of Science Degree in Geological Engineering from Princeton
University in 1952.
Item 2. PROPERTIES
Our research and development facility is based in Mountain View, California,
occupying four buildings covering approximately 85,000 square feet. Our lease
expires on December 31, 2003, with a five-year option for renewal. We currently
sublease approximately 20,000 square feet at this site.
In 2001, we initiated relocation of our headquarters to Gilbert, Arizona and
expanded our future manufacturing facilities under a seven-year lease for
approximately 43,000 square feet. In December 2001, we entered into an option
agreement to purchase this site. In March 2002, we completed the purchase of
this facility. We believe that our existing facilities are adequate for the
Company's present needs.
We lease an additional 5,300 square foot facility in Scottsdale, Arizona,
which is entirely subleased. This lease expires in August 2003.
Item 3. LEGAL PROCEEDINGS
On August 14, 2000, the City of Glendale filed a complaint against us,
Catalytica, Inc. and GENXON Power Systems, Inc. a then 50/50 joint venture
between us and Woodward Governor Company ("WGC"), in Los Angeles County
Superior Court. The case has been transferred to the Orange County Superior
Court, Case No. 00CC13002. The first amended complaint asserts claims against
all defendants for breach of contract, breach of the covenant of good faith and
fair dealing, fraud and negligent misrepresentation arising out of defendants'
failure to complete its performance under a Technical Services Agreement
between the City of Glendale and Catalytica, Inc. providing for the retrofit of
the FT4 engine with the FT4 Xonon Combustion System. The City of Glendale seeks
compensatory damages in excess of $7,500,000 and punitive damages. On May 31,
2001, we filed an answer to the first amended complaint. We have agreed to
indemnify Catalytica, Inc. for any costs associated with this matter.
In March 2002, the parties entered into a settlement agreement with respect
to this matter. Under the terms of the settlement agreement, we will pay the
City of Glendale $3.0 million, and all parties will dismiss and release all
claims. Under the terms of an agreement with WGC, WGC is obligated to reimburse
us for $1.5 million of this amount. On March 27, 2002, we were notified by WGC
that it was disputing the amount of its reimbursement obligation to us. We
believe that we are entitled to reimbursement of the entire $1.5 million
pursuant to the terms of our agreement with WGC and intend to pursue such
reimbursement.
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of the stockholders of the Company
during the fourth quarter of the fiscal year covered by this report.
17
PART II
Item 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
Common Stock
Our common stock is listed on the Nasdaq National Market under the symbol
"CESI." The following table sets forth high and low trading prices per share
for our common stock as quoted on the Nasdaq National Market for the period
from December 18, 2000 (the effective date of our spin-off) until December 31,
2000 and for each quarter of 2001. Such prices represent interdealer prices and
do not include retail mark-ups or mark-downs or commissions and may not
represent actual transactions.
December 18, Quarter Quarter Quarter Quarter
2000 through ended ended ended ended
December 31, March 31, June 30, September 30, December 31,
2000 2001 2001 2001 2001
------------ --------- -------- ------------- ------------
Common stock price per share:
High...................... $19.500 $20.937 $24.00 $20.57 $9.15
Low....................... 12.625 12.125 14.35 5.40 4.00
As of March 20, 2002, there were approximately 661 holders of record of our
common stock, as shown on the records of our transfer agent. The number of
record holders does not include shares held in "street name" through brokers.
Dividend Policy
We have never paid cash dividends on our common stock or any other
securities. We anticipate that we will retain any future earnings for use in
the expansion and operation of our business and do not anticipate paying cash
dividends in the foreseeable future.
Use of Proceeds from Registered Securities
On August 8, 2001, we and a selling stockholder offered an aggregate
5,000,000 shares of our common stock, par value $0.001 per share, at a per
share price to the public of $12.18 in a firm commitment underwritten public
offering. Of these shares, 4,250,000 were sold by us and 750,000 were sold by
an existing stockholder. The offering was effected pursuant to a Registration
Statement on Form S-1 (Registration No.333-64682), which the Securities and
Exchange Commission declared effective on August 7, 2001. Goldman, Sachs & Co.,
Merrill Lynch & Co. and Credit Suisse First Boston were the lead underwriters
for the offering.
Of the $60.9 million in aggregate proceeds raised in connection with the
offering, $51.8 million was paid to us and $9.1 million was paid to the selling
stockholder. Of our aggregate proceeds, we paid (i) $2.7 million to
underwriters in connection with underwriting discounts, and (ii) approximately
$1.5 million in connection with offering expenses, printing fees, filing fees
and legal fees. The net offering proceeds to us after deducting the foregoing
expenses were approximately $47.6 million.
From the date of receipt through December 31, 2001, our net proceeds from
this offering were used to develop and commercialize our Xonon Cool Combustion
technology, establish our commercial manufacturing facility in the Phoenix
metropolitan area, and for general corporate purposes.
Shareholder Rights Plan
On January 29, 2002, our Board of Directors adopted a Shareholder Rights
Plan. Under this plan, we will distribute Preferred Stock Purchase Rights as a
dividend at the rate of one Right for each share of our common
18
stock held by stockholders of record as of February 20, 2002 (the "Record
Date"). The Board of Directors also authorized the issuance of Rights for each
share of common stock issued after the Record Date, until the occurrence of
certain specified events. The Shareholder Rights Plan was adopted to provide
protection to stockholders in the event of an unsolicited attempt to acquire
us. Each Right will entitle the registered holder to purchase from us one
one-thousandth of a share of Series A Preferred stock at an exercise price of
$45, subject to adjustment.
The Rights are not exercisable until triggered by certain conditions
including the acquisition of beneficial ownership of 15% of our common stock.
However, Morgan Stanley Capital Partners III, L.P. ("MSCP"), and its affiliates
may acquire up to 21.5% of our common stock without triggering the Rights. If
the Rights are triggered then each holder of a Right which has not been
exercised (other than Rights beneficially owned by the Acquiring Person) will
have the right to receive, upon exercise, voting Common Shares having a value
equal to two times the Purchase Price.
We are entitled to redeem the Rights, for $0.001 per Right, at the
discretion of our Board of Directors, until certain specified times. We may
also require the exchange of Rights, under certain additional circumstances. We
also have the ability to amend the Rights, subject to certain limitations.
19
Item 6. SELECTED FINANCIAL DATA
The following tables contain selected financial data as of and for each of
the five years ended December 31, 1997, 1998, 1999, 2000 and 2001 derived from
our financial statements. The selected financial data are qualified by
reference to, and should be read in conjunction with, our financial statements
and the notes to those financial statements and Management's Discussion and
Analysis of Financial Condition and Results of Operations. No cash dividends
were declared in any of the periods presented.
Years ended December 31,
-----------------------------------------------
1997 1998 1999 2000 2001
-------- ------- -------- -------- --------
(in thousands, except per share data)
Statement of Operations Data:
Research and development contracts....... $ 5,139 $ 6,279 $ 3,053 $ 5,487 $ 5,523
-------- ------- -------- -------- --------
Costs and expenses:
Research and development(1).............. 6,009 9,313 9,627 11,277 14,622
Selling general and administrative....... 671 1,269 3,536 5,356 7,017
Spin-off and related transaction
costs.................................. -- -- -- 5,304 --
Legal settlements........................ -- -- 1,250 -- 3,250
-------- ------- -------- -------- --------
Total costs and expenses............. 6,680 10,582 14,413 21,937 24,889
-------- ------- -------- -------- --------
Operating loss.............................. (1,541) (4,303) (11,360) (16,450) (19,366)
Loss on equity investments.................. (4,355) (3,826) (1,133) (236) (707)
Impairment charge to implied goodwill
of an equity investment................... -- -- -- -- (2,145)
Interest income............................. -- 1,409 1,041 886 2,672
Interest expense............................ (374) (177) (278) (110) (43)
-------- ------- -------- -------- --------
Net loss.................................... $ (6,270) $(6,897) $(11,730) $(15,910) $(19,589)
======== ======= ======== ======== ========
Basic and diluted net loss per share(2)..... -- -- -- $ (15.91) $ (1.33)
======== ======= ======== ======== ========
Weighted average shares used for above
calculation............................... -- -- -- 1,000 14,747
======== ======= ======== ======== ========
December 31,
-----------------------------------------------
1997 1998 1999 2000 2001
-------- ------- -------- -------- --------
Combined Balance Sheet Data:
Cash, cash equivalents and short term
investments............................ $ -- $22,847 $ 16,032 $ 58,712 $ 87,647
Total assets......................... 2,871 28,520 19,840 67,772 95,140
Total stockholders' equity
(deficit).......................... (15,198) 24,137 12,552 57,470 86,722
- --------
(1) See Note 2 to the financial statements.
(2) Since we did not have a formal capital structure until December 2000, loss
per share information prior to that date has not been presented.
20
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
This report contains forward-looking statements within the meaning of
Section 27A of the Securities Act and Section 21E of the Exchange Act, which
involve risks and uncertainties including but not limited to those statements
containing the words "believes", "anticipates", "estimates", "expects", and
words of similar import, regarding the Company's strategy, financial
performance and revenue sources. The Company's actual results could differ
materially from the results anticipated in these forward- looking statements as
a result of certain factors including those set forth under "Risks That Could
Affect Our Financial Condition and Results of Operations" and elsewhere in this
report. The Company undertakes no obligation to update publicly any forward-
looking statements to reflect new information, events or circumstances after
the date of this release or to reflect the occurrence of unanticipated events.
See "Forward-Looking Statements".
Overview
We design and develop advanced products for cleaner energy production. Our
first product, the Xonon Cool Combustion system, prevents the formation
nitrogen oxides (NOx), a significant air pollutant in stationary gas turbines
that are used primarily for electric power generation. Our Xonon system is the
only commercially available pollution prevention technology proven to achieve
ultra-low emissions during combustion.
In December 2000, we and Catalytica Advanced Technologies, Inc. ("CAT") were
combined, and all of the shares of the combined company were distributed on a
pro rata basis by Catalytica, Inc. to its stockholders.
In our early stage of development we were engaged in developing,
manufacturing and marketing technologies that use catalysts to measure the
existence of harmful pollutants. In 1995, we ceased efforts to develop
measurement products and disposed of related assets in 1996. Prior to our
combination with Catalytica Advanced Technologies, new technologies were
developed through Catalytica Advanced Technologies. In July 2000, we formed
Catalytica NovoTec Inc. ("NovoTec") to develop improved catalytic processes
employing proprietary high speed testing and computer learning technologies. In
January 2001, all operations in NovoTec were ceased.
Our costs to date, excluding costs associated with the discontinued product
line of Advanced Sensor Devices ("ASD"), an inactive subsidiary of Catalytica
Energy, have primarily consisted of expenses to support Xonon development. We
expect to increase our research and development expenses to further
commercialize Xonon. As we begin to fulfill commercial orders, we will incur
cost of goods sold expenses. Costs associated with Catalytica Advanced
Technologies to date have primarily consisted of expenses to support contracted
research.
All of our revenue has consisted of revenue from research and development
contracts funded either from gas turbine manufacturers, government sources or
research institutions, as well as contracted and collaborative research.
Reimbursement contracts provide for partial recovery of our direct and indirect
costs. The timing of these reimbursements varies from year to year, and from
contract to contract, based on the terms agreed upon by us and the funding
party.
Most of our research and development contracts are subject to periodic
review by the funding partner, which may result in modifications, termination
of funding or schedule delays. We cannot ensure that we will continue to
receive research and development funding. In return for funding development,
collaborative partners receive certain rights in the commercialization of the
resulting technology. We expect to continue to pursue funded research programs.
These may not, however, be a continual source of revenue. Due to the nature of
our operating history, period comparisons of revenues are not necessarily
meaningful and should not be relied upon as indications of future performance.
We shipped our first commercial products in July 2001. Our sales will
require royalty payments to others.
21
Results of Operations
Comparison of the years ended December 31, 1999, December 31, 2000, and
December 31, 2001.
Revenue
For the year ended
December 31, Annual % Change
-------------------- ------------------
1999 2000 2001 2000/1999 2001/2000
------ ------ ------ --------- ---------
(in thousands)
Total revenue.......................... $3,053 $5,487 $5,523 80% 0.7%
Revenue remained relatively flat for the twelve months ended December 31,
2001, compared with the twelve months ended December 31, 2000. Revenue of
funded external research related to Catalytica Advanced Technologies decreased,
as anticipated, due to the merger with us and subsequent elimination of most of
Catalytica Advanced Technologies' efforts. This decrease was entirely offset by
increased research funding of Xonon efforts through the DOE.
Revenue increased 80% for the twelve months ended December 31, 2000,
compared with the twelve months ended December 31, 1999. This increase was
principally due to securing $2.7 million of additional external development
funding for Xonon development programs in 2000. During 2000 we received $2.9
million of revenue related to GE programs. This increase was slightly offset by
a $0.3 million decrease in external funding related to Catalytica Advanced
Technologies' revenues as it decreased its emphasis on contract research and
focused its efforts on development of new business opportunities.
Costs and Expenses
For the year ended
December 31, Annual % Change
---------------------- ------------------
1999 2000 2001 2000/1999 2001/2000
------ ------- ------- --------- ---------
(in thousands)
Research and development (includes allocated
costs from Catalytica, Inc. of $2,045, $1,678,
and $0 for the years ended December 31, 1999,
2000, and 2001, respectively)................... $9,627 $11,277 $14,622 17% 30%
Selling, general and administrative (includes
allocated costs from Catalytica, Inc. of $1,052,
$875, and $0 for the years ended December 31,
1999, 2000, and 2001, respectively)............. 3,536 5,356 7,017 51% 31%
Spin-off and related transaction costs............ -- 5,304 -- -- --
Legal settlements................................. 1,250 -- 3,250 -- --
Research and Development ("R&D") R&D expense includes compensation and
benefits for engineering staff, expenses for contract engineers, materials to
build prototype units, fees paid to outside suppliers for subcontracted
components and services, supplies used and facility-related costs. We expense
all R&D costs as incurred.
For the twelve months ended December 31, 2001, R&D expenses increased $3.3
million or 30% compared to the same period of 2000. This increase includes $1.4
million related to increased R&D staffing, $0.5 million of additional material
costs incurred to accelerate the development of Xonon technology, and $0.3
million related to the production of development units. R&D expenses are
expected to grow in the future as we continue to invest in our R&D capabilities
and participate in cost reimbursable government funded programs. In 2001, we
spent $14.6 million on R&D activities of which approximately $11.7 million was
related to customer and government sponsored programs in which we received $5.5
million of cost reimbursement.
22
In December 1999, we agreed to advance cash to an affiliate of Enron
Corporation ("Enron") in order to accelerate the development of Xonon Cool
Combustion applications for gas turbines. In exchange, Enron obligated itself
to repay any advances at the end of nine months in either cash or "turbine
credits." Under the arrangement, if certain conditions were met, Enron could
gain the unilateral right to select whether it would repay our advances with
cash or settle them through turbine credits. The turbine credits entitle the
holder to a dollar-for-dollar credit on the purchase of certain turbines that
specify the use of our Xonon system. Because Enron could gain the right to use
the turbine credits to settle the advances and because we were unable to
reasonably estimate the amount we would ultimately realize if Enron used
turbine credits to settle the advances, we recorded a $1.2 million provision,
which was equal to the amount advanced by us to Enron at December 31, 1999. In
March 2000, the agreement was amended and Enron reimbursed us in cash for
approximately $1.1 million of the previous advance. Accordingly, that amount
was recorded in the first quarter of 2000 as a reduction of related R&D expense.
R&D expense increased 17% for the twelve months ended December 31, 2000,
compared with the twelve months ended December 31, 1999. Once the prototype
development program of our then 50% owned GENXON joint venture was completed in
June 1999, the engineering efforts relating to additional catalyst system
testing and development were conducted principally by us and consequently
resulted in our having increased R&D costs of approximately $2.0 million in
2000 over 1999. The increase in R&D expenditures was also attributable to an
increase of $2.0 million from Xonon development programs.
Through the end of the second quarter of 1999, a significant portion of our
research activity was conducted on behalf of GENXON (see "Loss on Equity
Investments"). As a result, some R&D costs were incurred by GENXON rather than
by us. The following amounts of R&D expenses were incurred by us (under our
contract with GENXON) and charged to GENXON: none in 2001 and 2000, and $2.0
million in 1999. Additionally, GENXON incurred other significant R&D costs
reflected in the GENXON financial statements. Once GENXON completed its final
program in June 1999, all further R&D efforts were conducted principally by us
and consequently are reflected in our R&D costs. Until December 2001, we
accounted for losses of our equity investments in GENXON under the equity
method of accounting, at which time we obtained 100% ownership in GENXON and
consolidated GENXON in our financial statements.
Selling, General and Administrative ("SG&A") expenses include compensation,
benefits and related costs in support of corporate functions, which include
management, business development, marketing, human resources, sales, finance,
and allocated facilities costs. Prior to December 15, 2000, SG&A expenses
included charges by Catalytica, Inc. for various costs paid by Catalytica, Inc.
on our behalf, including facilities, finance, legal, human resources, pension
and other expenses. Charges for those services had been allocated based upon
square footage, usage, headcount and other methods that management believes to
be reasonable.
For the twelve months ended December 31, 2001, the increase of 31% in SG&A
primarily resulted from a payment of $0.9 million of severance and loan
forgiveness to a former officer in the third quarter of 2000, offset by $0.4
million in severance costs associated with the resignation of two officers in
2001, $0.2 million associated with the discontinuation of NovoTec's operations,
$0.8 million associated with the expansion of our Arizona office, $0.4 million
of restructuring costs, and $1.7 million of increased marketing, finance and
administration costs related to the commercialization of Xonon and operations
as a new stand alone company in 2001. We expect SG&A expenses to increase in
the future as we enter later stages of commercialization of our products.
In the third quarter of 2000, we incurred $1.2 million of expenses
associated with our spin-off from Catalytica, Inc. on December 15, 2000. During
December 2000, we incurred additional spin-off related transaction costs of
$4.1 million. In the third quarter of 2001, a related credit of $0.9 million,
negotiated pursuant to an agreement with our investment bankers to provide
service for our follow-on offering, was recorded as a reduction of SG&A costs.
SG&A expenses increased 51% for the twelve months ended December 31, 2000,
compared with the twelve months ended December 31, 1999. This increase resulted
from $0.9 million in severance costs associated with
23
the resignation of our former President and Chief Executive Officer. In
addition, $0.9 million of the increase was due to increased staffing and
administration costs of which $0.3 million was related to the commercialization
of Xonon and $0.6 million was related to NovoTec, our subsidiary, which was
formed in June 2000. Additionally, we recorded $5.3 million in transaction
costs in the third and fourth quarters of 2000, related to our spin-off.
In March 2002, we entered into a settlement agreement to settle a matter
between us and the City of Glendale. Under the terms of the settlement
agreement, we will pay the City of Glendale $3.0 million, and all parties will
dismiss and release all claims. Under the terms of an agreement with Woodward
Governor Company ("WGC"), WGC is obligated to reimburse us for $1.5 million of
this amount. We have recorded a net reserve of $1.5 million as of December 31,
2001, to accrue for the settlement of this matter of which $0.25 million was
reserved in 2001 and $1.25 million was reserved in 1999. On March 27, 2002, we
were notified by WGC that it was disputing the amount of its reimbursement
obligation to us. We believe that we are entitled to reimbursement of the
entire $1.5 million pursuant to the terms of our agreement with WGC and intend
to pursue such reimbursement.
In September 2001, we signed a $3.0 million cash settlement with AGC
Manufacturing Services, Inc. and AGC Project Development, Inc. (collectively
referred to as "AGC") to be paid over a 22-month period in connection with a
demand for arbitration filed by AGC with respect to a contract dispute. We
recorded the $3.0 million settlement amount in our financial statements for the
quarter ended September 30, 2001. The first $1.5 million settlement installment
was paid to AGC during the twelve months ended December 31, 2001. The $1.5
million balance will be paid to AGC in quarterly installments through June 30,
2003.
Loss on Equity Investments
For the year ended
December 31, Annual % Change
------------------ ------------------
1999 2000 2001 2000/1999 2001/2000
------ ---- ---- --------- ---------
(in thousands)
Loss on equity investments....................... $1,133 $236 $707 (79)% 200%
NovoDynamics. In March 2001, we entered into agreements to invest $2.3
million in NovoDynamics. This amount consisted of $1.8 million in cash,
forgiveness of a $0.2 million advance made to Nonlinear Dynamics, which was to
be payable to NovoTec, and investment of $0.3 million in assets formerly used
by NovoTec. In accordance with these agreements, our full investment was
completed in April 2001. We originally purchased shares of Series A voting
preferred stock representing approximately 38.4% of Novo Dynamics' outstanding
equity. Additionally, we agreed to loan NovoDynamics up to $1.5 million if
certain milestones are met. We accounted for losses in NovoDynamics under the
equity method of accounting until the fourth quarter of 2001. Under the equity
method of accounting, we are required to record losses to the extent of our
capital contribution and debt incurred, if any. We currently own approximately
34.4% of NovoDynamics' outstanding equity.
We periodically evaluate our equity investments for impairment. On December
31, 2001, we evaluated our investment in NovoDynamics under Accounting
Principles Board Opinion No. 18, The Equity Method of Accounting for
Investments in Common Stock ("APB 18") and determined that a loss in the
carrying value of the investment had occurred which was other than temporary
based on NovoDynamics' financial history and projected future losses. At that
time, we determined that the estimated fair value of our investment in
NovoDynamics was zero. The carrying value of the investment at December 31,
2001 had been $1.6 million, and based on our evaluation of the investment, that
entire amount was charged as an impairment to implied goodwill of an equity
investment on December 31, 2001. As of December 31, 2001, as a result of the
carrying value of this investment being zero, we discontinued applying the
equity method. In 2001, prior to the suspension of the equity method treatment
of this investment, we recorded losses of $0.6 million on this investment.
In December 2001, we committed to loan $0.5 million of the above described
$1.5 million aggregate loan to NovoDynamics to be made available on January 7,
2002. As of December 31, 2001, we recorded a note payable
24
for the $0.5 million and a receivable of $0.5 million on our balance sheet.
Because repayment of the note was not certain at the time it was made, an
allowance of $0.5 million was recorded against the loan and $0.5 million was
charged as an impairment to implied goodwill of an equity investment on
December 31, 2001.
GENXON On December 19, 2001, we purchased WGC's equity interest in GENXON
for $10,000 making us the sole equity owner of GENXON, which had, up until that
date, been a 50/50 joint venture between us and WGC. At that time, GENXON
became a wholly owned subsidiary of us. We recorded our loss in our equity
interest in GENXON through December 19, 2001. Prior to this date, GENXON was a
50/50 joint venture with WGC to develop the potential market for upgrading
out-of-warranty turbines with new systems to improve emissions and operating
performance. Because the carrying value of the net investment in GENXON is zero
and we were not obligated to pay down GENXON's debts, we ceased recognizing our
pro rata share of GENXON's losses in the first half of 2000. Under the equity
method of accounting, we were required to record losses in the joint venture
because we made a capital contribution in an equal amount during this period.
We recognized 50% of the loss of the joint venture to the extent of our capital
contribution, which resulted in $0.1 million, $0.2 million, and $1.1 million of
loss in the twelve months ended December 31, 2001, 2000, and 1999,
respectively. The financial statements of us and GENXON were consolidated as of
December 31, 2001.
Sud-Chemie Catalytica, Inc. In 1998, Catalytica Advanced Technologies,
which was subquently merged into us, formed a joint venture with United
Catalysts, Inc., a division of Sud-Chemie Group, to form Sud-Chemie Catalytica.
No losses were recorded by Catalytica Advanced Technologies or us in 2001, 2000
and 1999 related to Sud-Chemie Catalytica, because we had recorded its share of
losses to the extent of our capital contribution of $0.15 million in 1998. This
joint venture is currently winding down. The operating agreement for this joint
venture does not require any further capital contributions by Catalytica
Advanced Technologies or us beyond the initial $0.15 million contribution. We
do not expect to incur further losses as we do not intend to make any
additional capital contributions.
Interest Income
For the year ended
December 31, Annual % Change
------------------ ------------------
1999 2000 2001 2000/1999 2001/2000
------ ---- ------ --------- ---------
(in thousands)
Interest income........................ $1,041 $886 $2,672 (15)% 202%
Our interest income consists of interest earned on cash, cash equivalents
and short-term investments. Interest income increased for the twelve months
ended December 31, 2001, compared with the twelve months ended December 31,
2000, due to higher average cash balances related to $50.0 million of cash
Catalytica, Inc. invested in us in December 2000, immediately before the close
of the distribution of our common stock by Catalytica, Inc. Additionally, in
August 2001, we completed a follow-on offering which generated approximately
$47.6 million of cash. All interest income is generated from money market and
short-term investments. Interest income is expected to decrease as we use cash
to fund operations and the commercialization of Xonon.
Interest income decreased for the twelve months ended December 31, 2000,
compared with the twelve months ended December 31, 1999, due to reduced average
cash balances attributable to the funding of operations.
Interest Expense
For the year ended
December 31, Annual % Change
------------------ -----------------
1999 2000 2001 2000/1999 2001/2000
---- ---- ---- --------- ---------
(in thousands)
Interest expense....................... $278 $110 $43 (60)% (61%)
25
Interest expense decreased 61% for the twelve months ended December 31, 2001
compared with the twelve months ended December 31, 2000, due to $0.1 million of
interest cost in 2000 related to a repayment of an advance by Enron, which was
partially offset by interest expense related to office equipment leases.
Interest expense is expected to be minimal for the next few years.
Interest expense decreased 60% for the twelve months ended December 31,
2000, compared with the twelve months ended December 31, 1999, due to
Catalytica, Inc. discontinuing charging Catalytica Advanced Technologies
interest related to intercompany debt owed to Catalytica, Inc. Catalytica
Energy incurred a $0.1 million interest cost in the first quarter of 2000
related to the recovery of $1.1 million of the $1.2 million advance paid by us
to Enron and incurred to develop Xonon technology.
Income Taxes
No benefit from income taxes is recorded in 2001 due to our inability to
recognize the benefit from our losses. No benefit for federal and state income
tax is reported in 1999 and 2000 because of our Tax Sharing Agreement with
Catalytica, Inc. In accordance with this agreement, we are not reimbursed for
the tax benefit of our past losses and any net operating losses generated by us
prior to our separation with Catalytica, Inc. in December 2000.
Restructuring and Related Activities
In the fourth quarter of 2001, our management approved a restructuring plan
to move the Company's finance department to Gilbert, Arizona and to realign two
additional functions within its corporate structure. Accordingly, we plan to
eliminate 7 employee positions in connection with this plan. Restructuring and
related charges of $0.36 million were expensed during the fourth quarter of
2001. As of December 31, 2001, we had not yet completed any of the planned
employee separations under the 2001 restructuring plan. We expect to
substantially complete the initiatives contemplated under the restructuring
plan by July 1, 2002. Components of accrued restructuring costs and amounts
charged against the accrual as of December 31, 2001 were as follows:
Beginning Adjustments and December 31,
accrual expenditures 2001
--------- --------------- ------------
(in thousands)
Employee separation costs............... $359 -- $359
Critical Accounting Policies and Estimates
Our discussion and analysis of the financial condition and results of
operations are based upon our financial statements, which have been prepared in
accordance with accounting principles generally accepted in the United States.
The preparation of these financial statements requires us to make estimates and
judgments that affect the reported amounts of assets, liabilities, revenues and
expenses, and related disclosure of contingent liabilities. On an on-going
basis, we evaluate our estimates and judgments, including those related to
contract terms, equity investments, bad debts, inventories, investments,
intangible assets, income taxes, financing operations, restructuring,
contingencies and litigation. We base our estimates and judgments on historical
experience and on various other factors 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 financial
statements. We recognize revenue from our funded research and development
contracts as work is performed and billable hours are incurred by us, in
accordance with each contract. Since these programs are subject to government
audits, we maintain a revenue cost reserve for our government-funded programs
in the event any of these funded costs, including overhead, are disallowed. We
maintain an allowance for doubtful accounts for estimated losses resulting from
the inability of our customers to
26
make required payments. If the financial condition of any of our customers were
to deteriorate, resulting in an impairment of their ability to make payments,
additional allowances may be required. We maintain a reserve for employee and
related party notes in the event repayment of a note is uncertain. We
frequently review the repayment ability of employees and related parties. If
the financial condition of any employee or related party were to deteriorate,
resulting in an impairment of their ability to make payments, additional
allowances or write- offs would be required. We write down our inventory based
on market prices of precious metals equal to the difference between the cost of
inventory and their estimated realizable value. If actual market conditions
become less favorable, additional inventory write-downs may be required. We
currently hold equity interests in NovoDynamics and Sud-Chemie Catalytica. We
record an investment impairment charge against the carrying value of these
investment when we believe the investment has experienced a decline in value
that is other than temporary based on adverse changes in market conditions or
poor operating results of the underlying investment which could result in
losses or an inability to recover the carrying value of the investment that may
not be reflected in the investment's current carrying value. We record a
valuation allowance to reduce our deferred tax assets to the amount that is
more likely than not to be realized. We record a reserve for contingencies
including litigation settlements when a liability becomes probable.
Related Party Transactions
NovoDynamics, Inc. In March 2001, we entered into agreements to invest $2.3
million in NovoDynamics. This amount consisted of $1.8 million in cash,
forgiveness of a $0.2 million advance made to NonLinear Dynamics, which was to
be payable to NovoTec, a subsidiary of us, and investment of $0.3 million in
assets formerly used by NovoTec. In accordance with these agreements, this full
investment was completed in April 2001. In 2001, we owned shares of Series A
voting preferred stock representing approximately 38.4% of NovoDynamics'
outstanding equity. Subsequent to December 31, 2001, we owned approximately
34.4% of NovoDynamics' outstanding equity as a result of NovoDynamics issuing
an additional approximately $0.7 million of Series B preferred stock. We
recorded our investment at cost and recorded its share of pro rata losses under
the equity method in the period from March 2001 through December 31, 2001. The
investment was accounted for as implied goodwill.
Additionally, in March 2001, we agreed to loan NovoDynamics up to $1.5
million if certain milestones were met. On December 31, 2001, we committed to
loan $0.5 million of the $1.5 million to NovoDynamics on January 7, 2002. As of
December 31, 2001, we recorded a note payable for the $0.5 million and a
receivable of $0.5 million on its balance sheet. Because repayment of the note
was not certain at the time it was made, an allowance of $0.5 million was
recorded against the loan and this amount was charged as impairment to implied
goodwill of an equity investment on December 31, 2001.
We periodically evaluate our equity investments. On December 31, 2001, we
evaluated our investment in NovoDynamics under Accounting Principles Board
Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock
("APB 18") and determined that an impairment in the carrying value of the
investment had occurred which was other than temporary. At that time, we
determined that the estimated fair value of our investment in NovoDynamics was
zero. The carrying value of the investment at December 31, 2001 had been $1.6
million, and the entire amount was charged as impairment to implied goodwill in
non-operating expenses on December 31, 2001. At that time, we discontinued
applying the equity method because our net investment was zero.
As of December 31, 2001, two of our directors held a direct investment in
NovoDynamics Series B voting preferred stock, which represented slightly less
than 1% of NovoDynamics' outstanding stock.
Catalytica, Inc. Prior to the spin-off, the financial statements include
allocations from Catalytica, Inc. for the cost of functions and services
provided by them to us. These allocations include charges for facilities,
finance, legal, human resources, and other employee benefit costs and totaled
$3.1 million, $2.6 million, and none respectively, for the years ended December
31, 1999, 2000, and 2001. Charges for these services have been allocated based
upon square footage, usage, headcount and other methods that management
believes to be reasonable.
27
Prior to Enron Ventures Corporation's investment, we used borrowings from
Catalytica, Inc. to fund our operations. In January 1998, when Enron invested
in us, all of our intercompany debt was forgiven and we incurred no further
intercompany debt. CAT continued to borrow from Catalytica, Inc. and incurred
interest expense on these borrowings through December 31, 1999. Catalytica,
Inc. charged interest at a rate of 7%. Related interest charged was $0.3
million for the year ended December 31, 1999, and none for the years ended
December 31, 2000 and 2001.
In December 2000, in accordance with the merger agreement between DSM and
Catalytica, Inc., $7.3 million of intercompany debt owed to Catalytica, Inc. by
CAT was forgiven.
Investment By Enron On January 14, 1998, Enron, purchased a 15% minority
interest in us for $30.0 million in cash. Enron also received a three-year
option to purchase an additional 535,715 shares of us for $14.4 million in
cash. This option expired unexercised on January 14, 2001. In connection with
the Enron Stock Purchase Agreement, we entered into a Share Exchange Agreement,
providing Enron the right to exchange the Series B Preferred Stock of us for
Catalytica, Inc. common stock. After the five year anniversary of the
agreement, if we had not undertaken a public offering, in which we received at
least $20.0 million, Enron had the right to require Catalytica, Inc. to
exchange all of the outstanding shares of Series B Preferred Stock for that
number of shares of Catalytica, Inc. common stock based upon a determined
exchange rate. The exchange rate was based upon the fair value of the Series B
Preferred Stock and the market value of Catalytica, Inc.'s common stock at the
time of conversion. In conjunction with the Enron Stock Purchase Agreement,
$16.2 million of indebtedness owed to Catalytica, Inc. by us was contributed to
our capital. In December 2000, Enron converted all of its Series B Preferred
Stock and received 1,342,889 shares of our common stock. In November 2001,
Enron sold all of its shares of our common stock to a third party and did not
assign any of its rights under the Share Exchange Agreement.
Transaction With An Affiliate of Enron In December 1999, an affiliate of
Enron ("the Affiliate"), the holder of a minority interest in us, specified our
Xonon combustion system as the preferred emissions control system for certain
turbine orders from GE Power Systems ("GE"). In connection therewith, we and
this Affiliate of Enron signed an agreement, which provided, among other
things, that we agreed to advance the Affiliate up to $9.9 million to
accelerate the development of the Xonon-equipped GE gas turbines, and the
Affiliate had the right to elect to repay the advances to us in cash or turbine
credits. Turbine credits entitle the holder to a dollar-for-dollar credit on
the purchase of certain turbines (in the case of these specific credits, those
that specify the use of our Xonon process). Repayment in cash or other
consideration was required by September 30, 2000. We advanced the Enron
affiliate $1.2 million at December 31, 1999 under this arrangement. Since the
Enron affiliate had the option of repaying the advance in cash or turbine
credits and the fair market value of the latter was not reasonably estimatable
and because: (1) we are not in the business of buying turbines, (2) we are not
in the business of exchanging turbine credits with those that buy turbines, and
(3) in our particular case, the turbine credits we would receive specified they
could only be used on purchases of turbines that specify the use of our Xonon
process, and Xonon is a relatively new technology, and there can be no
assurance that it will be specified by sufficient buyers of turbines to create
a market for these turbine credits, we, therefore, recorded a provision equal
to the advance as research and development expense. In February 2000, we
advanced the Enron affiliate an additional $1.8 million. In March 2000, the
arrangement between us and the Affiliate was amended and all previous advances
through that date of $2.9 million from us were refunded, less certain costs,
and the related provision was eliminated and reduced research and development
expense in this period.
Transactions With Officers In July 2000, our President and Chief Executive
Officer resigned. His separation agreement provided for severance of
approximately $18,000 a month for twelve months and a payment of $18,900. We
recorded a charge in the third quarter of 2000 for $234,900 related to the
officer's severance. If he remained unemployed after the twelve months,
payments of $18,000 would continue for an additional six months or until he was
employed, whichever came first. These payments were expensed when they became
probable, through November 2001 when the arrangement ended. In addition,
previous loans and accrued interest of $620,000 were forgiven and we recorded a
charge in the third quarter of 2000 for this amount.
28
Additionally, vesting of his options to purchase common stock was accelerated.
We recorded compensation