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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
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ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2003.
OR
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934 FOR THE TRANSITION PERIOD FROM ______ TO ______.
Commission File Number: 0-23336
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AROTECH CORPORATION
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(Exact name of registrant as specified in its charter)
Delaware 95-4302784
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(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
632 Broadway, New York, New York 10012
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(Address of principal executive offices) (Zip Code)
(646) 654-2107
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(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
Title of each class Name of each exchange on which registered
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None Not applicable
Securities registered pursuant to Section 12(g) of the Act: Common Stock, $0.01
par value
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days: Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K (ss. 229.405 of this chapter) 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. [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes [ ] No [X]
The aggregate market value of the registrant's voting stock held by
non-affiliates of the registrant as of June 30, 2003 was approximately
$31,017,725 (based on the last sale price of such stock on such date as reported
by The Nasdaq National Market).
(Applicable only to corporate registrants) Indicate the number of shares
outstanding of each of the registrant's classes of common stock, as of the
latest practicable date: 62,312,796 as of 3/23/04
Documents incorporated by reference: None
PRELIMINARY NOTE
This annual report contains historical information and forward-looking
statements within the meaning of the Private Securities Litigation Reform Act of
1995 with respect to our business, financial condition and results of
operations. The words "estimate," "project," "intend," "expect" and similar
expressions are intended to identify forward-looking statements. These
forward-looking statements are subject to risks and uncertainties that could
cause actual results to differ materially from those contemplated in such
forward-looking statements. Further, we operate in an industry sector where
securities values may be volatile and may be influenced by economic and other
factors beyond our control. In the context of the forward-looking information
provided in this annual report and in other reports, please refer to the
discussions of risk factors detailed in, as well as the other information
contained in, our other filings with the Securities and Exchange Commission.
Electric Fuel(R) is a registered trademark and Arotech(TM) is a
trademark of Arotech Corporation, formerly known as Electric Fuel Corporation.
All company and product names mentioned may be trademarks or registered
trademarks of their respective holders. Unless otherwise indicated, "we," "us,"
"our" and similar terms refer to Arotech and its subsidiaries.
PART I
ITEM 1. BUSINESS
General
We are a defense and security products and services company, engaged in
three business areas: interactive simulation for military, law enforcement and
commercial markets; batteries and charging systems for the military; and
high-level armoring for military, paramilitary and commercial vehicles. Until
September 17, 2003, we were known as Electric Fuel Corporation. We operate
primarily as a holding company, through our various subsidiaries, which are
organized into three divisions. Our divisions and subsidiaries are as follows:
>> We develop, manufacture and market advanced hi-tech multimedia
and interactive digital solutions for use-of-force and driving
training of military, law enforcement and security personnel,
as well as offering security consulting and other services
(our Simulation, Training and Consulting Division), consisting
of:
o IES Interactive Training, Inc., located in Littleton,
Colorado, which provides specialized "use of force"
training for police, security personnel and the
military ("IES");
o FAAC Incorporated, located in Ann Arbor, Michigan,
which provides simulators, systems engineering and
software products to the United States military,
government and private industry ("FAAC"); and
o Arocon Security Corporation, located in New York, New
York, which provides security consulting and other
services, focusing on protecting life, assets and
operations with minimum hindrance to personal freedom
and daily activities ("Arocon").
>> We manufacture and sell Zinc-Air and lithium batteries for
defense and security products and other military applications
and we pioneer advancements in Zinc-Air technology for
electric vehicles (our Battery and Power Systems Division),
consisting of:
o Electric Fuel Battery Corporation, located in Auburn,
Alabama, which manufactures and sells Zinc-Air fuel
cells, batteries and chargers for the military,
focusing on applications that demand high energy and
light weight ("EFB");
o Epsilor Electronic Industries, Ltd., located in
Dimona, Israel (in Israel's Negev desert area), which
develops and sells rechargeable and primary lithium
batteries and smart chargers to the military and to
private industry in the Middle East, Europe and Asia
("Epsilor"); and
o Electric Fuel (E.F.L.) Ltd., located in Beit Shemesh,
Israel, which produces water-activated lifejacket
lights for commercial aviation and marine
applications, and which conducts our Electric Vehicle
effort, focusing on obtaining and implementing
demonstration projects in the U.S. and Europe, and on
building broad industry partnerships that can lead to
eventual commercialization of our Zinc-Air energy
system for electric vehicles ("EFL").
>> We utilize sophisticated lightweight materials and advanced
engineering processes to armor vehicles (our Armored Vehicle
Division), consisting of:
o MDT Protective Industries, Ltd., located in Lod,
Israel, which specialize in using state-of-the-art
lightweight ceramic materials, special ballistic
glass and advanced engineering processes to fully
armor vans and cars, and is a leading supplier to the
Israeli military, Israeli special forces and special
services ("MDT"), of which we own 75.5%; and
o MDT Armor Corporation, located in Auburn, Alabama,
which conducts MDT's United States activities ("MDT
Armor"), of which we own 88%.
We acquired FAAC and Epsilor in early 2004. Prior to the acquisition of
FAAC and Epsilor, we were organized into two divisions: Defense and Security
Products (consisting of IES, MDT, MDT Armor and Arocon), and Electric Fuel
Batteries (consisting of EFL and EFB). We have reported our results of
operations for 2003 and 2002 in accordance with these earlier divisions, and our
financial results for 2003 and 2002 do not include the activities of FAAC or
Epsilor.
Background
We began work in 1990 on the research, development and
commercialization of an advanced Zinc-Air battery system for powering electric
vehicles, work that continues to this day, under the name "Electric Fuel
Corporation"; we changed our name to Arotech Corporation in September 2003.
Beginning in 1998, we also began to apply our Zinc-Air fuel cell technology to
the defense industry, by receiving and performing a series of contracts from the
U.S. Army's Communications-Electronics Command (CECOM) to develop and evaluate
advanced primary Zinc-Air fuel cell packs. This effort culminated in 2002 in our
receipt of a National Stock Number, a Department of Defense catalog number
assigned to products authorized for use by the U.S. military, and our subsequent
receipt in 2002 and 2003 of a total of $9.3 million in delivery orders for our
newly designated BA-8180/U military batteries.
We further enhanced our capabilities in the defense industry through
our purchase in the third quarter of 2002 of IES and MDT. In the first quarter
of 2004, we added two new subsidiaries, with their business lines, to our
company: FAAC and Epsilor.
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Between 1998 and 2002, we were also engaged in the design, development
and commercialization of our proprietary Zinc-Air fuel cell technology for
portable consumer electronic devices such as cellular telephones, PDAs, digital
cameras and camcorders. In October 2002, we discontinued retail sales of our
consumer battery products because of the high costs associated with consumer
marketing and low volume manufacturing.
We were incorporated in Delaware in 1990 under the name "Electric Fuel
Corporation," and we changed our name to "Arotech Corporation" on September 17,
2003. Unless the context requires otherwise, all references to us refer
collectively to Arotech Corporation and Arotech's wholly-owned Israeli
subsidiaries, EFL and Epsilor; its majority-owned Israeli subsidiaries, MDT and
MDT Armor; and its wholly-owned United States subsidiaries, EFB, IES, Arocon and
FAAC.
For financial information concerning the business segments in which we
operate, see Note 15 of the Notes to the Consolidated Financial Statements. For
financial information about geographic areas in which we engage in business, see
Note 15.c of the Notes to the Consolidated Financial Statements.
Simulation, Training and Consulting Division
USE-OF-FORCE TRAINING
Through our wholly-owned subsidiary, IES Interactive Training, Inc., we
provide specialized "use of force" training for police, security personnel and
the military. We offer products and services that allow organizations to train
their personnel in safe, productive, and realistic environments. We believe that
our training systems offer more functionality, greater flexibility,
unprecedented realism and a wider variety of user interface options than
competing products. Our systems are sold to corporations, government agencies,
military and law enforcement professionals around the world. The simulators are
currently used by some of the worlds leading training academies and law
enforcement agencies, including (in the United States) the FBI, the Secret
Service, the Bureau of Alcohol, Tobacco and Firearms, the Customs Service, the
Federal Protective Service, the Border Patrol, the Bureau of Engraving and
Printing, the Coast Guard, the Federal Law Enforcement Training Centers, the
Department of Health and Human Services, the California Department of
Corrections, NASA, police departments in Texas (Houston), Michigan (Detroit),
D.C., California (Fresno and the California Highway Patrol), Massachusetts
(Brookline), Virginia (Newport News and the State Police Academy), Arizona
(Maricopa County), universities and nuclear power plants, as well as
international users such as the Israeli Defense Forces, the German National
Police, the Royal Thailand Army, the Hong Kong Police, the Russian Security
Police, and over 500 other training departments worldwide.
Our interactive training systems vary from the powerful Range 3000
use-of-force simulator system to the multi-faceted A2Z Classroom Training
system. The Range 3000 line of simulators addresses the entire use of force
training continuum in law enforcement, allowing the trainee to use posture,
verbalization, soft hand skills, impact weapons, chemical spray, low-light
electronic weapons and lethal force in a scenario based classroom environment.
The A2Z Classroom Trainer provides the trainer with real time electronic
feedback from every student through wireless handheld keypads. The combination
of interactivity and instant response assures that learning takes place in less
time with higher retention.
VEHICLE SIMULATORS
Through our wholly-owned subsidiary, FAAC Corporation, we provide
simulators, systems engineering and software products to the United States
military, government and private industry. FAAC's fully interactive
driver-training systems feature state-of-the-art vehicle simulator technology
enabling training in situation awareness, risk analysis and decision making,
emergency reaction and avoidance procedures, and conscientious equipment
operation. FAAC has an installed base of 179 simulators that have successfully
trained over 80,000 drivers. FAAC's customer base includes all branches of the
Department of Defense, state and local governments, and commercial entities.
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We believe that FAAC is the premier developer of validated, high
fidelity analytical models and simulations of tactical air and land warfare for
all branches of the Department of Defense and its related industrial
contractors. Simulations developed by FAAC are found in systems ranging from
instrumented air combat and maneuver ranges (such as Top Gun) to full task
training devices such as the F-18 Weapon Tactics Trainer.
FAAC supplies on-board software to support weapon launch decisions for
the F-15, F-18, and Joint Strike Fighter fighter aircraft. Pilots benefit by
having highly accurate presentations of their weapon's capabilities, including
susceptibility to target defensive reactions. FAAC designed and developed an
Instructor operator station, mission operator station and real-time, database
driven electronic combat environment for the special operational forces aircrew
training system. The special operational forces aircrew training system provides
a full range of aircrew training, including initial qualification, mission
qualification, continuation, and upgrade training, as well as combat mission
rehearsal.
SECURITY CONSULTING
Arocon Security Corporation focuses on protecting life, assets and
operations with minimum hindrance to personal freedom and daily activities.
Arocon Security, which provides security consulting and other services, has
signed an agreement with Rafael Armament Development Authority Ltd., Israel's
leading defense research and development company, to market and implement
certain of Rafael's security products and technology in the United States.
Battery and Power Systems Division
ZINC-AIR FUEL CELLS, BATTERIES AND CHARGERS FOR THE MILITARY
We have been engaged in research and development in the field of
Zinc-Air electrochemistry and battery design for over ten years, as a result of
which we have developed our current Zinc-Air technology and its applications. We
have successfully applied our technology to our high-energy battery packs for
military and security applications. We have also applied our technology to the
development of a refuelable Zinc-Air fuel cell for powering zero-emission
electric vehicles. Through these efforts, we have sought to position ourselves
as a world leader in the application of Zinc-Air technology to innovative
primary and refuelable power sources.
Our primary existing battery product for the military and defense
sectors is a 12/24 volt, 800 watt-hour battery pack for battlefield power, which
is based on our Zinc-Air fuel cell technology, weighs only six pounds and has
approximately twice the energy capacity per pound of the U.S. Army's standard
lithium-sulfur dioxide battery packs - the BA-8180/U battery, which offer
extended-use portable power using our commercial Zinc-Air cell technology. Our
BA-8180/U battery has received a National Stock Number (a Department of Defense
catalog number assigned to products authorized for use by the U.S. military),
making our batteries available for purchase by all units of the U.S. Armed
Forces.
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We believe that our Zinc-Air batteries provide the highest energy and
power density combination available today in the defense market, making them
particularly appropriate where long missions are required and low weight is
important.
LITHIUM BATTERIES AND CHARGING SYSTEMS FOR THE MILITARY
Recent developments and improvements in lithium rechargeable batteries
have caused the US military, as well as armies worldwide, to shift many
battery-operated devices to cost-effective rechargeable batteries.
Non-rechargeable batteries continue to be the leading source of energy in war
and during limited conflicts. For more than ten years, our wholly-owned
subsidiary Epsilor Electronic Industries, Ltd. has developed and sold
rechargeable and primary lithium batteries and smart chargers to the military,
and to private industry in the Middle East, Europe and Asia.
ELECTRIC VEHICLE
Our electric vehicle effort, conducted through our subsidiary Electric
Fuel Battery Corporation, continues to focus on finding a strategic partner that
can lead the way to eventual commercialization of the Zinc-Air energy system.
Our all-electric bus, powered by our Zinc-Air fuel cell technology, has
demonstrated a world-record 127-mile range under rigorous urban conditions.
LIFEJACKET LIGHTS
We produce water-activated lifejacket lights for commercial aviation
and marine applications based on our patented water-activated magnesium-cuprous
chloride battery technology. We intend to continue to work with original
equipment manufacturers (OEMs), distributors and end-user companies to expand
our market share in the aviation and marine segments. We presently sell five
products in the safety products group, three for use with marine life jackets
and two for use with aviation life vests. All five products are certified under
applicable international marine and aviation safety regulations.
Armored Vehicle Division
Through our majority-owned MDT Protective Industries Ltd. and MDT Armor
Corporation subsidiaries, we specialize in using state-of-the-art lightweight
ceramic materials, special ballistic glass and advanced engineering processes to
fully armor vans and cars. MDT is a leading supplier to the Israeli military,
Israeli special forces and special services. MDT's products are proven in
intensive battlefield situations and under actual terrorist attack conditions,
and are designed to meet the demanding requirements of governmental and private
sector customers worldwide.
Facilities
Our principal executive offices are located at 632 Broadway, New York,
New York 10012, and our telephone number at our executive offices is (646)
654-2107. Beginning April 15, 2004, we will move to new headquarters located at
250 West 57th Street, Suite 310, New York, New York 10107, and our new telephone
number will be (212) 258-3222. Our corporate website is www.arotech.com. Our
periodic reports to the Securities Exchange Commission, as well as recent
filings relating to transactions in our securities by our executive officers and
directors, that have been filed with the Securities and Exchange Commission in
EDGAR format are made available through hyperlinks located on the investor
relations page of our website, at http://www.arotech.com/compro/investor.html,
as soon as reasonably practicable after such material is electronically filed
with or furnished to the SEC. Reference to our websites does not constitute
incorporation of any of the information thereon or linked thereto into this
annual report.
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The offices and facilities of our three of our principal subsidiaries,
EFL, MDT and Epsilor, are located in Israel (in Beit Shemesh, Lod and Dimona,
respectively, all of which are within Israel's pre-1967 borders). Most of our
senior management is located at EFL's facilities. IES's offices and facilities
are located in Littleton, Colorado, FAAC's offices and facilities are located in
Ann Arbor, Michigan, and the offices and facilities of EFB and MDT Armor are
located in Auburn, Alabama.
Simulation, Training and Consulting Division
Use-of-Force Training
We conduct our interactive training activities through our subsidiary
IES Interactive Training, Inc. ("IES"), a Delaware corporation based in
Littleton, Colorado. IES is a leading provider of interactive, multimedia, fully
digital training simulators for law enforcement, security, military and similar
applications. With a customer base of over 500 customers in over twenty
countries around the world, IES is a leader in the supply of simulation training
products to military, law enforcement and corporate client communities. We
believe, based on our general knowledge of the size of the interactive
use-of-force market, our specific knowledge of the extent of our sales, and
discussions we have held with customers at trade shows, etc., that IES provides
more than 35% of the worldwide market for government and military judgment
training simulators.
INTRODUCTION
IES offers consumers the following interactive training products and
services:
>> Range 3000 - providing use of force simulation for military
and law enforcement. We believe that the Range 3000 is the
most technologically advanced judgment training simulator in
the world.
>> A2Z Classroom Trainer - a state-of-the-art computer based
training (CBT) system that allows students to interact with
realistic interactive scenarios projected life-size in the
classroom.
>> Range FDU (Firearms Diagnostic Unit) - a unique combination of
training and interactive technologies that give instructors a
first-person perspective of what trainees are seeing and doing
when firing a weapon.
>> Summit Training International - providing relevant,
cost-effective professional training services and interactive
courseware for law enforcement, corrections and corporate
clients.
>> IES Studio Productions - providing cutting edge multimedia
video services for law enforcement, military and security
agencies, utilizing the newest equipment to create the
training services required by the most demanding authorities.
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Our products feature state of the art all digital video formats,
ultra-advanced laser-based lane detection for optimal accuracy and performance,
customer-based authoring of training scenarios, and 95% COTS (commercial
off-the-shelf)-based system.
IES's revenues during 2001, 2002 and 2003 were approximately $3.5
million, $5.1 million and $8.0 million, respectively.
PRODUCTS
Below is a description of each of the core products and services in the
IES line.
Range 3000 "Use of Force" Simulator
We believe that the Range 3000, which IES launched in late 2002,
combines the most powerful operational hardware and software available, and
delivers performance unobtainable by any competing product presently on the
market.
The Range 3000 simulator allows training with respect to the full "Use
of Force" continuum. Training can be done on an individual basis, or as many as
four members of a team can participate simultaneously and be scored and recorded
individually. Topics of training include (but are not limited to):
>> Officer's Presence and Demeanor - Picture-on-picture digital
recordings of the trainee's actions allows visual review of
the trainee's reaction, body language and weapons handling
during the course of the scenario, which then can be played
back for debriefing of the trainee's actions.
>> Verbalization - Correct phrases, timing, manner and sequence
of an officer's dialogue is integrated within the platform of
the system, allowing the situation to escalate or de-escalate
through the officer's own words in the context of the scenario
and in conjunction with the trainer.
>> Less-Than-Lethal Training - Training in the use of non-lethal
devices such as Taser, OC (pepper spray), batons and other
devices can be used with the video training scenarios with
appropriate reactions of each.
>> Soft Hand Tactics - Low level physical control tactics with
the use of additional equipment such as take-down dummies can
be used.
>> Firearms Training and Basic Marksmanship - Either utilizing
laser based training weapons or in conjunction with a
live-fire screen, the use of "Live Ammunition" training can be
employed on the system.
The interactive training scenarios are projected either through single
or multiple screens and projectors, allowing IES to immerse a trainee in
true-to-life training scenarios and incorporating one or all the above training
issues in the "Use of Force" continuum.
A2Z Classroom Trainer
The A2Z is a state-of-the-art Computer Based Training (CBT) system that
allows students to interact with realistic interactive scenarios projected
life-size in the classroom.
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Using individual hand-held keypads, the students can answer true/false
or multiple choice questions. Based on the student's performance, the scenario
will branch and unfold to a virtually unlimited variety of different possible
outcomes of the student's actions. The system logs and automatically scores each
and every trainee's response and answer. At the end of the scenario, the system
displays a session results summary from which the trainer can debrief the class.
The advanced A2Z Courseware Authoring Tools allow the trainer easily to
create complete customized interactive courses and scenarios.
The Authoring Tools harness advances in digital video and multimedia,
allowing the trainer to capture video and graphics from any source. The A2Z
allows the trainer to combine his or her insight, experience and skills to
recreate a realistic learning environment. The A2Z Training System is based on
the well-known PC-Pentium technology and Windows XPTM operated. The menu and
mouse operation make the A2Z user-friendly.
The individual keypads are connected "wirelessly." The system is
completely portable and may be setup within a matter of minutes.
Key advantages:
>> Provides repeatable training to a standard based on
established policy
>> Quick dissemination and reinforcement of correct behavior and
policies
>> Helps reduces liability
>> More efficient than "traditional and redundant" role-playing
methods
>> Realistic scenarios instead of outdated "play-acting"
>> Interactive training of up to 250 students simultaneously with
wireless keypads
>> Easy Self-Authoring of interactive training content
>> PC-Pentium platform facilitates low cost of ownership
>> Easy to use Windows XP-based software
>> Easy to deploy in any classroom
Range FDU
The Range FDU (firearm diagnostics unit) is a unique combination of
training and interactive technologies that give instructors a first-person
perspective of what trainees are seeing and doing when firing a weapon. The
Range FDU is the only firearms training technology of its kind.
With the Range FDU, firearms instructors can see the trainees' actual
sight alignment to the target as well as measure trigger pressure against proper
trigger pressure graphs, making corrective instruction simple and effective. In
addition, the Range FDU records a trainee's recoil control, grip and stance -
allowing the instructor to playback the information in slow motion or real time
to better analyze the trainee's actions and more accurately diagnose any
deficiencies.
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The Range FDU also has the ability to record the firearm instruction
session to either DVD or VHS, allowing both the trainee and the instructor to
review it at a later time. Trainees now have a diagnostic tool that they can
learn from, even after their training has been completed. In addition,
instructors can build a library for each trainee to record progress.
The Range FDU provides the following benefits:
>> Fall of shot feedback
>> Trigger pressure analysis
>> Recoil control, grip and stance assessment
>> Sight alignment
>> Sight picture analysis and target reacquisition
Summit Training International
Summit Training International (STI) is a wholly-owned subsidiary of IES
Interactive Training. STI provides relevant, cost-effective professional
training seminars, consulting services, and interactive courseware for law
enforcement, corrections, and corporate clients. STI's emphasis and goal is to
create a "total training" environment designed to address the cutting edge
issues faced today. STI provides conferences throughout the United States, and
develops courseware dealing with these important topics. The incorporation of
IES Interactive Systems creates an intense learning environment and adds to the
realism of the trainee's experience.
Conferences
STI has provided conferences throughout the United States, on such
topics as:
>> Recruiting and Retention of Law Enforcement and Corrections
Personnel
>> Ethics and Integrity
>> Issues of Hate Crimes
>> Traffic Stops and Use of Force
>> Community and Corporate Partnerships for Public Safety
>> Creating a Safe School Environment
In addition to these national and regional conferences, STI designs and
produces training to address specific department issues. STI has a distinguished
cadre of instructors that allows adaptation of programs to make them
specifically focused for a more intense learning experience. The A2Z Classroom
Trainer is incorporated into the "live" presentation creating a stimulating
interactive training experience.
Courseware
STI develops courseware for use exclusively with IES's interactive
systems. Courses are designed to addresses specific department issues, and can
be customized to fit each agency's needs. These courses are available in boxed
sets that provide the customer with a turn-key training session. The A2Z
Classroom Trainer and the Range 3000 XP-4 are used to deliver the curriculum and
create a virtual world that the trainees respond and react to. Strategic
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relationships with high profile companies such as H&K Firearms, and Taser
International, provide customers with training that deals with cutting edge
issues facing law enforcement today. The incorporation of STI's courseware
library along with simulation systems allows training to remain consistent and
effective, giving customers more value for their training dollar.
IES Studio Productions
IES Studio Productions, a division of IES, provides multimedia video
services for law enforcement, military and security agencies, and others. IES
Studio Productions creates interactive courseware and interactive scenarios for
the Range 3000, Video Training Scenarios and all types of video production
services. With the latest in media equipment, IES Studio Productions provides
all media and marketing services to IES Interactive Training in-house.
MARKETING
IES markets its products and services to domestic and international law
enforcement, military and other federal agencies and to various companies that
serve them, through attendance and presentations at conferences, exhibits at
trade shows, seminars at law enforcement academies and government agencies,
through its web pages on the Internet, and to its compiled database of prospect
and customer names. IES's salespeople are also its marketing team. We believe
that this is effective for several reasons: (1) customers appreciate talking
directly with salespeople who can answer a wide range of technical questions
about methods and features, (2) our salespeople benefit from direct customer
contact through gaining an appreciation for the environment and problems of the
customer, and (3) the relationships we build through peer-to-peer contact are
useful in the military, police and federal agency market.
IES also uses its web pages on the Internet for such activities as
providing product information and software updates.
IES markets augmentative and alternative law enforcement products
through a network of employee representatives and independent resellers. These
products include but are not limited to products manufactured by:
>> Bristlecone Products
>> Airmunitions Inc.
>> Taser Inc.
>> ASP Inc.
>> H&K Training Centers
At the present time IES has six sales representatives based in Denver,
eight domestic independent distributors, and fifteen independent resellers /
representatives overseas. IES also has three inside sales/support persons who
answer telephone inquiries on IES's 800 line and Internet, and who can also
provide technical support. Additional outside salespersons and independent
dealers and resellers are being actively recruited at this time.
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IES typically participates in over thirty industry conferences
annually, held throughout the United States and in other countries, that are
attended by our potential customers and their respective purchasing and
budgeting decision makers. A significant percentage of IES's sales of products,
both software and hardware, are sold through leads developed at these shows.
IES and others in the industry demonstrate their products at these
conferences and present technical papers that describe the application of their
technologies and the effectiveness of their products. IES also advertises in
selected publications of interest to potential customers.
CUSTOMERS
Most of IES's customers are law enforcement agencies, both in the
United States (federal, state and local) and worldwide. Purchasers of IES
products have included (in the United States) the FBI, the Secret Service, the
Bureau of Alcohol, Tobacco and Firearms, the Customs Service, the Federal
Protective Service, the Border Patrol, the Bureau of Engraving and Printing, the
Coast Guard, the Federal Law Enforcement Training Centers, the Department of
Health and Human Services, the California Department of Corrections, NASA,
police departments in Texas (Houston), Michigan (Detroit), D.C., California
(Fresno and the California Highway Patrol), Massachusetts (Brookline), Virginia
(Newport News and the State Police Academy), Arizona (Maricopa County),
universities and nuclear power plants, as well as international users such as
the Israeli Defense Forces, the German National Police, the Royal Thailand Army,
the Hong Kong Police, the Russian Security Police, and over 500 other training
departments worldwide.
The mix of customers has historically been approximately 40% city and
state agencies, 30% federal agencies, and 30% international. During 2003, IES's
order from the German National Police accounted for 16% of our revenues on a
consolidated basis.
COMPETITION
IES competes against a number of established companies that provide
similar products and services, many of which have financial, technical,
marketing, sales, manufacturing, distribution and other resources significantly
greater than ours. There are also companies whose products do not compete
directly, but are sometimes closely related. Firearms Training Systems, Inc.,
Advanced Interactive Systems, Inc., and LaserShot Inc. are IES's main
competitors.
We believe the key factors in our competing successfully in this field
will be our ability to develop simulation software and related products and
services to effectively train law enforcement and military to today's standards,
our ability to develop and maintain a proprietary technologically advanced
hardware, and our ability to develop and maintain relationships with departments
and government agencies.
Vehicle Simulators
Through our wholly-owned subsidiary, FAAC Corporation, we provide
simulators, systems engineering and software products to the United States
military, government and private industry. FAAC's fully interactive
driver-training systems feature state-of-the-art vehicle simulator technology
enabling training in situation awareness, risk analysis and decision making,
emergency reaction and avoidance procedures, and conscientious equipment
operation. FAAC has an installed base of over 179 simulators that have
successfully trained over 80,000 drivers. FAAC's customer base includes all
branches of the U.S. Department of Defense, state and local governments, and
commercial entities.
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INTRODUCTION
Based in Ann Arbor, Michigan, FAAC is a premier developer of validated,
high fidelity analytical models and simulations of tactical air and land warfare
for all branches of the Department of Defense and its related industrial
contractors. Simulations developed by FAAC are found in systems ranging from
instrumented air combat and maneuver ranges (such as Top Gun) to full task
training devices such as the F-18 Weapon Tactics Trainer. FAAC is also the
leading supplier of wheeled vehicle simulators to the U.S. Armed Forces for
mission-critical vehicle training. Management believes that FAAC has held a 100%
market share in U.S. military wheeled simulators since 1999 and holds a market
share in excess of 50% in commercial wheeled vehicle simulators.
Simulators are cost-effective solutions, enabling users to reduce
overall aircraft and ground vehicle usage, vehicle maintenance costs, fuel
costs, repairs, and spares expenditures. For example, FAAC's Medium Tactical
Vehicle Replacement (MTVR) simulators have reduced total driver training time by
35%. Many customers have reduced actual "behind-the-wheel" time by up to 50%
while still maintaining or improving safety. Additionally, for customers with
multiple simulators, the corresponding increase in the student to instructor
ratio has reduced instructor cost per student.
The implementation of FAAC simulators has led to measurable benefits.
North American Van Lines, one of FAAC's earliest vehicle simulator customers,
has shown a 22% reduction in preventable accidents since it began using FAAC's
simulators. The German Army, one of FAAC's earliest Military Vehicle customers,
showed better driver testing scores in 14 of 18 driver skills compared to
classroom and live driver training results. Additionally, the New York City
Transit Authority documented a 43% reduction in preventable accidents over its
first six months of use and has reduced its driver hiring and training "washout"
by 50%.
Simulators can produce more drastic situations than can traditional
training, which inherently produces drivers that are more skilled in diverse
driving conditions. For example, while many first-time drivers will learn to
drive during the summer months, they are not trained to drive in wintry
conditions. Simulators can produce these and other situations, such as a tire
blowout or having to react to a driver cutting off the trainee, effectively
preparing the driver for adverse conditions.
FAAC supplies on-board software to support weapon launch decisions for
the F-15, F-18, and Joint Strike Fighter fighter aircraft. Pilots benefit by
having highly accurate presentations of their weapon's capabilities, including
susceptibility to target defensive reactions. FAAC designed and developed an
Instructor operator station, mission operator station and real-time, database
driven electronic combat environment for the special operational forces aircrew
training system. The special operational forces aircrew training system provides
a full range of aircrew training, including initial qualification, mission
qualification, continuation, and upgrade training, as well as combat mission
rehearsal.
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FAAC operates in two primary business areas: Vehicle Simulations, which
focuses on the development and delivery of complete driving simulations for a
wide range of vehicle types - such as trucks, automobiles, buses, fire trucks,
police cars, ambulances, airport ground vehicles, and military vehicles - for
commercial, governmental and foreign customers; and Military Operations, which
conducts tactical air and land combat analysis and develops analytical models,
simulations, and "turnkey" training systems for the U.S. military. In 2003,
Vehicle Simulations accounted for approximately 75% of FAAC's revenues, and
Military Operations accounted for approximately 25% of FAAC's revenues.
FAAC's revenues during 2001, 2002 and 2003 were approximately $12.2
million, $15.2 million and $9.8 million, respectively.
PRODUCT LINES
Below is a description of FAAC's products and product lines.
Vehicle Simulations
Military Vehicles
Military Vehicles is FAAC's largest business segment. Military vehicle
simulators are highly realistic vehicle simulators that include variable
reactive traffic and road conditions, the capacity to customize driving
conditions to be geography-specific, and training in hazardous and emergency
conditions. FAAC has several large contracts and task orders in the Military
Vehicles business, including (i) the MTVR contract to develop vehicle simulators
and related training services for the U.S. Marine Corps; (ii) a series of
scheduled General Services Administration purchases of simulators with the U.S.
Army to supply 78 simulators for 25 training sites; and (iii) a two-year
contract with the U.S. Navy Seabees to supply eight simulators for three
training sites. Management estimates that FAAC's software trained 9,000 soldiers
at four sites in 2002.
FAAC's military vehicle simulators provide complete training
capabilities based on integrated, effective simulation solutions to military
vehicle operators in the U.S. Armed Forces. FAAC's flagship military vehicle
simulation product is its MTVR Operator Driver Simulator, developed for the
USMC. The MTVR ODS concept is centered on a pod of up to six Student Training
Stations (STS) and a single controlling Instructor Operator Station (IOS). The
STS realistically simulates the form, fit, and feel of the MTVR vehicle. The
high-fidelity version of the STS consists of a modified production cab unit
mounted on a full six-degree-of-freedom motion platform. The STS provides over
an 180-degree field of view into a realistically depicted virtual world,
simulating a variety of on-road and off-road conditions. The IOS is the main
simulation control point supporting the instructor's role in simulator training.
The IOS initializes and configures the attached STS, conducts training
scenarios, assesses student performance, and maintains scenarios and approved
curriculum.
FAAC's software solution provides a complete operator training
curriculum based upon integrated simulation training. Military vehicle
simulators enable students to learn proper operational techniques under all
terrain, weather, road, and traffic conditions. Instructors can use simulators
as the primary instructional device, quantitatively evaluating student
performance under controlled, repeatable scenarios. This monitoring, combined
with the ability to create hazardous and potentially dangerous situations
without risk to man or material, results in well-trained students at
significantly less cost than through the use of traditional training techniques.
In addition to standard on-road driver training, FAAC's military vehicle
simulators can provide training in such tasks as:
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>> Off-road driving on severe slopes, including muddy or swampy
terrain;
>> Night vision goggle and blackout conditions;
>> Convoy training; and
>> The use of the Central Tire Inflation System in response to
changing terrain.
In addition to simulation systems, FAAC offers on-site operator and
maintenance staff, train-the-trainer courses, curriculum development, scenario
development, system maintenance, software upgrades, and warranty packages to its
U.S. Armed Forces customers.
Commercial Vehicles
Commercial Vehicles is FAAC's second largest business segment. The
Commercial Vehicles business is comprised of technology similar to that of the
Military Vehicles product line and also is customized to reflect the specific
vehicle being simulated. FAAC serves four primary customer bases in the
Commercial Vehicles business: transit, municipal, airport, and corporate
customers.
Transit
Transit customers represent an attractive customer base as they
generally have access to their own funds, which often exempts them from the
lengthy and complex process of requesting funds from a governing body. FAAC has
provided simulators to ten leading transit authorities, including the New York
City Transit Authority, Washington, D.C. Metro, and Dallas Area Rapid Transit.
Municipal
FAAC targets municipal customers in police departments, hospitals, fire
departments, and departments of transportation for sales of its municipal
product. FAAC's customers include the Mexico Department of Education, California
Department of Transportation, and the Fire Department of New York. FAAC is
developing an industry advisory group focusing on the municipal market to
identify and address customer needs. Additionally, FAAC has developed a
simulator module to extend the simulation once police, fire, or emergency
medical service personnel reach the incident location. FAAC management believes
that this represents another of FAAC's bases of differentiation over its
competition.
Airport
FAAC was a pioneer in providing simulation software to airports to
facilitate training personnel in adverse conditions, including the Detroit and
Toronto airports.
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Corporate
FAAC targets corporate fleets and "for-hire" haulers as customers of
the corporate simulator product. These customers use simulators to train
personnel effectively as well as to avoid the brand damage that could be
associated with poor driver performance. To date, FAAC has provided simulators
to customers such as Schlumberger Oil Services, Kramer Entertainment, and North
American Van Lines.
Military Operations
FAAC provides air combat range software, missile launch envelope
decision support software, the SimBuilder(TM) simulation software product, and
Weapon System Trainer software through the Military Operations business line.
Air Combat Range Software
FAAC serves the U.S. Air Force Air Combat Training System and U.S. Navy
Tactical Aircrew Training System with its air combat training range software.
Air combat training ranges allow pilots to train and evaluate new tactics in a
controlled airborne environment. Air "battles" are extremely realistic, with
FAAC software determining the outcome of weapon engagements based on launch
conditions and the target aircraft defensive reactions.
Missile Launch Envelope Software
Onboard weapon decision-making software enables pilots to assimilate
the complex information presented to them in F-15 and F-18 fighter aircraft.
FAAC provides its missile launch envelope software to the U.S. Navy and Air
Force through its subcontracting relationships with Boeing.
Weapon System Trainer Software
FAAC has successfully transitioned software from U.S. Navy Tactical
Aircrew Training Systems to over 15 Weapon Systems Trainers built by prime
contractors such as L-3, Boeing, Northrop Grumman, and Lockheed Martin.
SIMBuilder(TM)
The SimBuilder(TM) simulation software product is designed to provide
weapons simulation models for use in training environments for launched weapons.
This software enables foreign end-users to use weapons simulation models similar
to the U.S. military without classified U.S. weapons data. Militaries of Canada,
Taiwan, and Singapore currently use SimBuilders(TM).
MARKETING
The sales and marketing effort at FAAC focuses on developing new
business opportunities as well as generating follow-on sales of simulators and
upgrades. FAAC currently employs four dedicated sales representatives who focus
on Commercial Vehicles, Military Operations, and Military Vehicles
opportunities. Furthermore, two additional FAAC employees spend a significant
portion of their time in sales. Various members of senior management serve as
effective sales representatives in the generation of municipal, military, and
corporate business. FAAC also retains the services of four independent
consultants who act as marketing agents on FAAC's behalf. These representatives
are largely commission-based agents who focus on particular products and/or
regions (such as airport customers, Texas, California, and Eglin Air Force
Base). Finally, FAAC has four customers that have agreements wherein the
companies support FAAC marketing efforts and market FAAC products themselves in
exchange for commissions and/or free upgrade services.
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FAAC's sales representatives are salaried employees with minimal
commission-based revenue. Independent consultants generally do not receive a
base salary and receive 5% to 10% commissions on the amount of business that
they generate each year. The majority of FAAC's sales representatives have
engineering backgrounds that they leverage to anticipate the technical needs of
FAAC's dynamic customer base and targeted markets. Additionally, the program
manager and service department assist FAAC in gaining repeat business.
Developing a pipeline of follow-on work is one of the tasks for all
program managers. FAAC has a long history of repeat and follow-on work with
programs such as F-15 and F-18 ZAP (over 20 contracts with Boeing), the U.S.
Navy Tactical Aircrew Training System (a series of 6 sequential contracts over
the last 25 years), and F-18 Weapon Tactics Trainer (series of 20 contracts with
the simulator manufacturer).
FAAC also aggressively pursues several marketing initiatives to
complement its experienced sales force. FAAC's most successful marketing
strategy includes the formation of industry advisory groups. Such advisory
groups, which consist of simulation users within select industries, conduct
regular seminars to educate transit and similar agencies on the benefits and
challenges of simulation-based training, as well as to share training concepts,
curriculums, and experiences. These sessions not only serve as excellent sales
and marketing tools to generate orders but also have created significant
goodwill with customers. FAAC management believes that these industry advisory
groups have proven to be particularly successful in cooperative industries, such
as transit, where users are self-funded and do not compete with one another.
CUSTOMERS
FAAC has long-term relationships, many of over ten years' duration,
with the U.S. Air Force, U.S. Navy, U.S. Army, and most major Department of
Defense training and simulation prime contractors and related subcontractors.
The quality of FAAC's customer relationships is illustrated by the multiple
program contract awards it has earned with many of its customers. For example,
under a series of 20 subcontracts over 15 years, FAAC has provided the tactical
environment and F-18 weapons and avionics models for the F/A-18 Weapons Tactics
Trainer. FAAC has served as a subcontractor for the F/A-18 WTT through three
distinct prime contractor tenures.
COMPETITION
FAAC's technical excellence, superior product reliability, and high
customer satisfaction have enabled FAAC to develop market leadership and an
attractive competitive position. Several potential competitors in the military
segment are large, diversified defense and aerospace conglomerates who do not
focus on FAAC's specific niches. As such, FAAC is able to serve certain large
military contracts through strategic agreements with these organizations or can
compete directly with these organizations based on FAAC's strength in developing
higher quality software solutions. In commercial market applications, FAAC
competes against smaller, less sophisticated software companies.
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FAAC differentiates itself from its competition on several bases:
>> Leading Technology - Management believes that FAAC offers
better-developed, more dynamic software than its competitors.
Additionally, FAAC incorporates leading graphics and
motion-cueing technologies in its systems to provide customers
with the most realistic simulation experience on the market.
>> Long History in the Simulation Software Business - As a market
leader in the simulation software business for more than
thirty years, FAAC's professionals understand customer
requirements and operating environments. Thus, FAAC builds its
software to meet and exceed demanding customers' expectations.
>> Low-Cost Research and Development Capabilities for New
Products - FAAC's customers benefit from government and
commercial funding of research and development and the low
cost of subsequent adaptation. As such, internally funded new
product development costs have been less than $100,000 per
year since 1999.
>> Service Reputation - FAAC is known for providing better
service than the competition, a characteristic that drives new
business within FAAC's chosen markets.
>> Standardized Development Processes - FAAC generally delivers
its products to the market more quickly than its competition
and at higher quality due to its standardized development
processes.
Below is a description of FAAC's competition organized by product
lines.
Vehicle Simulations
Military Vehicles
FAAC has been the sole provider of wheeled vehicle simulation solutions
to the U.S. military since 1999. FAAC's devotion to developing realistic,
comprehensive products for a wide range of vehicle types positions it as the
preferred simulation provider within this market niche. FAAC's strategy of
identifying a training need, isolating government funds, and then developing a
customized training solution has led to considerable successes. This approach,
which differs from the "build first and market later" strategy employed by a
number of FAAC's competitors, effectively identifies market opportunities and
provides a better product to the military customer. Diversified defense
companies and commercial simulation providers have attempted to enter the
military wheeled vehicle market but have been unsuccessful thus far. Although
FAAC's management believes that market penetration by these companies is
ultimately inevitable, FAAC's established brand, understanding of customer
requirements, and engineering expertise provide FAAC with a competitive
advantage in this market segment. FAAC's primary competitors for military
vehicle simulation solutions include Lockheed Martin Corporation's Information &
Technology Services Group, Raydon Corporation, and the Cubic Defense
Applications division of Cubic Corporation.
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Commercial Vehicles
A handful of simulation product and service companies currently compete
with FAAC's targeted commercial driving simulator markets. However, FAAC's
marketing and development of selected commercial market segments has positioned
FAAC as a leading provider of commercial simulation solutions. Competition
within each market segment varies, but the following companies generally
participate in selected driving simulator market opportunities: GE Capital I-Sim
(a subsidiary of GE Capital Commercial Equipment Financing), Doron Precision
Systems, Lockheed-Martin Corporation's LMIS Division, Global SIM, and
USADriveSafe, Inc.
Military Operations
Currently no significant competitors participate in the market for
FAAC's tactical environment software, and there are essentially no independent
competitors that exist in the market for FAAC's decision support software.
Competition for software to support tactical environment requirements in
aircraft weapon systems trainers comes from the manufacturers of the simulators
themselves and from a handful of companies who produce tactical environment
software. FAAC's primary competitors for training range software, decision
support software, and weapons system trainer software solutions include Lockheed
Martin Corporation, L-3 Communications Holdings, Raytheon Company, Science
Applications International Corporation, Dynetics, Inc., and Georgia Tech
Research Institute.
Security Consulting
Arocon Security Corporation focuses on protecting life, assets and
operations with minimum hindrance to personal freedom and daily activities.
Arocon Security, which provides security consulting and other services, has
signed an agreement with Rafael Armament Development Authority Ltd., Israel's
leading defense research and development company, to market and implement
certain of Rafael's security products and technology in the United States.
Battery and Power Systems Division
Zinc-Air Fuel Cells, Batteries and Chargers for the Military
We base our strategy in the field of Zinc-Air military batteries on the
development and commercialization of our next-generation Zinc-Air fuel cell
technology, as applied in our batteries that we produce for the U.S. Army's
Communications and Electronics Command (CECOM). We will continue to seek new
applications for our technology in defense projects, wherever synergistic
technology and business benefits may exist. We intend to continue to develop our
battery products for defense agencies, and plan to sell our products either
directly to such agencies or through prime contractors.
Since 1998 we have received and performed a series of contracts from
CECOM to develop and evaluate advanced primary Zinc-Air fuel cell packs.
Pursuant to these contracts, we developed and began selling in 2002 a 12/24
volt, 800 watt-hour battery pack for battlefield power, which is based on our
Zinc-Air fuel cell technology, weighs only six pounds and has approximately
twice the energy capacity per pound of the U.S. Army's standard lithium-sulfur
dioxide battery packs - the BA-8180/U battery.
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In the second half of 2002, our five-year program with CECOM to develop
a Zinc-Air battery for battlefield power culminated in the assignment of a
National Stock Number and a $2.5 million delivery order for the newly designated
BA-8180/U battery. Subsequent to this initial $2.5 million delivery order, we
received in 2003 an additional $6.8 million in follow-on orders from the Army.
Our batteries have been used in both Afghanistan (Operation Enduring
Freedom) and in Iraq (Operation Iraqi Freedom). The significant contribution
that our batteries made to both these endeavors was recognized by General Tommy
R. Franks, then the Commander of United States Central Command (USCENTCOM), who
said in a letter to EFB dated July 3, 2003, "Your efforts in managing and
supplying zinc-air batteries were seen as nothing less than spectacular. The
long hours, hard work, and personal sacrifices made in support of these
operations have ensured our War Fighters had the necessary resources to
successfully conduct their missions without interruption."
Our Zinc-Air fuel cells, batteries and chargers for the military are
manufactured through our Electric Fuel Battery Corporation subsidiary. In 2003,
EFB's facilities were granted ISO 9001 "Top Quality Standard" certification.
PRODUCTS
Zinc-Air Power Packs
BA-8180/U
Electric Fuel Zinc-Air power packs are lightweight, low-cost primary
Zinc-Air batteries with up to twice the energy capacity per pound of primary
lithium (LiSO2) battery packs, which are the most popular batteries used in the
US military today. Zinc-Air batteries are inherently safe in storage,
transportation, use, and disposal.
The BA-8180/U is a 12/24 volt, 800 watt-hour battery pack approximately
the size and weight of a notebook computer. The battery is based on a new
generation of lightweight, 30 ampere-hour cells developed by us over the last
five years with partial funding by CECOM. Each BA-8180/U battery pack contains
24 cells.
The battery has specific energy of up to 350 Wh/kg, which is
substantially higher than that of any competing disposable battery available to
the defense and security industries. By way of comparison, the BA-5590, a
popular LiSO2 battery pack, has only 175 Wh/kg. Specific energy, or energy
capacity per unit of weight, translates into longer operating times for
battery-powered electronic equipment, and greater portability as well. Because
of lower cost per watt-hour, the BA-8180/U can provide substantial cost savings
to the Army when deployed for longer missions, even for applications that are
not man-portable.
CECOM has assigned a National Stock Number (NSN) to our Zinc-Air
battery, making it possible to order and stock the battery for use by the Armed
Forces. CECOM also assigned the designation BA-8180/U to our Zinc-Air battery,
the first time an official US Army battery designation was ever assigned to a
Zinc-Air battery.
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Based on extensive contacts with the US and foreign military agencies,
we believe that a significant market exists for the BA-8180/U both in the US
Armed Forces and abroad.
8140/U
The BA-8140/U is a new product, presently being field tested and at its
initial procurement stages. The BA-8140/U is a smaller version of our 8180/U,
which we developed at the request of CECOM. It is approximately half the size,
weight and capacity of our 8180/U, and is appropriate for smaller hand-held
communications devices.
Adapters
The BA-8180/U is a battery, but in order to connect it to a specific
piece of equipment, an adapter must be used. In order to provide compatibility
between the BA-8180/U and various items of military equipment, we supply various
types of electrical interface adapters for the BA-8180/U, including
equipment-specific adapters for the AN/PRC-119 SINCGARS and SINCGARS ASIP
tactical radio sets, and a generic interface for items of equipment that were
designed to interface with a BA-5590 or equivalent battery. Each of the three
interfaces was also assigned a national stock number (NSN) by CECOM. In
addition, we are in the process of adding more electrical interfaces for the
BA-8180/U. These will address various applications, including other radios,
night vision, missile launchers and chemical detectors.
Hybrids
We have also developed interface adapters for other items of equipment
which require higher power than the BA-8180/U can provide by itself. For
example, we have developed a hybrid battery system comprising a BA-8180/U
battery pack and two small rechargeable lead-acid packs. Even with the weight of
the lead-acid batteries, this hybrid system powers a satellite communications
terminal for significantly longer than an equivalent weight of BA-5590 LiSO2
battery packs. We have also developed experimental hybrid systems incorporating
other rechargeable technologies, such as lithium-ion batteries and
ultracapacitors.
Forward Field Chargers
One of the initial goals to develop high energy density and power
density Zinc-Air was to deploy them as forward field chargers. It was envisioned
that a man portable power pack would be required by the dismounted soldier to
charge the range of rechargeable batteries now proliferating the military. A
high efficiency forward field charger has been developed which enables either a
BB-390/U (NiMH) or a BB-2590/U (Li-ion) to receive multiple charges from a
single BA-8180/U.
Other Zinc-Air Products
A fourth generation of Zinc-Air products has been developed for
applications where volume is critical, and/or where the power to energy ratio
needs to be significantly higher than that of the BA-8180/U. These "Gen4"
Zinc-Air products consist of an air cathode folded around a zinc electrode. Gen4
was originally developed for the Marine Corps Dragon Eye UAV, which requires up
to 200 W from a battery that fits into its sleek fuselage and which weighs less
than one kilogram. Along the way, it was recognized that the Gen4 design could
be applied to other battery missions requiring high power as well as energy
density, such as Land Warrior and Objective Force Warrior soldier systems, where
up to 300 Wh of energy are required of a 24 hour battery that must be worn
conformably, at minimal weight. For these systems the battery currently limits
functionality, and Gen4 zinc-air may be the enabling technology.
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We are currently under contract with the U.S. military and an Israeli
security agency, to demonstrate the feasibility of Zinc-Air batteries for both
unmanned aerial vehicles (UAV) and micro-air vehicles (MAV) platforms,
respectively. Short-term development goals include the optimization and
integration of cell components for performance and manufacturability.
System-level objectives include refinement of battery envelope design and
vehicle interfaces, and continued actual flight testing. During 2003, our
Zinc-Air battery successfully powered a Dragon Eye unmanned drone and an MAV in
test flights, outperforming a competing technology, a high-performance
lithium-ion polymer battery.
UAVs
Man-portable UAVs are considered to be an increasingly important
battlefield tool for reconnaissance and surveillance of enemy positions. At
present, power sources available to the military provide only marginally
adequate operating times for these UAVs. For example, the Marine Corps'
DragonEye system, operating off primary lithium batteries, can run for 30 to 60
minutes. We expect to achieve a cruise time of at least two hours using an
equivalent weight of Zinc-Air cells. Our Zinc-Air battery successfully powered a
Dragon Eye unmanned drone in a test flight in June 2003.
MAVs
Development of electrically propelled MAVs has been hampered by the
lack of a satisfactory battery solution. Achievement of our development targets
will enable a Zinc-Air battery to power a typical 5-oz. MAV for as long as 30
minutes. Our Zinc-Air battery successfully powered an MAV in a test flight in
June 2003, outperforming a competing technology, a high-performance lithium-ion
polymer battery.
MARKETS/APPLICATIONS
Being an external alternative to the popular lithium based BA-5590/U,
the BA-8180 can be used in many applications operated by the 5590. The BA-8180/U
can be used for a variety of military applications, including:
>> Tactical radios
>> SIGINT systems
>> Training systems
>> SATCOM radios
>> Nightscope power
>> Guidance systems
>> Surveillance systems
>> Sensors
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CUSTOMERS
EFB's principal customer during 2003 was the U.S. Army's
Communications-Electronics Command (CECOM), sales to which accounted for
approximately 27% of our revenues in 2003.
COMPETITION
The BA-8180/U is the only Zinc-Air battery to hold a US Army battery
designation. It does, however, compete with other primary (disposable)
batteries, and primarily lithium based batteries. In some cases, primarily in
training missions, it will also compete with rechargeable batteries.
Zinc-Air batteries are inherently safer than primary lithium battery
packs in storage, transportation, use, and disposal, and are more cost
effective. They are lightweight, with up to twice the energy capacity per pound
of primary lithium battery packs. Zinc-Air batteries for the military are also
under development by Rayovac Corporation. Rayovac's military Zinc-Air batteries
utilize cylindrical cells, rather than the prismatic cells that we developed.
While cylindrical cells may provide higher specific power than our prismatic
cells, we believe they will generally have lower energy densities and be more
difficult to manufacture.
The most popular competing primary battery in use by the US Armed
Forces is the BA-5590, which uses lithium-sulfur dioxide (LiSO2) cells. The
largest suppliers of LiSO2 batteries to the US military are believed to be Saft
America Inc and Eagle Picher Technologies LLC. The battery compartment of most
military communications equipment, as well as other military equipment, is
designed for the x90 family of batteries, of which the BA-5590 battery is the
most commonly deployed. Another primary battery in this family is the BA-5390,
which uses lithium-manganese dioxide (LiMnO2) cells. Suppliers of LiMnO2
batteries include Ultralife Batteries Inc., Saft and Eagle Picher.
Rechargeable batteries in the x90 family include lithium-ion and
nickel-metal hydride batteries which may be used in training missions in order
to save the higher costs associated with primary batteries. Because of the short
usage time per charge cycle, rechargeable batteries are not considered suitable
for use in combat.
Our BA-8180 does not fit inside the battery compartment of any military
equipment, and therefore is connected externally using an interface adapter that
we also sell to the Army. Our battery offers greatly extended mission time,
along with lower total mission cost, and these significant advantages often
greatly outweigh the slight inconvenience of fielding an external battery.
MANUFACTURING
EFB has established a battery factory at our new location in Auburn,
Alabama, where we have leased 15,000 square feet of light industrial space from
the city of Auburn. We also have production capabilities for some battery
components at the facility of EFL in Beit Shemesh, Israel. Both the facilities
in Auburn and those in Beit Shemesh have received ISO 9001 "Top Quality
Standard" certification.
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Lithium Batteries and Charging Systems for the Military
We sell lithium batteries and charging systems to the military through
our subsidiary Epsilor Electronic Industries, Ltd., an Israeli corporation
established in 1985 that we purchased early in 2004.
Epsilor specializes in the design and manufacture of primary and
rechargeable batteries, related electronic circuits and associated chargers for
military applications. Epsilor has experience in working with government
agencies, the military and large corporations. Epsilor's technical team has
significant expertise in the fields of electrochemistry, electronics, software
and battery design, production, packaging and testing.
PRODUCTS
Epsilor currently produces over 50 different products in the following
categories:
>> Primary batteries;
>> Rechargeable batteries;
>> Smart chargers;
>> State of charge indicators; and
>> Control and monitoring battery circuits
Epsilor's batteries are based on commercially-available battery cells
that we purchase from several leading suppliers, with proprietary energy
management circuitry and software. Epsilor's battery packs are designed to
withstand harsh environments, and have a track record of years of service in
armies worldwide.
Epsilor produces a wide range of primary batteries based on the
following chemistries: lithium sulfur dioxide, lithium thionyl chloride, lithium
manganese dioxide and alkaline. The rechargeable battery chemistries that
Epsilor employs are: nickel cadmium, nickel metal hydride and lithium-ion.
Epsilor manufactures single and multi-channel smart chargers for nickel cadmium,
nickel metal hydride and lithium-ion batteries.
Epsilor has designed a number of sophisticated state of charge
indicators. These are employed in Epsilor's products and are also sold as
components to other battery pack manufacturers. Epsilor also develops and
manufactures control systems for high rate primary battery-packs and monitoring
systems for rechargeable battery-packs.
MARKETS/APPLICATIONS
Epsilor's target markets are military and security entities seeking
high-end solutions for their power source needs. By their nature, the sell-in
cycles are long and the resultant entry barriers are high. This is due to the
high cost of developing custom designs and the long period needed to qualify any
product for military use.
Epsilor's present customers include:
>> Armed forces in the Middle East and Asia;
23
>> Military original equipment manufacturers (OEMs); and
>> Various battery manufacturers.
COMPETITION
Epsilor's main competitors are Bren-tronics Inc. in the United States,
which controls much of the U.S. rechargeable market, and AEA Battery Systems (a
wholly owned subsidiary of AEA Technology plc) in the United Kingdom, which has
the majority of the English military market. On the primary end of the market
there are a host of players who include the cell manufacturers themselves,
including Saft S.A. and Ultralife Batteries, Inc.
It should be noted that a number of OEMs, such as Motorola, have
internal engineering groups that can develop competitive products in-house.
However, on many occasions they outsource such activities in order to stabilize
their staffing level.
MARKETING
Epsilor markets to its existing customers through direct sales. To
generate new customers and applications, Epsilor relies on its working
relationship with a selection of OEMs, with the intent of having these OEMs
design Epsilor products into their equipment, thereby creating a market with a
high entry barrier.
MANUFACTURING
Epsilor has developed and built battery production lines for military
batteries and chargers which have been ISO-9001 certified since 1994. We believe
that Epsilor's 19,000 square foot facility in Dimona, Israel has the necessary
capabilities and operations to support its production cycle.
Electric Vehicles
We believe that electric buses represent a particularly important
market for electric vehicles in the United States. Transit buses powered by
diesel engines operate in large urban areas where congestion is a fact of life
and traffic is largely stop-and-go. As a result, they are the leading
contributor to inner city toxic emissions, and are a major factor for those U.S.
cities that have been designated as in "non-attainment" with respect to air
quality standards. Moreover, the U.S. Environmental Protection Agency has
identified particulate emissions from diesel engine emissions as a carcinogen.
Electric Fuel-powered full-size vehicles, capable of clean, long-range,
high-speed travel, could fulfill the needs of transit operators in all weather
conditions, with fast, cost-effective refueling. An all-electric, full-size bus
powered by the Electric Fuel system can provide to transit authorities a full
day's operating range for both heavy duty city and suburban routes in all
weather conditions.
THE ELECTRIC FUEL ZINC-AIR ENERGY SYSTEM FOR ELECTRIC VEHICLES
The Electric Fuel Zinc-Air Energy System consists of:
>> an in-vehicle, Zinc-Air fuel cell unit consisting of a series
of Zinc-Air cells and refuelable zinc-fuel anode cassettes;
24
>> a battery exchange unit for fast vehicle turn-around that is
equivalent to the time needed to refuel a diesel bus;
>> an automated battery refueling system for mechanically
replacing depleted zinc-fuel cassettes with charged cassettes;
and
>> a regeneration system for electrochemical recycling and
mechanical repacking of the discharged fuel cassettes.
With its proprietary high-power air cathode and zinc anode
technologies, our Zinc-Air fuel cell delivers a unique combination of
high-energy density and high-power density, which together power electric
vehicles with speed, acceleration, driving range and driver convenience similar
to that of conventionally powered vehicles.
THE DEPARTMENT OF TRANSPORTATION-FEDERAL TRANSIT ADMINISTRATION
ZINC-AIR ALL ELECTRIC TRANSIT BUS PROGRAM
In the United States, our Zinc-Air technology is the focus of a
Zinc-Air All Electric Bus demonstration program the costs and expenditures of
which are 50% offset by subcontracting fees paid by the U.S. Department of
Transportation's Federal Transit Administration (FTA). The test program is
designed to prove that an all-electric bus can meet these and all other Los
Angeles and New York Municipal Transit Authority mass transit requirements
including requirements relating to performance, speed, acceleration and hill
climbing.
The bus used in the program, which includes General Electric and the
Regional Transportation Commission of Southern Nevada (RTC) as project partners,
is a standard 40-foot (12.2 meter) transit bus manufactured by NovaBus
Corporation. It has a capacity of 40 seated and 37 standing passengers and a
gross vehicle weight of 39,500 lbs. (17,955 kg.). The all-electric hybrid system
consists of an Electric Fuel Zinc-Air fuel cell as the primary energy source, an
auxiliary battery to provide supplementary power and recuperation of energy when
braking. Ultracapacitors enhance this supplementary power, providing faster
throughput and higher current in both directions than the auxiliary battery can
supply on its own. The vehicle draws cruising energy from the Zinc-Air fuel
cell, and supplementary power for acceleration, merging into traffic and hill
climbing, from the auxiliary battery and ultracapacitors.
During Phase II of performance testing, our bus was driven a
record-breaking 127 miles, more than 100 of them under the rigorous stop-and-go
diving conditions of the Society of Automotive Engineers' Central Business
District cycle with a full passenger load. We demonstrated our bus in a public
demonstration in Las Vegas, Nevada in November 2001, and in Washington, D.C., on
Capitol Hill, with the participation of certain members of the United States
Senate, in March 2002. We have now completed Phase III of the project, which
focused on installation, testing and commissioning of new generation advanced
ultracapacitors and associated interface controls, and culminated in a
performance evaluation test in Schenectady and Albany, New York, with the
participation of New York Assembly Speaker Sheldon Silver, in November 2003.
Phase IV of the program, which we began in October 2003, is a $1.5
million cost-shared program (half of which is funded by the FTA and the
remainder by the program partners, including us) that will explore steps
necessary for commercializing the all-electric zinc-air/ultracapacitor hybrid
bus. It will focus on continued optimization of the propulsion system developed
in previous phases, on additional vehicle and system testing, including testing
alternative advanced auxiliary battery technologies, and on evaluating
alternative zinc anodes, which are more commercially available in North America.
25
COMPETITION
We believe that our products must be available at a price that is
competitive with alternative technologies, particularly those intended for use
in zero or low-emission vehicles. Besides other battery technologies, these
include hydrogen fuel cells, "hybrid systems" that combine an internal
combustion engine and battery technologies, and use of regular or low-pollution
fuels such as gasoline, diesel, compressed natural gas, liquefied natural gas,
ethanol and methanol. Other alternative technologies presently use costly
components, including use of flywheels and catalytic removal of pollutants.
These various technologies are at differing stages of development and any one of
them, or a new technology, may prove to be more cost effective, or otherwise
more readily acceptable by consumers, than the Electric Fuel Zinc-Air Energy
System for electric vehicles. In addition, the California Air Resource Board has
expressed to us concerns about the costs associated with the Zinc-Air
regeneration infrastructure as compared to battery technologies that use
electrical recharging.
An area of increased development has been that of hydrogen fuel cell
powered vehicles, spearheaded by the Ballard Corporation's solid polymer
electrolyte hydrogen-air fuel cell program. Major automobile companies have made
significant investments in this technology. We believe that vehicles based on
hydrogen fuel cells are many years away from commercialization, with significant
issues of hydrogen production and storage. We feel that storing hydrogen in
containers on board vehicles may be risky and involves major investments in
infrastructure for highly-pressurized hydrogen, and that using methanol for
making hydrogen on board vehicles is highly complex, costly and risky. We also
believe that competing Zinc-Air technologies, such as those offered by Metallic
Power (Carlsbad, California) and Powerzinc Electric (City of Industry,
California), are at a much earlier stage of development, not just in terms of
size and number of cells, modules and demonstrations in electric vehicles, but
also in terms of the scale of development effort. We are not aware of a
competing Zinc-Air development effort that could yield a product that is
superior to ours in terms of vehicle performance or life-cycle cost.
Lifejacket Lights
In 1996, we began to produce and market lifejacket lights built with
our patented magnesium-cuprous chloride batteries, which are activated by
immersion in water (water-activated batteries), for the aviation and marine
safety and emergency markets. At present we have a product line consisting of
five lifejacket light models, three for use with marine life jackets and two for
use with aviation life vests, all of which work in both freshwater and seawater.
Each of our lifejacket lights is certified for use by relevant governmental
agencies under various U.S. and international regulations. We manufacture,
assemble and package all our lifejacket lights in our factory in Beit Shemesh,
Israel.
MARKETING
We market our marine safety products through our own network of
distributors in Europe, the United States, Asia and Oceania. We market our
lights to the commercial aviation industry in the United States exclusively
through The Burkett Company of Houston, Texas, which receives a commission on
sales.
26
COMPETITION
Two of the largest manufacturers of aviation and marine safety
products, including TSO and SOLAS-approved lifejacket lights, are ACR
Electronics Inc. of Hollywood, Florida, and Pains Wessex McMurdo Ltd. of
England. Other significant competitors in the marine market include Daniamant
Aps of Denmark, and SIC of Italy.
Armored Vehicle Division
MDT Protective Industries and MDT Armor
INTRODUCTION
MDT Protective Industries Ltd. was established in Israel in 1989 as one
of Israel's first car armoring companies, and is Israel's leader in lightweight
armoring of vehicles, ranging from light tactical vehicles to passenger
vehicles. With two production lines, MDT specializes in using state-of-the-art
lightweight ceramic materials, special ballistic glass and advanced engineering
processes to fully armor vans and cars. MDT is a leading supplier to the Israeli
military, Israeli special forces and special services. MDT's products have been
proven in intensive battlefield situations and under actual terrorist attack
conditions, and are designed to meet the demanding requirements of governmental
and private sector customers worldwide.
MDT has acquired many years of battlefield experience in Israel. MDT's
vehicles have provided proven life-saving protection for their passengers in
incidents of rock throwing, handgun and assault rifle attack at point-blank
range, roadside bombings and suicide bombings. In fact, to our knowledge an
MDT-armored vehicle has never experienced bullet penetration into a vehicle
cabin under attack. MDT also uses its technology to protect vehicles against
vandalism.
In 2003, MDT Armor established operations in a new facility in Auburn,
Alabama. Soon thereafter, the United States General Services Administration
(GSA) awarded a five-year contract to MDT Armor for vehicle armoring,
establishing a pricing schedule for armoring of GM Suburban and Toyota Land
Cruiser SUVs and of GM Savana/Express passenger vans. With this contract, these
armored vehicles became available for purchase directly by all federal agencies
beginning December 1, 2003.
MDT's revenues during 2001, 2002 and 2003 were approximately $6.8
million, $6.4 million and $3.4 million, respectively.
THE ARMORING PROCESS
Armoring a vehicle involves much more than just adding "armor plates."
It includes professional and secure installation of a variety of armor
components - inside doors, dashboards, and all other areas of passenger and
engine compartments. MDT uses overlapping sections to ensure protection from all
angles, and installs armored glass in the windshield and windows. MDT has
developed certain unique features, such as new window operation mechanisms that
can raise windows rapidly despite their increased weight, gun ports, run-flat
tires, and more. MDT developed the majority of the materials that it uses
in-house, or in conjunction with Israeli companies specializing in protective
materials.
27
In order to armor a vehicle, MDT first disassembles the vehicle and
removes the interior paneling, passenger seats, doors, windows, etc. MDT then
fortifies the entire body of the vehicle, including the roof, motor and other
critical components, and reinforces the door hinges. MDT achieves firewall
protection from frontal assault with carefully designed overlapping armor.
Options, such as air-conditioning, seating modifications and run-flat tires, are
also available. MDT fixes the armoring into the shell of the vehicle, ensuring
that the installation and finishing is according to the standards set for that
particular model. MDT then reassembles the vehicle as close to its original
appearance as possible.
Once MDT has ensured full vehicle protection, it places a premium on
retaining the original vehicle's look and feel to the extent possible, including
enabling full serviceability of the vehicle, thereby rendering the armoring
process "invisible." MDT works with its customers to understand their
requirements, and together with the customer develops an optimized armoring
solution. A flexible design-to-cost process helps evaluate tradeoffs between
heavy and light materials and various levels of protection.
By working within the vehicle manufacturer's specifications, MDT
maintains stability, handling, center-of-gravity and overall integrity. MDT's
methods minimize impact on payload, and do not obstruct the driver's or
passengers' views. In most cases all the original warranties provided by the
manufacturer are still in effect.
ARMORING MATERIALS
MDT offers a variety of armoring materials, optimized to the customer's
requirements. MDT uses ballistic steel, composite materials (including
Kevlar(R), Dyneema(R) and composite armor steel) as well as special ceramics
developed by MDT, together with special armored glass. MDT uses advanced
engineering techniques and "light" composite materials, and avoids, to the
extent possible, using traditional "heavy" materials such as armored steel
because of the added weight, which impairs the driving performance and handling
of the vehicle.
All materials used by MDT meet not only international ballistic
standards, but also the far more stringent requirements set down by the Israeli
military, the Israeli Ministries of Defense and Transport, and the Israel
Standards Institute. MDT's factory has also been granted the ISO 9002 quality
standards award.
PRODUCTS AND SERVICES
MDT armors a variety of vehicles for both commercial and military
markets. At present, MDT offers armoring for approximately thirty different
models of motor vehicles.
In the military market, MDT armors:
>> troop and personnel carriers (such as vehicles in the
Mercedes-Benz Vario and Sprinter lines);
>> front-line police and military vehicles;
28
>> command vehicles (such as the Land Rover Defender 4x4);
>> specialty vehicles.
In the commercial market, MDT armors:
>> sports utility vehicles (such as the GM Suburban, the Toyota
Land Cruiser and the Land Rover Defender);
>> passenger vans (such as the Chevrolet Savana, the General
Motors Vandura and the Ford Econoline).
SALES AND MARKETING
Most of MDT's business has historically come from Israel, although MDT
has armored vehicles under contracts from companies in Yugoslavia, Mexico,
Colombia, South Africa and Singapore, and MDT recently received a $5.5 million
order from the United States. MDT's principal customer at present is the Israeli
Ministry of Defense. Other customers include Israeli government ministries and
agencies, private companies, medical services and private clients.
MDT markets its vehicle armoring through Israeli vehicle importers,
both pursuant to marketing agreements and otherwise, and directly to private
customers. Most sales are through vehicle importers.
MDT holds exclusive armoring contracts with Israel's sole General
Motors and Chevrolet distributors. This means that these distributors will
continue to honor the original vehicle warranty on armored versions of vehicles
sold by them only if the armoring was done by MDT.
CUSTOMERS
MDT's principal customer during 2003 was the Israeli Ministry of
Defense, sales to which accounted for approximately 17% of our consolidated
revenues in 2003.
COMPETITION
The global armored car industry is highly fragmented. Major suppliers
include both vehicle manufacturers and aftermarket specialists. As a highly
labor-intensive process, vehicle armoring is numerically dominated by relatively
small businesses. Industry estimates place the number of companies doing vehicle
armoring in the range of around 500 suppliers globally. While certain large
companies may armor several hundred cars annually, most of these companies are
smaller operations that may armor in the range of five to fifty cars per year.
In 2002, MDT armored over 130 vehicles against weapons and explosives, and
another approximately 300 vehicles against vandalism.
Among vehicle manufacturers, Mercedes-Benz has the largest
vehicle-armoring market share, estimated at around 7% of the global market.
Among aftermarket specialists, the largest share of the vehicle-armoring market
is held by O'Gara-Hess & Eisenhardt. Other aftermarket specialists include
International Armoring Corp. Lasco, Texas Armoring and Chicago Armor (Moloney).
Many of these companies have financial, technical, marketing, sales,
manufacturing, distribution and other resources significantly greater than ours.
29
We believes the key factors in our competing successfully in this field
will be our ability to penetrate new military and paramilitary markets outside
of Israel, particularly in North and South America and in Europe.
Backlog
We generally sell our products under standard purchase orders. Orders
constituting our backlog are subject to changes in delivery schedules and are
typically cancelable by our customers until a specified time prior to the
scheduled delivery date. Accordingly, our backlog is not necessarily an accurate
indication of future sales. As of December 31, 2003 and 2002, our backlog for
the following years was approximately $17.2 million and $7.2 million,
respectively, divided among our product lines as follows (backlog for product
lines acquired after December 31, 2003 is given as it stood at such date in the
books of the seller, prior to the acquisition):
- ------------------------------------------------------------------------------------------------------------
Division Product Line 2003 2002
- ------------------------------------------------------------------------------------------------------------
Use-of-force training.................... $ 334,000 $ 2,690,000
Simulation, Training and
Consulting Division
- ------------------------------------------------------------------------------------------------------------
Vehicle simulators*...................... 6,206,000 -
Security consulting...................... 60,000 -
- ------------------------------------------------------------------------------------------------------------
Zinc-Air batteries for the military...... 5,250,000 2,700,000
Battery and Power Systems
Division
- ------------------------------------------------------------------------------------------------------------
Lithium batteries for the military*...... 3,800,000 -
- ------------------------------------------------------------------------------------------------------------
Electric vehicle......................... 436,000 420,000
- ------------------------------------------------------------------------------------------------------------
Water-activated batteries................ 144,000 300,000
- ------------------------------------------------------------------------------------------------------------
Armored Vehicle Division Car armoring............................. 931,000 1,040,000
- -------------------- ------------------------------------------------------------------------
TOTAL:.............................. $ 17,161,000 $ 7,150,000
- -------------------- ------------------------------------------------------------------------
* Not owned at December 31, 2002.
Patents and Trade Secrets
We rely on certain proprietary technology and seek to protect our
interests through a combination of patents, trademarks, copyrights, know-how,
trade secrets and security measures, including confidentiality agreements. Our
policy generally is to secure protection for significant innovations to the
fullest extent practicable. Further, we seek to expand and improve the
technological base and individual features of our products through ongoing
research and development programs.
We rely on the laws of unfair competition and trade secrets to protect
our proprietary rights. We attempt to protect our trade secrets and other
proprietary information through confidentiality and non-disclosure agreements
with customers, suppliers, employees and consultants, and through other security
measures. However, we may be unable to detect the unauthorized use of, or take
appropriate steps to enforce our intellectual property rights. Effective trade
secret protection may not be available in every country in which we offer or
intend to offer our products and services to the same extent as in the United
States. Failure to adequately protect our intellectual property could harm or
even destroy our brands and impair our ability to compete effectively. Further,
enforcing our intellectual property rights could result in the expenditure of
significant financial and managerial resources and may not prove successful.
Although we intend to protect our rights vigorously, there can be no assurance
that these measures will be successful.
30
Research and Development
Research and development is conducted by IES in Denver, Colorado; by
FAAC in Ann Arbor, Michigan; by MDT in Lod, Israel; by EFB in Auburn, Alabama;
by Epsilor in Dimona, Israel; and by EFB and EFL in Beit Shemesh, Israel. During
the years ended December 31, 2003, 2002 and 2001, our gross research and product
development expenditures were approximately $1.1 million, $2.2 million and $4.2
million, respectively, including research and development in discontinued
operations. During these periods, the Office of the Chief Scientist of the
Israel Ministry of Industry and Trade (the "Chief Scientist") participated in
our research and development efforts relating to our consumer battery business,
thereby reducing our gross research and product development expenditures in the
amounts of approximately $26,000, $49,000 and $705,000 for the years 2003, 2002
and 2001, respectively.
EFL has certain contingent royalty obligations to Chief Scientist and
the Israel-U.S. Binational Industrial Research and Development Foundation (BIRD,
which apply (in respect of continuing operations) only to our Electric Vehicle
program. As of December 31, 2003, our total outstanding contingent liability in
this connection was approximately $10.1 million.
Employees
As of February 29, 2004, we had 219 full-time employees worldwide. Of
these employees, 4 hold doctoral degrees and 20 hold other advanced degrees. Of
the total, 52 employees were engaged in product research and development, 125
were engaged in production and operations, 12 were engaged in marketing and
sales, and 30 were engaged in general and administrative functions. Our success
will depend in large part on our ability to attract and retain skilled and
experienced employees.
We and our employees are not parties to any collective bargaining
agreements. However, as certain of our employees are located in Israel and
employed by EFL, MDT or Epsilor, certain provisions of the collective bargaining
agreements between the Histadrut (General Federation of Labor in Israel) and the
Coordination Bureau of Economic Organizations (including the Manufacturers'
Association of Israel) are applicable to EFL's, MDT's and Epsilor's employees by
order (the "Extension Order") of the Israeli Ministry of Labor and Welfare.
These provisions principally concern the length of the work day and the work
week, minimum wages for workers, contributions to a pension fund, insurance for
work-related accidents, procedures for dismissing employees, determination of
severance pay and other conditions of employment, including certain automatic
salary adjustments based on changes in the Israeli CPI.
Israeli law generally requires severance pay upon the retirement or
death of an employee or termination of employment without due cause;
additionally, some of our senior employees have special severance arrangements,
certain of which are described under "Item 11. Executive Compensation -
Employment Contracts," below. We currently fund our ongoing severance
obligations by making monthly payments to approved severance funds or insurance
policies. In addition, Israeli employees and employers are required to pay
specified sums to the National Insurance Institute, which is similar to the
United States Social Security Administration. Since January 1, 1995, such
amounts also include payments for national health insurance. The payments to the
National Insurance Institute are approximately 15.6% of wages, of which the
employee contributes approximately 62% and the employer contributes
approximately 38%. The majority of the permanent employees of EFL, about a
quarter of the permanent employees of MDT, and one of the permanent employees of
Epsilor, are covered by "managers' insurance," which provides life and pension
insurance coverage with customary benefits to employees, including retirement
and severance benefits. We contribute 14.33% to 15.83% (depending on the
employee) of base wages to such plans and the permanent employees contribute 5%
of their base wages.
31
In 1993, an Israeli court held that companies that are subject to the
Extension Order are required to make pension contributions exclusively through
contributions to Mivtachim Social Institute of Employees Ltd., a pension fund
managed by the Histadrut. We subsequently reached an agreement with Mivtachim
with respect to providing coverage to certain production employees and bringing
ourselves into conformity with the court decision. The agreement does not
materially increase our pension costs or otherwise materially adversely affect
its operations. Mivtachim has agreed not to assert any claim against us with
respect to any of our past practices relating to this matter. Although the
arrangement does not bind employees with respect to instituting claims relating
to any nonconformity by us, we believe that the likelihood of the assertion of
claims by employees is low and that any potential claims by employees against
us, if successful, would not result in any material liability to us.
ITEM 2. PROPERTIES
Our New York headquarters, constituting approximately 4,000 square
feet, is located in New York City and subleased on a month-to-month basis.
Beginning April 15, 2004, we will move to new corporate headquarters consisting
of approximately 1,100 square feet, at 250 West 57th Street in New York City,
pursuant to an agreement of lease expiring in June 2009. Under the terms of this
lease, we have an option to request an increase in our leased space of at least
50%, and the failure to provide such increased space in the same building would
enable us to terminate the lease without penalty.
The Auburn, Alabama research and manufacturing facility, constituting
approximately 15,000 square feet, is leased from the City of Auburn through July
2004, with an option to extend the lease for an additional 1 1/2 years at the
same rent and for another three years thereafter at a 10% rent increase. We also
have an option to expand to 30,000 square feet, and we have free use of this
additional space through mid-2004.
Our management and administrative facilities and research, development
and production facilities for the manufacture and assembly of our Survivor
Locator Lights, constituting approximately 18,300 square feet, are located in
Beit Shemesh, Israel, located between Jerusalem and Tel-Aviv (within Israel's
pre-1967 borders). The lease for these facilities in Israel expires on December
31, 2007; we have the ability to terminate the lease every two years upon three
months' written notice. Moreover, we may terminate the lease at any time upon
twelve months written notice.
Our Epsilor subsidiary rents approximately 19,000 square feet of
factory, office and warehouse space in Dimona, Israel, in Israel's Negev desert
(within Israel's pre-1967 borders), on a month-to-month basis.
32
Our IES subsidiary rents approximately 8,900 square feet of office and
warehouse space in Littleton, Colorado, approximately ten miles outside of
Denver, pursuant to a lease expiring in September 2005, with an option to extend
the lease for an additional five years, or until September 2010. IES also holds
an option under certain circumstances to rent an additional 3,200 square feet of
contiguous space.
Our FAAC subsidiary rents approximately 17,800 square feet of office
and warehouse space in Ann Arbor, Michigan, pursuant to a lease expiring in
February 2005, with an option to extend the lease for an additional five years,
or until February 2010.
Our MDT subsidiary rents approximately 20,000 square feet of office
space in Lod, Israel, near Ben-Gurion International airport (within Israel's
pre-1967 borders) pursuant to a lease renewable on an annual basis.
We believe that our existing facilities are adequate to meet our
current and foreseeable future needs.
ITEM 3. LEGAL PROCEEDINGS
As of the date of this filing, there were no material pending legal
proceedings against us.
In October 2003, I.E.S. Group, the parent company of IES Electronics
Industries Ltd., the seller from which we purchased the assets of our IES
subsidiary in 2002, filed a lawsuit in Tel-Aviv District Court against us and
certain of our past and present officers. The complaint alleged breaches by us
of certain of our agreements with IES Electronics Industries Ltd. and claims
monetary damages in the amount of approximately $3 million.
On February 4, 2004, we entered into an agreement settling this
litigation. Pursuant to the terms of the settlement agreement, in addition to
agreeing to dismiss their lawsuit with prejudice, IES Electronics agreed (i) to
cancel our $450,000 debt to them that had been due on December 31, 2003, and
(ii) to transfer to us title to certain certificates of deposit in the
approximate principal amount of $112,000. In consideration of the foregoing, we
issued to IES Electronics (i) 450,000 shares of our common stock, and (ii)
five-year warrants to purchase up to an additional 450,000 shares of our common
stock at a purchase price of $1.91 per share.
The foregoing description of our settlement agreement with IES
Electronics is qualified in its entirety by reference to the summary of the
settlement agreement filed as an exhibit to our Current Report on Form 8-K that
we filed with the SEC on February 5, 2004.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
33
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Since February 1994, our common stock has been traded on the Nasdaq
National Market. Our Nasdaq ticker symbol is currently "ARTX"; prior to February
2003, our Nasdaq ticker symbol was "EFCX." The following table sets forth, for
the periods indicated, the range of high and low closing prices of our common
stock on the Nasdaq National Market System:
Year Ended December 31, 2003 High Low
---- ---
Fourth Quarter.......................... $ 2.86 $ 1.28
Third Quarter........................... $ 1.62 $ 0.81
Second Quarter.......................... $ 1.19 $ 0.49
First Quarter........................... $ 0.66 $ 0.43
Year Ended December 31, 2002
Fourth Quarter.......................... $ 1.06 $ 0.61
Third Quarter........................... $ 1.59 $ 0.83
Second Quarter.......................... $ 1.68 $ 0.73
First Quarter........................... $ 2.20 $ 1.42
As of February 29, 2004 we had approximately 300 holders of record of
our common stock.
Dividends
We have never paid any cash dividends on our common stock. The Board of
Directors presently intends to retain all earnings for use in our business. Any
future determination as to payment of dividends will depend upon our financial
condition and results of operations and such other factors as the Board of
Directors deems relevant.
Recent Sales of Unregistered Securities
Sale of Debentures
Pursuant to the terms of a Securities Purchase Agreement dated
September 30, 2003 (the "Purchase Agreement") by and between Arotech Corporation
and six institutional investors (the "Debenture Holders"), we issued and sold to
the Debenture Holders (i) an aggregate principal amount of $5,000,000 in 8%
secured convertible debentures due September 30, 2006, convertible into shares
of our common stock at any time after January 1, 2004 at a conversion price of
$1.15 per share, and (ii) three-year warrants to purchase up to an aggregate of
1,250,000 shares of our common stock at any time after January 1, 2004 at an
exercise price of $1.4375 per share.
The Debenture Holders also had the right, at their option, at any time
prior to September 30, 2006, to purchase up to an additional $6,000,000 in
debentures (the "Additional Debentures") convertible into shares of our common
stock at any time after January 1, 2004 at a conversion price of $1.45 per
share, and to receive warrants to purchase up to an aggregate of 1,500,000
shares of our common stock at any time after January 1, 2004 (the "Additional
Warrants") at an exercise price of $1.8125 per share. The Debenture Holders
exercised this right pursuant to Amendment and Exercise Agreements dated
December 10, 2003.
34
We also granted to the Debenture Holders supplemental warrants to
purchase up to an aggregate of 1,038,000 shares of our common stock (the
"Supplemental Warrants" and, together with the Additional Warrants, the
"Warrants") at an exercise price of $2.20 per share (the closing price of our
common stock on December 10, 2003 was $1.70 per share) and, on December 18,
2003, we issued to the Debenture Holders the Additional Debentures and the
Warrants.
As of February 29, 2004, we had $7,225,000 principal amount of
Debentures outstanding.
Under the terms of the Purchase Agreement, we granted the Debenture
Holders a first position security interest in the stock of MDT Armor
Corporation, the assets of our IES Interactive Training, Inc. subsidiary, the
stock of our subsidiaries, and in any stock that we acquire in future
Acquisitions (as defined in the Purchase Agreement).
The foregoing description of our agreement with the Debenture Holders
is qualified in its entirety by reference to the agreements with the Debenture
Holders filed as exhibits to our Current Report on Form 8-K that we filed with
the SEC on December 23, 2003.
We issued the above securities in reliance on the exemption from
registration provided by Section 4(2) of the Securities Act as transactions by
an issuer not involving a public offering. The issuance of these securities was
without the use of an underwriter, and the shares of common stock were issued
with restrictive legends permitting transfer thereof only upon registration or
an exemption under the Act.
Issuance of Warrants in Connection with an Offering of Registered Shares
Pursuant to the terms of a Securities Purchase Agreement dated January
7, 2004 (the "SPA") by and between us and several institutional investors (the
"Investors"), we issued and sold to the Investors registered stock off of our
effective shelf registration statement, and three-year warrants to purchase up
to an aggregate of 9,840,426 shares of our common stock at any time beginning
six months after closing (the "Warrants") at an exercise price per share equal
to $1.88. The common stock underlying the Warrants was not registered.
The foregoing description of our agreement with the Investors is
qualified in its entirety by reference to the agreements with the Investors
filed as exhibits to our Current Report on Form 8-K that we filed with the SEC
on January 9, 2004.
We issued the Warrants in reliance on the exemption from registration
provided by Section 4(2) of the Securities Act as transactions by an issuer not
involving a public offering. The issuance of these securities was without the
use of an underwriter, and the Warrants were issued with restrictive legends
permitting transfer thereof and of the shares underlying the Warrants only upon
registration or an exemption under the Act.
Issuance of Shares to a Consultant
Under the terms of an independent contractor agreement between us and
InteSec Group LLC, we pay InteSec a commission in stock of 5% of the military
battery sales that InteSec brings to us from U.S. and NATO defense, security and
military entities and U.S. defense contractors. Pursuant to the terms of this
agreement, in February 2004, we issued 74,215 shares to InteSec.
35
We issued the above securities in reliance on the exemption from
registration provided by Section 4(2) of the Securities Act as transactions by
an issuer not involving a public offering. The issuance of these securities was
without the use of an underwriter, and the shares of common stock were issued
with restrictive legends permitting transfer thereof only upon registration or
an exemption under the Act.
ITEM 6. SELECTED FINANCIAL DATA
The selected financial information set forth below with respect to the
consolidated financial statements for each of the five fiscal years in the
period ended December 31, 2003, and with respect to the balance sheets at the
end of each such fiscal year has been derived from our consolidated financial
statements audited by Kost, Forer, Gabbay & Kassierer, independent certified
public accountants in Israel and a member firm of Ernst & Young Global.
The results of operations, including revenue, operating expenses, and
financial income of the consumer battery segment for the years ended December
31, 2003, 2002, 2001, 2000 and 1999 have been reclassified in the accompanying
statements of operations as discontinued operations. Our balance sheets at
December 31, 2003, 2002, 2001, 2000 and 1999 give effect the assets of the
consumer battery business as discontinued operations within current assets and
liabilities. Thus, the financial information presented herein includes only
continuing operations.
The financial information set forth below is qualified by and should be
read in conjunction with the Consolidated Financial Statements contained in Item
8 of this Report and the notes thereto and "Item 7. Management's Discussion and
Analysis of Financial Condition and Results of Operations," below.
36
Year Ended December 31,
------------------------------------------------------------------------------
1999 2000 2001 2002 2003
---- ---- ---- ---- ----
(dollars in thousands, except per share data)
Statement of Operations Data:
Revenues........................................ $ 2,422 $ 1,490 $ 2,094 $ 6,407 $ 17,326
Research and development expenses and costs of
revenues...................................... 3,867 1,985 2,448 5,108 12,141
Selling, general and administrative expenses
and amortization of intangible assets......... 2,754 3,434 3,934 5,982 10,594
Operating loss.................................. (4,198) (3,929) (4,288) (4,683) (5,409)
Financial income (expenses), net................ 190 544 263 100 (3,470)
Loss before minority interest in loss
(earnings) of subsidiary and tax expenses..... (4,008) (3,385) (4,026) (4,583) (8,879)
Taxes on income................................. (6) - - - (396)
Minority interest in loss (earnings) of
subsidiary.................................... - - - (355) 157
Loss from continuing operations................. (4,014) (3,385) (4,026) (4,938) (9,118)
Income (loss) from discontinued operations...... (2,902) (8,596) (13,261) (13,566) 110
Net loss for the period......................... (6,916) (11,981) (17,287) (18,504) (9,008)
Deemed dividend to certain shareholders of
common stock.................................. - - (1,197) - -
Net loss attributable to shareholders of common
stock ........................................ $ (6,916) $ (11,981) $ (18,483) $ (18,504) $ (9,008)
Basic and diluted net loss per share from
continuing operations......................... $ (0.28) $ (0.18) $ (0.21) $ (0.15) $ (0.23)
Loss per share for combined operations.......... $ (0.48) $ (0.62) $ (0.76) $ (0.57) $ (0.23)
Weighted average number of common shares used
in computing basic and diluted net loss per
share (in thousands).......................... 14,334 19,243 24,200 32,382 38,890
As At December 31,
------------------------------------------------------------------------------
1999 2000 2001 2002 2003
Balance Sheet Data:
Cash, cash equivalents, investments in
marketable debt securities and restricted
collateral deposits........................... $ 2,556 $ 11,596 $ 12,672 $ 2,091 $ 14,391
Receivables and other assets*................... 5,215 13,771 11,515 7,895 8,898
Property and equipment, net of depreciation..... 2,258 2,289 2,221 2,555 2,293
Goodwill and other intangible assets, net....... - - - 7,522 7,440
Total assets.................................... $ 10,029 $ 27,656 $ 26,408 $ 20,063 $ 33,022
Current liabilities*............................ $ 3,427 $ 4,787 $ 3,874 $ 7,272 $ 6,860
Long-term liabilities........................... 2,360 2,791 3,126 3,753 4,118
Stockholders' equity............................ 4,242 20,078 19,408 9,038 22,044
Total liabilities and stockholders equity*...... $ 10,029 $ 27,656 $ 26,408 $ 20,063 $ 33,022
- ------------------------------------
* Includes assets and liabilities, as applicable, from discontinued operations.
37
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following Management's Discussion and Analysis of Financial
Condition and Results of Operations contains forward-looking statements that
involve inherent risks and uncertainties. When used in this discussion, the
words "believes," "anticipated," "expects," "estimates" and similar expressions
are intended to identify such forward-looking statements. Such statements are
subject to certain risks and uncertainties that could cause actual results to
differ materially from those projected. Readers are cautioned not to place undue
reliance on these forward-looking statements, which speak only as of the date
hereof. We undertake no obligation to publicly release the result of any
revisions to these forward-looking statements that may be made to reflect events
or circumstances after the date hereof or to reflect the occurrence of
unanticipated events. Our actual results could differ materially from those
anticipated in these forward-looking statements as a result of certain factors
including, but not limited to, those set forth elsewhere in this report. Please
see "Risk Factors," below, and in our other filings with the Securities and
Exchange Commission.
The following discussion and analysis should be read in conjunction
with the Consolidated Financial Statements contained in Item 8 of this report,
and the notes thereto. We have rounded amounts reported here to the nearest
thousand, unless such amounts are more than 1.0 million, in which event we have
rounded such amounts to the nearest hundred thousand.
General
We are a defense and security products and services company, engaged in
three business areas: interactive simulation for military, law enforcement and
commercial markets; batteries and charging systems for the military; and
high-level armoring for military, paramilitary and commercial vehicles. Until
September 17, 2003, we were known as Electric Fuel Corporation. We operate in
three business units:
>> we develop, manufacture and market advanced hi-tech multimedia
and interactive digital solutions for use-of-force and driving
training of military, law enforcement and security personnel,
as well as offering security consulting and other services
(our Simulation, Training and Consulting Division);
>> we manufacture and sell Zinc-Air and lithium batteries for
defense and security products and other military applications
and we pioneer advancements in Zinc-Air battery technology for
electric vehicles (our Battery and Power Systems Division);
and
>> we utilize sophisticated lightweight materials and advanced
engineering processes to armor vehicles (our Armored Vehicle
Division).
Early in 2004, we acquired two new businesses: FAAC Corporation,
located in Ann Arbor, Michigan, which provides simulators, systems engineering
and software products to the United States military, government and private
industry (which we have placed in our Simulation, Training and Consulting
Division), and Epsilor Electronic Industries, Ltd., located in Dimona, Israel,
which develops and sells rechargeable and primary lithium batteries and smart
chargers to the military and to private industry in the Middle East, Europe and
Asia (which we have placed in our Battery and Power Systems Division). Prior to
the acquisition of FAAC and Epsilor, we were organized into two divisions:
Defense and Security Products (consisting of IES, MDT, MDT Armor and Arocon),
and Electric Fuel Batteries (consisting of EFL and EFB). We have reported our
results of operations for 2003 and 2002 in accordance with these earlier
divisions, and our financial results for 2003 and 2002 do not include the
activities of FAAC or Epsilor.
38
Critical Accounting Policies
The preparation of financial statements requires us to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
the disclosure of contingent liabilities at the date of the financial statements
and the reported amounts of revenues and expenses during the reporting period.
On an ongoing basis, we evaluate our estimates and judgments, including those
related to revenue recognition, allowance for bad debts, inventory, impairment
of intangible assets and goodwill. We base our estimates and judgments on
historical experience and on various other factors that we believe 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. Under different assumptions or
conditions, actual results may differ from these estimates.
We believe the following critical accounting policies, among others,
affect our more significant judgments and estimates used in the preparation of
our consolidated financial statements.
Revenue Recognition and Bad Debt
We generate revenues primarily from sales of multimedia and interactive
digital training systems and use-of-force simulators specifically targeted for
law enforcement and firearms training and from service contracts related to such
sales; from providing lightweight armoring services of vehicles; from sale of
zinc-air battery products for defense applications; and, to a lesser extent,
from development services and long-term arrangements subcontracted by the U.S
government. We recognize revenues in respect of products when, among other
things, we have delivered the goods being purchased and we believe
collectibility to be reasonably assured. We do not grant a right of return to
our customers. We perform ongoing credit evaluations of our customers' financial
condition and we require collateral as deemed necessary. We make judgments as to
our ability to collect outstanding receivables and provide allowances for a
portion of such receivables when and if collection becomes doubtful. Provisions
are made based upon a specific review of all significant outstanding
receivables. In determining the provision, we analyze our historical collection
experience and current economic trends. If the historical data we use to
calculate the allowance provided for doubtful accounts does not reflect the
future ability to collect outstanding receivables, additional provisions for
doubtful accounts may be needed and the future results of operations could be
materially affected.
Revenues from development services are recognized using contract
accounting on a percentage of completion method, based on completion of
agreed-upon milestones and in accordance with the "Output Method" or based on
the time and material basis. Provisions for estimated losses on uncompleted
contracts are recognized in the period in which the likelihood of such losses is
determined.
39
The complexity of the estimation process and the issues related to the
assumptions, risks and uncertainties inherent with the application of the
percentage of completion method of accounting affect the amounts of revenue and
related expenses reported in our consolidated financial statements.
Inventories
Our policy for valuation of inventory and commitments to purchase
inventory, including the determination of obsolete or excess inventory, requires
us to perform a detailed assessment of inventory at each balance sheet date,
which includes a review of, among other factors, an estimate of future demand
for products within specific time horizons, valuation of existing inventory, as
well as product lifecycle and product development plans. The estimates of future
demand that we use in the valuation of inventory are the basis for our revenue
forecast, which is also used for our short-term manufacturing plans. Inventory
reserves are also provided to cover risks arising from slow-moving items. We
write down our inventory for estimated obsolescence or unmarketable inventory
equal to the difference between the cost of inventory and the estimated market
value based on assumptions about future demand and market conditions. We may be
required to record additional inventory write-down if actual market conditions
are less favorable than those projected by our management. For fiscal 2003, no
significant changes were made to the underlying assumptions related to estimates
of inventory valuation or the methodology applied.
Goodwill
Our business acquisitions typically result in the recognition of
goodwill and other intangible assets, which affect the amount of current and
future period charges and amortization expenses. The determination of value of
these components of a business combination, as well as associated asset useful
lives, requires our management to make various estimates and assumptions.
Estimates using different, but each reasonable, assumptions could produce
significantly different results. We test goodwill for possible impairment on an
annual basis and at any other time if an event occurs or circumstances change
that would more likely than not reduce the fair value of a reporting unit below
its carrying amount. Such impairment loss is measured by comparing the
recoverable amount of an asset with its carrying value. The determination of the
value of goodwill requires our management to make assumptions regarding
estimated future cash flows and other factors to determine the fair value of a
respective asset. If these estimates or the related assumptions change in the
future, we could be required to record impairment charges. Any material change
in our valuation of assets in the future and any consequent adjustment for
impairment could have a material adverse impact on our future reported financial
results.
Impairment of long-lived assets and intangibles
Long-lived assets and certain identifiable intangibles are reviewed for
impairment in accordance with Statement of Financial Accounting Standard No. 144
"Accounting for the Impairment or Disposal of Long-Lived Assets" whenever events
or changes in circumstances indicate that the carrying amount of an asset may
not be recoverable. Recoverability of the carrying amount of assets to be held
and used is measured by a comparison of the carrying amount of an asset to the
future undiscounted cash flows expected to be generated by the assets. If such
assets are considered to be impaired, the impairment to be recognized is
measured by the amount by which the carrying amount of the assets exceeds the
fair value of the assets. Assets to be disposed of are reported at the lower of
the carrying amount or fair value less selling costs. As of December 31, 2003,
no impairment losses have been identified.
40
The determination of the value of such long-lived and intangible assets
requires management to make assumptions regarding estimated future cash flows
and other factors to determine the fair value of the respective assets. These
estimates have been based on our business plans for the entities acquired. If
these estimates or the related assumptions change in the future, we could be
required to record impairment charges. Any material change in our valuation of
assets in the future and any consequent adjustment for impairment could have a
material adverse impact on our future reported financial results.
Functional Currency
We consider the United States dollar to be the currency of the primary
economic environment in which we and our Israeli subsidiary EFL operate and,
therefore, both we and EFL have adopted and are using the United States dollar
as our functional currency. Transactions and balances originally denominated in
U.S. dollars are presented at the original amounts. Gains and losses arising
from non-dollar transactions and balances are included in net income.
The majority of financial transactions of our Israeli subsidiaries MDT
and Epsilor is in New Israel Shekels ("NIS") and a substantial portion of MDT's
and Epsilor's costs is incurred in NIS. Management believes that the NIS is the
functional currency of MDT and Epsilor. Accordingly, the financial statements of
MDT and Epsilor have been translated into U.S. dollars. All balance sheet
accounts have been translated using the exchange rates in effect at the balance
sheet date. Statement of operations amounts have been translated using the
average exchange rate for the period. The resulting translation adjustments are
reported as a component of accumulated other comprehensive loss in shareholders'
equity.
Executive Summary
The following executive summary includes, where appropriate, discussion
of our two new subsidiaries, FAAC Incorporated and Epsilor Electronic
Industries, Ltd., that we purchased early in 2004. The results of these
subsidiaries are not included in our results of operations for 2003 and 2002,
but are included in this discussion to the extent that they are relevant to our
anticipated financial condition and results of operations going forward.
Divisions and Subsidiaries
We operate primarily as a holding company, through our various
subsidiaries, which we have organized into three divisions. Our divisions and
subsidiaries (all 100% owned, unless otherwise noted) are as follows:
>> Our Simulation, Training and Consulting Division, consisting
of:
o IES Interactive Training, Inc., located in Littleton,
Colorado, which provides specialized "use of force"
training for police, security personnel and the
military ("IES");
o FAAC Incorporated, located in Ann Arbor, Michigan,
which provides simulators, systems engineering and
software products to the United States military,
government and private industry ("FAAC"); and
41
o Arocon Security Corporation, located in New York, New
York, which provides security consulting and other
services, focusing on protecting life, assets and
operations with minimum hindrance to personal freedom
and daily activities ("Arocon").
>> Our Battery and Power Systems Division, consisting of:
o Electric Fuel Battery Corporation, located in Auburn,
Alabama, which manufactures and sells Zinc-Air fuel
sells, batteries and chargers for the military,
focusing on applications that demand high energy and
light weight ("EFB");
o Epsilor Electronic Industries, Ltd., located in
Dimona, Israel (in Israel's Negev desert area), which
develops and sells rechargeable and primary lithium
batteries and smart chargers to the military and to
private industry in the Middle East, Europe and Asia
("Epsilor"); and
o Electric Fuel (E.F.L.) Ltd., located in Beit Shemesh,
Israel, which produces water-activated lifejacket
lights for commercial aviation and marine
applications, and which conducts our Electric Vehicle
effort, focusing on obtaining and implementing
demonstration projects in the U.S. and Europe, and on
building broad industry partnerships that can lead to
eventual commercialization of our Zinc-Air energy
system for electric vehicles ("EFL").
>> Our Armored Vehicle Division, consisting of:
o MDT Protective Industries, Ltd., located in Lod,
Israel, which specializes in using state-of-the-art
lightweight ceramic materials, special ballistic
glass and advanced engineering processes to fully
armor vans and cars, and is a leading supplier to the
Israeli military, Israeli special forces and special
services ("MDT") (75.5% owned); and
o MDT Armor Corporation, located in Auburn, Alabama,
which conducts MDT's United States activities ("MDT
Armor") (88% owned).
Prior to the acquisition of FAAC and Epsilor, we were organized into
two divisions: Defense and Security Products (consisting of IES, MDT, MDT Armor
and Arocon), and Electric Fuel Batteries (consisting of EFL and EFB). We have
reported our results of operations for 2003 and 2002 in accordance with these
earlier divisions.
Overview of Results of Operations
We incurred significant operating losses for the years ended December
31, 2003, 2002 and 2001. While we expect to continue to derive revenues from the
sale of products that we manufacture and the services that we provide, there can
be no assurance that we will be able to achieve or maintain profitability on a
consistent basis.
42
During 2003, we substantially increased our revenues and reduced our
operating loss, from $18.5 million in 2002 to $9.0 million in 2003. This was
achieved through a combination of cost-cutting measures and increased revenues,
particularly from the sale of Zinc-Air batteries to the military and from sales
of interactive training systems by IES. We believe that our new acquisitions,
FAAC and Epsilor, will contribute to our goal of achieving profitability.
We regard moving the company to a positive cash flow situation on a
consistent basis to be an important goal, and we are focused on achieving that
goal for the second half of 2004 and beyond. In this connection, we note that
most of our business lines historically have had weaker first halves than second
halves, and weaker first quarters than second quarters. We expect this to be the
case for 2004 as well.
A portion of our operating loss during 2003 arose as a result of
non-cash charges. These charges were primarily related to our acquisitions and
to our raising capital. Because we anticipate continuing these activities during
2004, we expect to continue to incur such non-cash charges in the future.
Non-cash charges related to acquisitions arise when the purchase price
for an acquired company exceeds the company's book value. In such a
circumstance, a portion of the excess of the purchase price is recorded as
goodwill, and a portion as intangible assets. In the case of goodwill, the
assets recorded as goodwill are not amortized; instead, we are required to
perform an annual impairment review. If we determine, through the impairment
review process, that goodwill has been impaired, we must record the impairment
charge in our statement of operations. Intangible assets are amortized in
accordance with their useful life. Accordingly, for a period of time following
an acquisition, we incur a non-cash charge in the amount of a fraction (based on
the useful life of the intangible assets) of the amount recorded as intangible
assets. Such non-cash charges will continue during 2004; additionally, our
acquisitions of FAAC and Epsilor will result in our incurring similar non-cash
charges beginning in 2004.
As a result of the application of the above accounting rule, we
incurred non-cash charges in the amount of $865,000 during 2003. See "Critical
Accounting Policies - Goodwill," above.
The non-cash charges that relate to our financings occurred in
connection with our sale of convertible debentures with warrants, and in
connection with our repricing of certain warrants and grants of new warrants.
When we issue convertible debentures, we record an expense for a beneficial
conversion feature that is amortized ratably over the life of the debenture.
When a debenture is converted, however, the entire remaining unamortized
beneficial conversion feature expense is immediately recognized in the quarter
in which the debenture is converted. Similarly, when we issue warrants in
connection with convertible debentures, we record an expense for financial
expenses that is amortized ratably over the term of the warrant; when the
warrant is exercised, the entire remaining unamortized financial expense is
immediately recognized in the quarter in which the warrant is exercised. As and
to the extent that our remaining convertible debentures and warrants are
converted and exercised, we would incur similar non-cash charges going forward.
43
As a result of the application of the above accounting rule, we
incurred non-cash charges in the amount of $3.4 million during 2003.
Additionally, in an effort to improve our cash situation and our
shareholders' equity, and in order to reduce the number of our outstanding
warrants, during 2003 we induced holders of certain of our warrants to exercise
their warrants by lowering the exercise price of the warrants to approximately
market value in exchange for immediate exercise of such warrants, and by issuing
to such investors a lower number of new warrants at a higher exercise price.
Under such circumstances, accounting rules require us to record a compensation
expense in an amount determined based upon the fair value of the new warrants
(using a Black-Scholes pricing model). As and to the extent that we engage in
similar warrant repricings and issuances in the future, we would incur similar
non-cash charges.
As a result of the application of the above accounting rule, we
incurred non-cash charges in the amount of $388,000 during 2003.
We also incurred a non-cash charge in the amount of $839,000 during
2003 arising out of the shares and warrants we granted to IES Electronics in
connection with the settlement of our litigation with them, as a result of and
expense in an amount determined based upon the fair value of these warrants
(using a Black-Scholes pricing model). This charge is not expected to recur.
Overview of Financial Condition and Operating Performance
We shut down our money-losing consumer battery operations and began
acquiring new businesses in the defense and security field in 2002. Since then,
we have concentrated on eliminating our operating deficit and moving Arotech to
cash-flow positive operations. In order to do this, we have focused on acquiring
businesses with strong revenues and profitable operations.
In our Defense and Security Products Division, MDT experienced a
slowdown in revenues during 2003 because MDT's primary customer, the Israel
Defense Forces, reduced orders as a result of cuts in that portion of its budget
that it can spend in Israel. We noted this trend in 2003 and began to work on
reversing it by opening production facilities for MDT Armor in Auburn, Alabama.
As of December 31, 2003, our backlog for MDT totaled $931,000, most of which was
from orders from customers other than the Israel Defense Forces.
IES had record sales in 2003; IES sales have grown from $3.5 million in
2001 (before we owned it) to more than $8.0 million in 2003. We attribute this
to a number of substantial orders, such as orders from the German Police and
from the United States Department of Health and Human Services. Since sales of
new IES simulation systems (as opposed to upgrades and add-ons) have a very long
sales cycle, it is difficult to predict what sales will be like in 2004. As of
December 31, 2003, our backlog for IES totaled $334,000.
In our Electric Fuel Batteries Division, EFB had its first sales in
2003. These sales were almost exclusively from the United States Army, which
continues to use our BA-8180 Zinc-Air battery for its CECOM division. We believe
the war in Iraq had a substantial positive effect on our sales in 2003. However,
we are hopeful that since the war came at a time when we were just beginning the
introduction of our batteries to the Army, much of the falloff in use of our
products that would normally be expected to occur at the war's end (which is not
presently anticipated to occur in the immediate future) will be offset by
growing acceptance of our batteries by soldiers in the field and their supply
officers. As of December 31, 2003, our backlog for EFB totaled $5.3 million.
44
We do not anticipate a substantial change in our revenues from EFL,
either from the water-activated battery line or from the electric vehicle. In
this connection, we have begun an effort to find external financing for
development of our electric vehicle in the form of a partnership or joint
venture, but there can be no assurance that we will succeed in this effort, and
we do not anticipate that our electric vehicle program will provide significant
revenues in 2004.
We anticipate that our acquisitions of Epsilor and FAAC, which occurred
in January 2004, will add to our revenues, our gross profit and our cash flow in
2004.
Results of Operations
Preliminary Note
Results for the years ended December 31, 2003 and 2002 include the
results of IES and MDT for such periods as a result of our acquisitions of these
companies early in the third quarter of 2002. However, the results of IES and
MDT were not included in our operating results for the full year ended December
31, 2002. Accordingly, the following year-to-year comparisons should not
necessarily be relied upon as indications of future performance.
In addition, results are net of the operations of the retail consumer
battery products, which operations were discontinued in the third quarter of
2002.
Following is a table summarizing our results of operations for the
years ended December 31, 2003 and 2002, after which we present a narrative
discussion and analysis:
Year Ended December 31,
----------------------------------------
2003 2002
------------------- -------------------
Revenues:
Defense and Security Products................ $ 11,457,741 $ 4,724,443
Electric Fuel Batteries...................... 5,868,899 1,682,296
All other.................................... - -
------------------- -------------------
$ 17,326,641 $ 6,406,739
Cost of revenues:
Defense and Security Products................ $ 6,566,252 $ 2,380,387
Electric Fuel Batteries...................... 4,521,588 2,041,361
All other.................................... - -
------------------- -------------------
$ 11,087,840 $ 4,421,748
Research and development expenses.:
Defense and Security Products................ $ 216,800 $ 175,796
Electric Fuel Batteries...................... 836,608 510,123
All other.................................... - -
------------------- -------------------
$ 1,053,408 $ 685,919
Sales and marketing expenses:
Defense and Security Products................ $ 2,418,017 $ 636,066
Electric Fuel Batteries...................... 926,872 673,601
All other.................................... 187,747 -
------------------- -------------------
$ 3,532,636 $ 1,309,669
45
Year Ended December 31,
----------------------------------------
2003 2002
------------------- -------------------
General and administrative expenses:
Defense and Security Products................ $ 1,519,458 $ 833,610
Electric Fuel Batteries...................... 188,655 89,945
All other.................................... 4,488,666 3,099,548
------------------- -------------------
$ 6,196,779 $ 4,023,103
Financial expense (income):
Defense and Security Products................ $ (139,668) $ (4,556)
Electric Fuel Batteries...................... 7,936 -
All other.................................... 3,602,191 (95,895)
------------------- -------------------
$ 3,470,459 $ (100,451)
Tax expenses:
Defense and Security Products................ $ 393,303 $ -
Electric Fuel Batteries...................... - -
All other.................................... 2,890 -
------------------- -------------------
$ 396,193 $ -
Amortization of intangible assets:
Defense and Security Products................ $ 864,910 $ 649,543
Electric Fuel Batteries...................... - -
All other.................................... - -
------------------- -------------------
$ 864,910 $ 649,543
Minority interest in loss (profit) of subsidiaries:
Defense and Security Products................ $ 156,900 $ (355,360)
Electric Fuel Batteries...................... - -
All other.................................... - -
------------------- -------------------
$ 156,900 $ (355,360)
Net loss from continuing operations:
Defense and Security Products................ $ 224,431 $ 301,765
Electric Fuel Batteries...................... 612,760 1,632,734
All other.................................... 8,281,493 3,003,653
------------------- -------------------
$ 9,118,684 $ 4,938,152
Net loss (profit) from discontinued operations:
Defense and Security Products................ $ - $ -
Electric Fuel Batteries...................... (110,410) 13,566,206
All other.................................... - -
------------------- -------------------
$ (110,410) $ 13,566,206
Net loss:
Defense and Security Products................ $ 224,431 $ 301,765
Electric Fuel Batteries...................... 502,350 15,198,940
All other.................................... 8,281,493 3,003,653
------------------- -------------------
$ 9,008,274 $ 18,504,358
=================== ===================
Fiscal Year 2003 compared to Fiscal Year 2002
Revenues. During 2003, we (through our subsidiaries) recognized
revenues as follows:
>> IES recognized revenues from the sale of interactive
use-of-force training systems and from the provision of
warranty services in connection with such systems;
>> MDT recognized revenues from payments under vehicle armoring
contracts and for service and repair of armored vehicles;
>> EFB recognized revenues from the sale of batteries and
adapters to the military, and under certain development
contracts with the U.S. Army;
46
>> Arocon recognized revenues under consulting agreements; and
>> EFL recognized revenues from the sale of lifejacket lights and
from subcontracting fees received in connection with Phase III
of the United States Department of Transportation (DOT)
electric bus program, which began in October 2002 and was
completed in March 2004. Phase IV of the DOT program, which
began in October 2003, did not result in any revenues during
2003.
Revenues from continuing operations for the year ended December 31,
2003 totaled $17.3 million, compared to $6.4 million for 2002, an increase of
$10.9 million, or 170%. This increase was primarily the result of increased
sales attributable to IES and EFB, as well as the inclusion of IES and MDT in
our results for the full year of 2003 but only part of 2002.
In 2003, revenues were $11.5 million for the Defense and Security
Products Division (compared to $4.7 million in 2002, an increase of $6.7
million, or 143%, due primarily to increased sales on the part of IES, as well
as the inclusion of IES and MDT in our results for the full year of 2003 but
only part of 2002), and $5.9 million for the Electric Fuel Batteries Division
(compared to $1.7 million in the comparable period in 2002, an increase of $4.2
million, or 249%, due primarily to increased sales to the U.S. Army on the part
of EFB).
Cost of revenues and gross profit. Cost of revenues totaled $11.1
million during 2003, compared to $4.4 million in 2002, an increase of $6.7
million, or 151%, due to increased cost of goods sold, particularly by IES and
EFB, as well as the inclusion of IES and MDT in our results for the full year of
2003 but only part of 2002.
Direct expenses for our two divisions during 2003 were $10.9 million
for the Defense and Security Products Division (compared to $4.4 million in
2002, an increase of $6.5 million, or 150%, due primarily to increased sales
attributable to IES, as well as the inclusion of IES and MDT in our results for
the full year of 2003 but only part of 2002), and $5.9 million for the Electric
Fuel Batteries Division (compared to $3.1 million in the comparable period in
2002, an increase of $2.9 million, or 94%, due primarily to increased sales on
the part of EFB to the U.S. Army).
Gross profit was $6.2 million during 2003, compared to $2.0 million
during 2002, an increase of $4.3 million, or 214%. This increase was the direct
result of all factors presented above, most notably the increased sales of IES
and EFB, as well as the inclusion of IES and MDT in our results for the full
year of 2003 but only part of 2002. In 2003, IES contributed $4.1 million to our
gross profit, EFB contributed $1.6 million, and MDT contributed $833,000.
Research and development expenses. Research and development expenses
for 2003 were $1.1 million, compared to $686,000 in 2002, an increase of
$367,000, or 54%. This increase was primarily because certain research and
development personnel who had worked on the discontinued consumer battery
operations during 2002 (the expenses of which are not reflected in the 2002
number above) were reassigned to military battery research and development in
2003.
47
Sales and marketing expenses. Sales and marketing expenses for 2003
were $3.5 million, compared to $1.3 million in 2002, an increase of $2.2
million, or 170%. This increase was primarily attributable to the following
factors:
>> The inclusion of the sales and marketing expenses of IES and
MDT in our results for the full year of 2003 but only part of
2002;
>> An increase in IES's sales activity during 2003, which
resulted in both increased sales and increased sales and
marketing expenses during 2003; and
>> We incurred expenses for consultants in the amount of $810,000
in connection with our CECOM battery program with the U.S.
Army and $345,000 in connection with our security consulting
business.
General and administrative expenses. General and administrative
expenses for 2003 were $6.2 million, compared to $4.0 million in 2002, an
increase of $2.2 million, or 54%. This increase was primarily attributable to
the following factors:
>> The inclusion of the general and administrative expenses of
IES and MDT in our results for the full year of 2003 but only
part of 2002;
>> Expenses in 2003 in connection with a litigation settlement
agreement, in the amount of $864,000, that were not present in
2002;
>> Expenses in 2003 in connection with warrant repricings, in the
amount of $388,000, that were not present in 2002;
>> Legal and consulting expenses in 2003 in connection with our
convertible debentures, in the amount of $484,000, that were
not present in 2002; and
>> Expenses in 2003 in connection with the start-up of our
security consulting business in the United States and with the
beginning of operations of MDT Armor, in the amount of
250,000, that were not present in 2002.
Financial income (expense). Financial expense totaled approximately
$3.5 million in 2003 compared to financial income of $100,000 in 2002, an
increase of $3.6 million. This increase was due primarily to amortization of
compensation related to the issuance of convertible debentures issued in
December 2002 and during 2003 in the amount of $3.4 million, and interest
expenses related to those debentures in the amount of $376,000.
Tax expenses. We and our Israeli subsidiary EFL incurred net operating
losses during 2003 and 2002 and, accordingly, we were not required to make any
provision for income taxes. MDT and IES had taxable income, and accordingly we
were required to make provision for income taxes in the amount of $396,000 in
2003. We were able to offset IES's federal taxes against our loss carryforwards.
In 2002 we did not accrue any tax expenses due to our belief that we would be
able to utilize our loss carryforwards against MDT's taxable income, estimation
was revised in 2003. Of the amount accrued in 2003, approximately $352,000 was
accrued on account of income in 2002.
48
Amortization of intangible assets and in-process research and
development. Amortization of intangible assets totaled $865,000 in 2003,
compared to $649,000 in 2002, an increase of $215,000, or 33%, resulting from
amortization of these assets subsequent to our acquisition of IES and MDT in
2002. Of this $215,000 increase, $169,000 was attributable to IES and $46,000
was attributable to MDT.
Loss from continuing operations. Due to the factors cited above, we
reported a net loss from continuing operations of $9.1 million in 2003, compared
to a net loss of $4.9 million in 2002, an increase of $4.2 million, or 85%.
Profit (loss) from discontinued operations. In the third quarter of
2002, we decided to discontinue operations relating to the retail sales of our
consumer battery products. Accordingly, all revenues and expenses related to
this segment have been presented in our consolidated statements of operations
for the years ended December 31, 2003 and 2002 in an item entitled "Loss from
discontinued operations."
Profit from discontinued operations in 2003 was $110,000, compared to a
net loss of $13.6 million in 2002, a decrease of $13.7 million. This decrease
was the result of the elimination of the losses from these discontinued
operations beginning with the fourth quarter of 2002. The profit from
discontinued operations was primarily from cancellation of past accruals made
unnecessary by the closing of the discontinued operations.
Net loss. Due to the factors cited above, we reported a net loss of
$9.0 million in 2003, compared to a net loss of $18.5 million in 2002, a
decrease of $9.5 million, or 51%.
Fiscal Year 2002 compared to Fiscal Year 2001
Revenues. Revenues from continuing operations for the year ended
December 31, 2002 totaled $6.4 million, compared to $2.1 million for 2001, an
increase of $4.3 million, or 206%. This increase was primarily the result of the
inclusion of IES and MDT in our results in 2002.
During 2002, we recognized revenues from the sale of interactive
use-of-force training systems (through our IES subsidiary), from payments under
vehicle armoring contracts (through our MDT subsidiary), and from the sale of
lifejacket lights, as well as under contracts with the U.S. Army's CECOM for
deliveries of batteries and for design and procurement of production tooling and
equipment. We also recognized revenues from subcontracting fees received in
connection with Phase II of the United States Department of Transportation (DOT)
program, which began in the fourth quarter of 2001 and was completed in July
2002, and Phase III of the DOT program, which began in October 2002. We
participate in this program as a member of a consortium seeking to demonstrate
the ability of the Electric Fuel battery system to power a full-size,
all-electric transit bus. The total program cost of Phase II was $2.7 million,
50% of which was covered by the DOT subcontracting fees. Subcontracting fees
cover less than all of the expenses and expenditures associated with our
participation in the program. In 2001, we derived revenues principally from the
sale of lifejacket lights, under contracts with the U.S. Army's CECOM for
deliveries of batteries and for design and procurement of production tooling and
equipment and from subcontracting fees received in connection with the DOT
program.
49
In 2002, revenues were $4.7 million for the Defense and Security
Products Division (compared to $0 in 2001), due to the inclusion of IES and MDT
in our 2002 results, and $1.7 million for the Electric Fuel Batteries Division
(compared to $2.1 million in the comparable period in 2001, a decrease of
$411,000, or 20%), due primarily to $471,000 in revenues from a German
consortium project relating to our electric vehicle that were included in 2001
but that did not exist in 2002. Of the $4.7 million increase in Defense and
Security Products revenues, $2.0 million was attributable to the inclusion of
IES in our results in 2002 and $2.7 million was attributable to the inclusion of
MDT in our results in 2002.
Cost of revenues and gross profit. Cost of revenues totaled $4.4
million during 2002, compared to $2.0 million in 2001, an increase of $2.4
million, or 122%, due to the inclusion of IES and MDT in our 2002 results.
Direct expenses for our two divisions during 2002 were $4.4 million for
the Defense and Security Products Division (compared to $0 in 2001), due to the
inclusion of IES and MDT in our 2002 results, and $3.1 million for the Electric
Fuel Batteries Division (compared to $2.3 million in the comparable period in
2001, an increase of $767,000, or 33%), due primarily to the following factors:
>> We began to ramp up production at our CECOM facility in
Alabama in anticipation of the CECOM order that we received in
December 2002; and
>> We wrote off certain disqualified CECOM inventory in the
amount of $116,000.
Of the $4.4 million increase in Defense and Security Products direct
expenses, $2.1 million was attributable to the inclusion of IES in our results
in 2002 and $2.3 million was attributable to the inclusion of MDT in our results
in 2002.
Gross profit was $2.0 million during 2002, compared to $101,000 during
2001, an increase of $1.9 million. This increase was the direct result of all
factors presented above, most notably the inclusion of IES and MDT in our 2002
results. In 2002, IES contributed $1.3 million to our gross profit, and MDT
contributed $1.1 million, which was offset by a gross loss of $360,000 in our
other divisions.
Research and development expenses. Research and development expenses
for 2002 were $686,000, compared to $456,000 in 2001, an increase of $230,000,
or 50%. This increase was primarily the result of the inclusion of IES, which
accounted for $130,000 of the increase, in our 2002 results.
Sales and marketing expenses. Sales and marketing expenses for 2002
were $1.3 million, compared to $106,000 in 2001, an increase of $1.2 million, or
1,136%. This increase was primarily attributable to the following factors:
>> We had sales and marketing expenses in 2002 related to IES of
$572,000, which we did not have in 2001;
50
>> We had sales and marketing expenses in 2002 related to MDT of
$63,000, which we did not have in 2001; and
>> We incurred expenses for consultants, primarily lobbyists, in
the amount of $128,000 in connection with our Electric Vehicle
program and $441,000 in connection with our CECOM battery
program with the U.S. Army.
General and administrative expenses. General and administrative
expenses for 2002 were $4.0 million compared to $3.8 million in 2001, an
increase of $196,000, or 5%. This increase was primarily attributable to the
inclusion of IES and MDT in our results beginning with the third quarter, which
increased general and administrative expenses by approximately $839,000. This
increase was offset by a decrease in general and administrative expenses of
$643,000, resulting from:
>> the dismissal of our litigation with Electrofuel Inc., which
resulted in a decrease in litigation-related legal expenses;
and
>> the settlement of our dispute with a former employee on terms
that resulted in a savings to us over the amount that we had
set aside on our books.
Financial income. Financial income, net of interest expenses and
exchange differentials, totaled approximately $100,000 in 2002 compared to
$263,000 in 2001, a decrease of $163,000, or 62%. This decrease was due
primarily to lower interest rates and lower balances of invested funds as a
result of our use of the proceeds of private placements of our securities.
Income taxes. We and our Israeli subsidiary EFL incurred net operating
losses during 2002 and 2001 and, accordingly, we were not required to make any
provision for income taxes. MDT had taxable income, but we may use EFL's losses
to offset MDT's income, and accordingly MDT has made no provision for income
taxes.
Amortization of intangible assets. Amortization of intangible assets
totaled $649,000 in 2002, compared to $0 in 2001, due to the inclusion of IES
and MDT in our 2002 results. Of this $649,000 increase, $551,000 was
attributable to the inclusion of IES in our results in 2002 and $98,000 was
attributable to the inclusion of MDT in our results in 2002.
Loss from continuing operations. Due to the factors cited above, we
reported a net loss from continuing operations of $4.9 million in 2002, compared
to a net loss of $4.0 million in 2001, an increase of $913,000, or 22%.
Loss from discontinued operations. In the third quarter of 2002, we
decided to discontinue operations relating to the retail sales of our consumer
battery products. Accordingly, all revenues and expenses related to this segment
have been presented in our consolidated statements of operations for the year
ended December 31, 2002 in an item entitled "Loss from discontinued operations."
Loss from discontinued operations in 2002 was $13.6 million, compared
to $13.3 million in 2001, an increase of $306,000, or 2%. This increase was the
result of a write-off of fixed inventory and assets in the amount of $7.1
million in connection with our discontinuation of the operations relating to the
retail sales of our consumer battery products at the end of the third quarter of
2002, which was not entirely offset by the elimination of the losses from these
discontinued operations beginning with the fourth quarter of 2002.
51
Net loss. Due to the factors cited above, we reported a net loss of
$18.5 million in 2002, compared to a net loss of $17.3 million in 2001, an
increase of $1.2 million, or 7%.
Liquidity and Capital Resources
As of December 31, 2003, we had cash and cash equivalents of
approximately $13.7 million, compared with $1.5 million as of December 31, 2002,
an increase of $12.2 million, or 839%. The increase in cash was primarily the
result of sales of our securities during 2003. In January 2004, we raised an
additional $17.8 million, net of expenses, through additional sales of our
securities. As of February 29, 2004, our cash totaled approximately $4.2
million, not including approximately $9.1 million held in restricted deposits to
fund future obligations in connection with such acquisitions, primarily as a
result of our use of cash for the Epsilor and FAAC acquisitions.
We used available funds in 2003 primarily for working capital needs. We
increased our investment in fixed assets by $585,000 during the year ended
December 31, 2003, primarily in the Electric Fuel Batteries Division. Our fixed
assets amounted to $2.3 million as at year end.
Net cash used in operating activities from continuing operations for
2003 and 2002 was $3.0 million and $3.5 million, respectively, a decrease of
$465,000, or 13%. This decrease was primarily the result of changes in operating
assets and liabilities, such as accounts payable and inventory.
Net cash used in investing activities for 2003 and 2002 was $1.8
million and $5.4 million, respectively, a decrease of $3.6 million, or 66%. This
decrease was primarily the result of our investment in the acquisition of IES
and MDT in 2002.
Net cash provided by financing activities for 2003 and 2002 was $17.4
million and $3.1 million, respectively, an increase of $14.3 million, or 464%.
This increase was primarily the result of higher amounts of funds raised through
sales of our securities in 2003 compared to 2002.
During 2003, certain of our employees exercised options under our
registered employee stock option plan. The proceeds to us from the exercised
options were approximately $434,000.
On September 30, 2003 we issued and sold to various institutional
investors an aggregate $5,000,000 principal amount of 8% Secured Convertible
Debentures due September 30, 2006, as more fully described in the Current Report
on Form 8-K that we filed with the Securities and Exchange Commission on October
3, 2003.
On December 18, 2002 we issued and sold to various institutional
investors an aggregate $6,000,000 principal amount of 8% Secured Convertible
Debentures due December 31, 2006, as more fully described under "Item 5. Market
For Registrant's Common Equity and Related Stockholder Matters - Recent Sales of
Unregistered Securities," above.
52
We have approximately $10.5 million in long term debt outstanding, of
which $8.4 million was convertible debt, and approximately $6.9 million in
short-term debt.
We believe that our present cash position and anticipated cash flows
from operations should be sufficient to satisfy our current estimated cash
requirements through the next year. Over the long term, we will need to become
profitable, at least on a cash-flow basis, and maintain that profitability in
order to avoid future capital requirements. Additionally, we would need to raise
additional capital in order to fund any future acquisitions.
Our current debt agreements grant to our investors a right of first
refusal on any future financings, except for underwritten public offerings in
excess of $30 million. We do not believe that this covenant will materially
limit our ability to undertake future financings.
Effective Corporate Tax Rate
Arotech and EFL have incurred net operating losses or had earnings
arising from tax-exempt income during the years ended December 31, 2001, 2002
and 2003 and accordingly no provision for income taxes was required. Taxes in
these entities paid in 2001, 2002 and 2003 are primarily composed of United
States federal alternative minimum taxes.
As of December 31, 2003, we had U.S. net operating loss carry forwards
of approximately $17.0 million that are available to offset future taxable
income, expiring primarily in 2015, and foreign net operating and capital loss
carry forwards of approximately $84.0 million, which are available indefinitely
to offset future taxable income.
Contractual Obligations
The following table lists our contractual obligations and commitments
as of December 31, 2003:
Contractual Obligations Payment Due by Period
- ------------------------------ ------------------------------------------------------------------------------------
Total Less Than 1 Year 1-3 Years 3-5 Years More than 5 Years
- ------------------------------ ---------------- ---------------- ---------------- ---------------- ----------------
Long-term debt*............... $ 8,525,000 $ - $ 8,525,000 $ - $ -
Short-term debt............... $ 190,849 $ 190,849 $ - $ - $ -
Operating lease obligations... $ 590,778 $ 393,512 $ 197,266 $ - $ -
Severance obligations......... $ 1,749,391 $ 183,056 $ 1,387,738 $ - $ 178,597
- -------------------
* Includes convertible debentures in the gross amount of $8,375,000.
Unamortized financial expenses related to the beneficial conversion feature
of these convertible debentures amounted to $7,493,056 at year end.
RISK FACTORS
The following factors, among others, could cause actual results to
differ materially from those contained in forward-looking statements made in
this Report and presented elsewhere by management from time to time.
Business-Related Risks
We have had a history of losses and may incur future losses.
We were incorporated in 1990 and began our operations in 1991. We have
funded our operations principally from funds raised in each of the initial
public offering of our common stock in February 1994; through subsequent public
and private offerings of our common stock and equity and debt securities
convertible into shares of our common stock; research contracts and supply
contracts; funds received under research and development grants from the
Government of Israel; and sales of products that we and our subsidiaries
manufacture. We have incurred significant operating losses since our inception.
Additionally, as of December 31, 2003, we had an accumulated deficit of
approximately $110.0 million. There can be no assurance that we will ever be
able to maintain profitability consistently or that our business will continue
to exist.
53
Our existing indebtedness may adversely affect our ability to obtain
additional funds and may increase our vulnerability to economic or business
downturns.
Our indebtedness aggregated approximately $8.7 million as of December
31, 2003. Accordingly, we are subject to the risks associated with indebtedness,
including:
o we must dedicate a portion of our cash flows from operations
to pay debt service costs and, as a result, we have less funds
available for operations, future acquisitions of consumer
receivable portfolios, and other purposes;
o it may be more difficult and expensive to obtain additional
funds through financings, if available at all;
o we are more vulnerable to economic downturns and fluctuations
in interest rates, less able to withstand competitive
pressures and less flexible in reacting to changes in our
industry and general economic conditions; and
o if we default under any of our existing debt instruments or if
our creditors demand payment of a portion or all of our
indebtedness, we may not have sufficient funds to make such
payments.
The occurrence of any of these events could materially adversely affect our
results of operations and financial condition and adversely affect our stock
price.
The agreements governing the terms of our debentures contain numerous
affirmative and negative covenants that limit the discretion of our management
with respect to certain business matters and place restrictions on us, including
obligations on our part to preserve and maintain our assets and restrictions on
our ability to incur or guarantee debt, to merge with or sell our assets to
another company, and to make significant capital expenditures without the
consent of the debenture holders. Our ability to comply with these and other
provisions of such agreements may be affected by changes in economic or business
conditions or other events beyond our control.
Failure to comply with the terms of our debentures could result in a
default that could have material adverse consequences for us.
A failure to comply with the obligations contained in our debenture
agreements could result in an event of default under such agreements which could
result in an acceleration of the debentures and the acceleration of debt under
other instruments evidencing indebtedness that may contain cross-acceleration or
cross-default provisions. If the indebtedness under the debentures or other
indebtedness were to be accelerated, there can be no assurance that our assets
would be sufficient to repay in full such indebtedness.
54
We have pledged a substantial portion of our assets to secure our
borrowings.
Our debentures are secured by a substantial portion of our assets. If
we default under the indebtedness secured by our assets, those assets would be
available to the secured creditors to satisfy our obligations to the secured
creditors, which could materially adversely affect our results of operations and
financial condition and adversely affect our stock price.
We need significant amounts of capital to operate and grow our business.
We require substantial funds to market our products and develop and
market new products. To the extent that we are unable to fully fund our
operations through profitable sales of our products and services, we may
continue to seek additional funding, including through the issuance of equity or
debt securities. However, there can be no assurance that we will obtain any such
additional financing in a timely manner or on acceptable terms. If additional
funds are raised by issuing equity securities, stockholders may incur further
dilution. If additional funding is not secured, we will have to modify, reduce,
defer or eliminate parts of our anticipated future commitments and/or programs.
We may not be successful in operating a new business.
Prior to the acquisitions of IES and MDT in 2002 and the acquisitions
of FAAC and Epsilor early in 2004, our primary business was the marketing and
sale of products based on primary and refuelable Zinc-Air fuel cell technology
and advancements in battery technology for defense and security products and
other military applications, electric vehicles and consumer electronics. As a
result of our acquisitions, a substantial component of our business is the
marketing and sale of hi-tech multimedia and interactive training solutions and
sophisticated lightweight materials and advanced engineering processes used to
armor vehicles. These are new businesses for us and our management group has
limited experience operating these types of businesses. Although we have
retained our acquired companies' management personnel, we cannot assure that
such personnel will continue to work for us or that we will be successful in
managing this new business. If we are unable to successfully operate these new
businesses, our business, financial condition and results of operations could be
materially impaired.
Our acquisition strategy involves various risks.
Part of our strategy is to grow through the acquisition of companies
that will complement our existing operations or provide us with an entry into
markets we do not currently serve. Growth through acquisitions involves
substantial risks, including the risk of improper valuation of the acquired
business and the risk of inadequate integration. There can be no assurance that
suitable acquisition candidates will be available, that we will be able to
acquire or manage profitably such additional companies or that future
acquisitions will produce returns that justify our investments therein. In
addition, we may compete for acquisition and expansion opportunities with
companies that have significantly greater resources than we do. Furthermore,
acquisitions could disrupt our ongoing business, distract the attention of our
senior managers, make it difficult to maintain our operational standards,
controls and procedures and subject us to contingent and latent risks that are
different, in nature and magnitude, than the risks we currently face.
We may finance future acquisitions with cash from operations or
additional debt or equity financings. There can be no assurance that we will be
able to generate internal cash or obtain financing from external sources or
that, if available, such financing will be on terms acceptable to us. The
issuance of additional common stock to finance acquisitions may result in
substantial dilution to our stockholders. Any debt financing may significantly
increase our leverage and may involve restrictive covenants which limit our
operations.
55
We may not successfully integrate our new acquisitions.
In light of our recent acquisitions of IES, MDT, FAAC and Epsilor, our
success will depend in part on our ability to manage the combined operations of
these companies and to integrate the operations and personnel of these companies
along with our other subsidiaries and divisions into a single organizational
structure. There can be no assurance that we will be able to effectively
integrate the operations of our subsidiaries and divisions and our
newly-acquired businesses into a single organizational structure. Integration of
these operations could also place additional pressures on our management as well
as on our key technical resources. The failure to successfully manage this
integration could have an adverse material effect on us.
If we are successful in acquiring additional businesses, we may
experience a period of rapid growth that could place significant additional
demands on, and require us to expand, our management, resources and management
information systems. Our failure to manage any such rapid growth effectively
could have a material adverse effect on our financial condition, results of
operations and cash flows.
If we are unable to manage our growth, our operating results will be
impaired.
We are currently experiencing a period of growth and development
activity which could place a significant strain on our personnel and resources.
Our activity has resulted in increased levels of responsibility for both
existing and new management personnel. Many of our management personnel have had
limited or no experience in managing growing companies. We have sought to manage
our current and anticipated growth through the recruitment of additional
management and technical personnel and the implementation of internal systems
and controls. However, our failure to manage growth effectively could adversely
affect our results of operations.
A significant portion of our business is dependent on government contracts.
Many of the customers of IES and FAAC to date have been in the public
sector of the U.S., including the federal, state and local governments, and in
the public sectors of a number of other countries, and most of MDT's customers
have been in the public sector in Israel, in particular the Ministry of Defense.
Additionally, all of EFB's sales to date of battery products for the military
and defense sectors have been in the public sector in the United States. A
significant decrease in the overall level or allocation of defense spending or
law enforcement in the U.S. or other countries could have a material adverse
effect on our future results of operations and financial condition. MDT has
already experienced a slowdown in orders from the Ministry of Defense due to
budget constraints and a requirement of U.S. aid to Israel that a substantial
proportion of such aid be spent in the U.S., where MDT has only recently opened
a factory in operation.
Sales to public sector customers are subject to a multiplicity of
detailed regulatory requirements and public policies as well as to changes in
training and purchasing priorities. Contracts with public sector customers may
be conditioned upon the continuing availability of public funds, which in turn
depends upon lengthy and complex budgetary procedures, and may be subject to
certain pricing constraints. Moreover, U.S. government contracts and those of
many international government customers may generally be terminated for a
variety of factors when it is in the best interests of the government and
contractors may be suspended or debarred for misconduct at the discretion of the
government. There can be no assurance that these factors or others unique to
government contracts or the loss or suspension of necessary regulatory licenses
will not have a material adverse effect on our future results of operations and
financial condition.
56
Our U.S. government contracts may be terminated at any time and may contain
other unfavorable provisions.
The U.S. government typically can terminate or modify any of its
contracts with us either for its convenience or if we default by failing to
perform under the terms of the applicable contract. A termination arising out of
our default could expose us to liability and have a material adverse effect on
our ability to re-compete for future contracts and orders. Our U.S. government
contracts contain provisions that allow the U.S. government to unilaterally
suspend us from receiving new contracts pending resolution of alleged violations
of procurement laws or regulations, reduce the value of existing contracts,
issue modifications to a contract and control and potentially prohibit the
export of our products, services and associated materials.
A negative audit by the U.S. government could adversely affect our
business, and we might not be reimbursed by the government for costs that we
have expended on our contracts.
Government agencies routinely audit government contracts. These
agencies review a contractor's performance on its contract, pricing practices,
cost structure and compliance with applicable laws, regulations and standards.
If we are audited, we will not be reimbursed for any costs found to be
improperly allocated to a specific contract, while we would be required to
refund any improper costs for which we had already been reimbursed. Therefore,
an audit could result in a substantial adjustment to our revenues. If a
government audit uncovers improper or illegal activities, we may be subject to
civil and criminal penalties and administrative sanctions, including termination
of contracts, forfeitures of profits, suspension of payments, fines and
suspension or debarment from doing business with United States government
agencies. We could suffer serious reputational harm if allegations of
impropriety were made against us. A governmental determination of impropriety or
illegality, or an allegation of impropriety, could have a material adverse
effect on our business, financial condition or results of operations.
We may be liable for penalties under a variety of procurement rules and
regulations, and changes in government regulations could adversely impact our
revenues, operating expenses and profitability.
Our defense and commercial businesses must comply with and are affected
by various government regulations that impact our operating costs, profit
margins and our internal organization and operation of our businesses. Among the
most significant regulations are the following:
o the U.S. Federal Acquisition Regulations, which regulate the
formation, administration and performance of government
contracts;
o the U.S. Truth in Negotiations Act, which requires
certification and disclosure of all cost and pricing data in
connection with contract negotiations; and
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o the U.S. Cost Accounting Standards, which impose accounting
requirements that govern our right to reimbursement under
certain cost-based government contracts.
These regulations affect how we and our customers do business and, in
some instances, impose added costs on our businesses. Any changes in applicable
laws could adversely affect the financial performance of the business affected
by the changed regulations. With respect to U.S. government contracts, any
failure to comply with applicable laws could result in contract termination,
price or fee reductions or suspension or debarment from contracting with the
U.S. government.
Our operating margins may decline under our fixed-price contracts if we
fail to estimate accurately the time and resources necessary to satisfy our
obligations.
Some of our contracts are fixed-price contracts under which we bear the
risk of any cost overruns. Our profits are adversely affected if our costs under
these contracts exceed the assumptions that we used in bidding for the contract.
In 2003, approximately 36% of our revenues were derived from fixed-price
contracts for both defense and non-defense related government contracts. Often,
we are required to fix the price for a contract before we finalize the project
specifications, which increases the risk that we will mis-price these contracts.
The complexity of many of our engagements makes accurately estimating our time
and resources more difficult.
If we are unable to retain our contracts with the U.S. government and
subcontracts under U.S. government prime contracts in the competitive rebidding
process, our revenues may suffer.
Upon expiration of a U.S. government contract or subcontract under a
U.S. government prime contract, if the government customer requires further
services of the type provided in the contract, there is frequently a competitive
rebidding process. We cannot guarantee that we, or if we are a subcontractor
that the prime contractor, will win any particular bid, or that we will be able
to replace business lost upon expiration or completion of a contract. Further,
all U.S. government contracts are subject to protest by competitors. The
termination of several of our significant contracts or nonrenewal of several of
our significant contracts, could result in significant revenue shortfalls.
We cannot assure you of market acceptance of our electric vehicle
technology.
Our batteries for the defense industry and a signal light powered by
water-activated batteries for use in life jackets and other rescue apparatus are
the only commercial Zinc-Air battery products we currently have available for
sale. Significant resources will be required to develop and produce additional
products utilizing this technology on a commercial scale. Additional development
will be necessary in order to commercialize our technology and each of the
components of the Electric Fuel System for electric vehicles. We cannot assure
you that we will be able to successfully develop, engineer or commercialize our
Zinc-Air energy system. The likelihood of our future success must be considered
in light of the risks, expenses, difficulties and delays frequently encountered
in connection with the operation and development of a relatively early stage
business and with development activities generally.
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We believe that public pressure and government initiatives are
important factors in creating an electric vehicle market. However, there can be
no assurance that there will be sufficient public pressure or that further
legislation or other governmental initiatives will be enacted, or that current
legislation will not be repealed, amended, or have its implementation delayed.
In addition, we are subject to the risk that even if an electric fuel vehicle
market develops, a different form of zero emission or low emission vehicle will
dominate the market. In addition, we cannot assure you that other solutions to
the problem of containing emissions created by internal combustion engines will
not be invented, developed and produced. Any other solution could achieve
greater market acceptance than electric vehicles. The failure of a significant
market for electric vehicles to develop would have a material adverse effect on
our ability to commercialize this aspect of our technology. Even if a
significant market for electric vehicles develops, there can be no assurance
that our technology will be commercially competitive within that market.
Some of the components of our electric vehicle technology and our products
pose potential safety risks which could create potential liability exposure for
us.
Some of the components of our electric vehicle technology and our
products contain elements that are known to pose potential safety risks. Also,
because electric vehicle batteries contain large amounts of electrical energy,
they may cause injuries if not handled properly. In addition to these risks, and
there can be no assurance that accidents in our facilities will not occur. Any
accident, whether occasioned by the use of all or any part of our products or
technology or by our manufacturing operations, could adversely affect commercial
acceptance of our products and could result in significant production delays or
claims for damages resulting from injuries. Any of these occurrences would
materially adversely affect our operations and financial condition.
We may face product liability claims.
In the event that our products, including the products manufactured by
MDT, fail to perform as specified, users of these products may assert claims for
substantial amounts. These claims could have a materially adverse effect on our
financial condition and results of operations. There is no assurance that the
amount of the general product liability insurance that we maintain will be
sufficient to cover potential claims or that the present amount of insurance can
be maintained at the present level of cost, or at all.
Our fields of business are highly competitive.
The competition to develop defense and security products and electric
vehicle battery systems, and to obtain funding for the development of these
products, is, and is expected to remain, intense.
Our defense and security products compete with other manufacturers of
specialized training systems, including Firearms Training Systems, Inc., a
producer of interactive simulation systems designed to provide training in the
handling and use of small and supporting arms. In addition, we compete with
manufacturers and developers of armor for cars and vans, including O'Gara-Hess &
Eisenhardt, a division of Armor Holdings, Inc.
Our battery technology competes with other battery technologies, as
well as other Zinc-Air technologies. The competition in this area of our
business consists of development stage companies, major international companies
and consortia of such companies, including battery manufacturers, automobile
manufacturers, energy production and transportation companies, consumer goods
companies and defense contractors. Many of our competitors have financial,
technical, marketing, sales, manufacturing, distribution and other resources
significantly greater than ours.
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Various battery technologies are being considered for use in electric
vehicles and defense and safety products by other manufacturers and developers,
including the following: lead-acid, nickel-cadmium, nickel-iron, nickel-zinc,
nickel-metal hydride, sodium-sulfur, sodium-nickel chloride, zinc-bromine,
lithium-ion, lithium-polymer, lithium-iron sulfide, primary lithium,
rechargeable alkaline and Zinc-Air.
If we are unable to compete successfully in each of our operating
areas, especially in the defense and security products area of our business, our
business and results of operations could be materially adversely affected.
Our business is dependent on proprietary rights that may be difficult to
protect and could affect our ability to compete effectively.
Our ability to compete effectively will depend on our ability to
maintain the proprietary nature of our technology and manufacturing processes
through a combination of patent and trade secret protection, non-disclosure
agreements and licensing arrangements.
Litigation, or participation in administrative proceedings, may be
necessary to protect our proprietary rights. This type of litigation can be
costly and time consuming and could divert company resources and management
attention to defend our rights, and this could harm us even if we were to be
successful in the litigation. In the absence of patent protection, and despite
our reliance upon our proprietary confidential information, our competitors may
be able to use innovations similar to those used by us to design and manufacture
products directly competitive with our products. In addition, no assurance can
be given that others will not obtain patents that we will need to license or
design around. To the extent any of our products are covered by third-party
patents, we could need to acquire a license under such patents to develop and
market our products.
Despite our efforts to safeguard and maintain our proprietary rights,
we may not be successful in doing so. In addition, competition is intense, and
there can be no assurance that our competitors will not independently develop or
patent technologies that are substantially equivalent or superior to our
technology. Moreover, in the event of patent litigation, we cannot assure you
that a court would determine that we were the first creator of inventions
covered by our issued patents or pending patent applications or that we were the
first to file patent applications for those inventions. If existing or future
third-party patents containing broad claims were upheld by the courts or if we
were found to infringe third party patents, we may not be able to obtain the
required licenses from the holders of such patents on acceptable terms, if at
all. Failure to obtain these licenses could cause delays in the introduction of
our products or necessitate costly attempts to design around such patents, or
could foreclose the development, manufacture or sale of our products. We could
also incur substantial costs in defending ourselves in patent infringement suits
brought by others and in prosecuting patent infringement suits against
infringers.
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We also rely on trade secrets and proprietary know-how that we seek to
protect, in part, through non-disclosure and confidentiality agreements with our
customers, employees, consultants, and entities with which we maintain strategic
relationships. We cannot assure you that these agreements will not be breached,
that we would have adequate remedies for any breach or that our trade secrets
will not otherwise become known or be independently developed by competitors.
We are dependent on key personnel and our business would suffer if we fail
to retain them.
We are highly dependent on the presidents of our IES and FAAC
subsidiaries and the general managers of our MDT and Epsilor subsidiaries, and
the loss of the services of one or more of these persons could adversely affect
us. We are especially dependent on the services of our Chairman, President and
Chief Executive Officer, Robert S. Ehrlich. The loss of Mr. Ehrlich could have a
material adverse effect on us. We are party to an employment agreement with Mr.
Ehrlich, which agreement expires at the end of 2005. We do not have key-man life
insurance on Mr. Ehrlich.
There are risks involved with the international nature of our business.
A significant portion of our sales are made to customers located
outside the U.S., primarily in Europe and Asia. In 2003, 2002 and 2001, without
taking account of revenues derived from discontinued operations, 42%, 56% and
49%, respectively, of our revenues, were derived from sales to customers located
outside the U.S. We expect that our international customers will continue to
account for a substantial portion of our revenues in the near future. Sales to
international customers may be subject to political and economic risks,
including political instability, currency controls, exchange rate fluctuations,
foreign taxes, longer payment cycles and changes in import/export regulations
and tariff rates. In addition, various forms of protectionist trade legislation
have been and in the future may be proposed in the U.S. and certain other
countries. Any resulting changes in current tariff structures or other trade and
monetary policies could adversely affect our sales to international customers.
Investors should not purchase our common stock with the expectation of
receiving cash dividends.
We currently intend to retain any future earnings for funding growth
and, as a result, do not expect to pay any cash dividends in the foreseeable
future.
Market-Related Risks
The price of our common stock is volatile.
The market price of our common stock has been volatile in the past and
may change rapidly in the future. The following factors, among others, may cause
significant volatility in our stock price:
o Announcements by us, our competitors or our customers;
o The introduction of new or enhanced products and services by
us or our competitors;
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o Changes in the perceived ability to commercialize our
technology compared to that of our competitors;
o Rumors relating to our competitors or us;
o Actual or anticipated fluctuations in our operating results;
and
o General market or economic conditions.
If our shares were to be delisted, our stock price might decline further
and we might be unable to raise additional capital.
One of the continued listing standards for our stock on the Nasdaq
National Market is the maintenance of a $1.00 bid price. Our stock price has
periodically traded below $1.00 in the recent past. If our bid price were to go
and remain below $1.00 for 30 consecutive business days, Nasdaq could notify us
of our failure to meet the continued listing standards, after which we would
have 180 calendar days to correct such failure or be delisted from the Nasdaq
National Market.
Although we would have the opportunity to appeal any potential
delisting, there can be no assurances that this appeal would be resolved
favorably. As a result, there can be no assurance that our common stock will
remain listed on the Nasdaq National Market. If our common stock were to be
delisted from the Nasdaq National Market, we might apply to be listed on the
Nasdaq SmallCap market; however, there can be no assurance that we would be
approved for listing on the Nasdaq SmallCap market, which has the same $1.00
minimum bid and other similar requirements as the Nasdaq National Market. If we
were to move to the Nasdaq SmallCap market, current Nasdaq regulations would
give us the opportunity to obtain an additional 180-day grace period and an
additional 90-day grace period after that if we meet certain net income,
stockholders' equity or market capitalization criteria. While our stock would
continue to trade on the over-the-counter bulletin board following any delisting
from the Nasdaq, any such delisting of our common stock could have an adverse
effect on the market price of, and the efficiency of the trading market for, our
common stock. Also, if in the future we were to determine that we need to seek
additional equity capital, it could have an adverse effect on our ability to
raise capital in the public equity markets.
In addition, if we fail to maintain Nasdaq listing for our securities,
and no other exclusion from the definition of a "penny stock" under the
Securities Exchange Act of 1934, as amended, is available, then any broker
engaging in a transaction in our securities would be required to provide any
customer with a risk disclosure document, disclosure of market quotations, if
any, disclosure of the compensation of the broker-dealer and its salesperson in
the transaction and monthly account statements showing the market values of our
securities held in the customer's account. The bid and offer quotation and
compensation information must be provided prior to effecting the transaction and
must be contained on the customer's confirmation. If brokers become subject to
the "penny stock" rules when engaging in transactions in our securities, they
would become less willing to engage in transactions, thereby making it more
difficult for our stockholders to dispose of their shares.
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A substantial number of our shares are available for sale in the public
market and sales of those shares could adversely affect our stock price.
Sales of a substantial number of shares of common stock into the public
market, or the perception that those sales could occur, could adversely affect
our stock price or could impair our ability to obtain capital through an
offering of equity securities. As of February 29, 2004, we had 59,904,449 shares
of common stock issued and outstanding. Of these shares, most are freely
transferable without restriction under the Securities Act of 1933, and a
substantial portion of the remaining shares may be sold subject to the volume
restrictions, manner-of-sale provisions and other conditions of Rule 144 under
the Securities Act of 1933.
In connection with a stock purchase agreement dated September 30, 1996
between Leon S. Gross and us, we also entered into a registration rights
agreement with Mr. Gross dated September 30, 1996, providing registration rights
with respect to the shares of common stock issued to Mr. Gross in connection
with the offering. These rights include the right to make two demands for the
registration of the shares of our common stock owned by Mr. Gross. In addition,
Mr. Gross was granted unlimited rights to "piggyback" on registration statements
that we file for the sale of our common stock. Mr. Gross presently owns
3,482,534 shares, of which 1,538,462 have never been registered.
Exercise of our warrants, options and convertible debt could adversely
affect our stock price and will be dilutive.
As of February 29, 2004, there were outstanding warrants to purchase a
total of 19,302,156 shares of our common stock at a weighted average exercise
price of $1.85 per share, options to purchase a total of 9,627,212 shares of our
common stock at a weighted average exercise price of $1.48 per share, of which
6,477,440 were vested, at a weighted average exercise price of $1.67 per share,
and outstanding debentures convertible into a total of 5,203,149 shares of our
common stock at a weighted average conversion price of $1.39 per share. Holders
of our options, warrants and convertible debt will probably exercise or convert
them only at a time when the price of our common stock is higher than their
respective exercise or conversion prices. Accordingly, we may be required to
issue shares of our common stock at a price substantially lower than the market
price of our stock. This could adversely affect our stock price. In addition, if
and when these shares are issued, the percentage of our common stock that
existing stockholders own will be diluted.
Our certificate of incorporation and bylaws and Delaware law contain
provisions that could discourage a takeover.
Provisions of our amended and restated certificate of incorporation may
have the effect of making it more difficult for a third party to acquire, or of
discouraging a third party from attempting to acquire, control of us. These
provisions could limit the price that certain investors might be willing to pay
in the future for shares of our common stock. These provisions:
o divide our board of directors into three classes serving
staggered three-year terms;
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o only permit removal of directors by stockholders "for cause,"
and require the affirmative vote of at least 85% of the
outstanding common stock to so remove; and
o allow us to issue preferred stock without any vote or further
action by the stockholders.
The classification system of electing directors and the removal provision
may tend to discourage a third-party from making a tender offer or otherwise
attempting to obtain control of us and may maintain the incumbency of our board
of directors, as the classification of the board of directors increases the
difficulty of replacing a majority of the directors. These provisions may have
the effect of deferring hostile takeovers, delaying changes in our control or
management, or may make it more difficult for stockholders to take certain
corporate actions. The amendment of any of these provisions would require
approval by holders of at least 85% of the outstanding common stock.
Israel-Related Risks
A significant portion of our operations takes place in Israel, and we could
be adversely affected by the economic, political and military conditions in that
region.
The offices and facilities of three of our subsidiaries, EFL, MDT and
Epsilor, are located in Israel (in Beit Shemesh, Lod and Dimona, respectively,
all of which are within Israel's pre-1967 borders). Most of our senior
management is located at EFL's facilities. Although we expect that most of our
sales will be made to customers outside Israel, we are nonetheless directly
affected by economic, political and military conditions in that country.
Accordingly, any major hostilities involving Israel or the interruption or
curtailment of trade between Israel and its present trading partners could have
a material adverse effect on our operations. Since the establishment of the
State of Israel in 1948, a number of armed conflicts have taken place between
Israel and its Arab neighbors and a state of hostility, varying in degree and
intensity, has led to security and economic problems for Israel.
Historically, Arab states have boycotted any direct trade with Israel
and to varying degrees have imposed a secondary boycott on any company carrying
on trade with or doing business in Israel. Although in October 1994, the states
comprising the Gulf Cooperation Council (Saudi Arabia, the United Arab Emirates,
Kuwait, Dubai, Bahrain and Oman) announced that they would no longer adhere to
the secondary boycott against Israel, and Israel has entered into certain
agreements with Egypt, Jordan, the Palestine Liberation Organization and the
Palestinian Authority, Israel has not entered into any peace arrangement with
Syria or Lebanon. Moreover, since September 2000, there has been a significant
deterioration in Israel's relationship with the Palestinian Authority, and a
significant increase in terror and violence. Efforts to resolve the problem have
failed to result in an agreeable solution. Continued hostilities between the
Palestinian community and Israel and any failure to settle the conflict may have
a material adverse effect on our business and us. Moreover, the current
political and security situation in the region has already had an adverse effect
on the economy of Israel, which in turn may have an adverse effect on us.
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Some of our employees are currently obligated to perform annual reserve
duty in the Israel Defense Forces and are subject to being called for active
military duty at any time. No assessment can be made of the full impact of such
requirements on us in the future, particularly if emergency circumstances occur,
and no prediction can be made as to the effect on us of any expansion of these
obligations. However, further deterioration of hostilities with the Palestinian
community into a full-scale conflict might require more widespread military
reserve service by some of our employees, which could have a material adverse
effect on our business.
Service of process and enforcement of civil liabilities on us and our
officers may be difficult to obtain.
We are organized under the laws of the State of Delaware and will be
subject to service of process in the United States. However, approximately 35%
of our assets are located outside the United States. In addition, two of our
directors and all of our executive officers are residents of Israel and a
portion of the assets of such directors and executive officers are located
outside the United States.
There is doubt as to the enforceability of civil liabilities under the
Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as
amended, in original actions instituted in Israel. As a result, it may not be
possible for investors to enforce or effect service of process upon these
directors and executive officers or to judgments of U.S. courts predicated upon
the civil liability provisions of U.S. laws against our assets, as well as the
assets of these directors and executive officers. In addition, awards of
punitive damages in actions brought in the U.S. or elsewhere may be
unenforceable in Israel.
Exchange rate fluctuations between the U.S. dollar and the Israeli NIS may
negatively affect our earnings.
Although a substantial majority of our revenues and a substantial portion of our
expenses are denominated in U.S. dollars, a portion of our costs, including
personnel and facilities-related expenses, is incurred in New Israeli Shekels
(NIS). Inflation in Israel will have the effect of increasing the dollar cost of
our operations in Israel, unless it is offset on a timely basis by a devaluation
of the NIS relative to the dollar. In 2003, the inflation adjusted NIS
appreciated against the dollar, which raised the dollar cost of our Israeli
operations.
Some of our agreements are governed by Israeli law.
Israeli law governs some of our agreements, such as our lease
agreements on our subsidiaries' premises in Israel, and the agreements pursuant
to which we purchased IES, MDT and Epsilor. While Israeli law differs in certain
respects from American law, we do not believe that these differences materially
adversely affect our rights or remedies under these agreements.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Interest Rate Risk
It is our policy not to enter into interest rate derivative financial
instruments, except for hedging of foreign currency exposures discussed below.
We do not currently have any significant interest rate exposure.
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Foreign Currency Exchange Rate Risk
Since a significant part of our sales and expenses are denominated in
U.S. dollars, we have experienced only insignificant foreign exchange gains and
losses to date, and do not expect to incur significant gains and losses in 2004.
Our research, development and production activities are primarily carried out by
our Israeli subsidiary, EFL, at its facility in Beit Shemesh, and accordingly we
have sales and expenses in New Israeli Shekels. Additionally, our MDT and
Epsilor subsidiaries operate primarily in New Israeli Shekels. However, the
majority of our sales are made outside Israel in U.S. dollars, and a substantial
portion of our costs are incurred in U.S. dollars. Therefore, our functional
currency is the U.S. dollar. Please see "Impact of Inflation and Currency
Fluctuations," above and Note 2.b to the Notes to the Consolidated Financial
Statements.
While we conduct our business primarily in U.S. dollars, some of our
agreements are denominated in foreign currencies. Specifically, at the end of
2003 our IES contract with the German National Police, which accounted for 16%
of our revenues on a consolidated basis in 2003, was denominated in Euros. Thus,
we are exposed to market risk, primarily related to fluctuations in the value of
the Euro. Therefore, due to the volatility in the exchange rate of the Euro
versus the U.S. dollar, we decided to hedge part of the risk of a devaluation of
the U.S dollar, which could have an adverse effect on the revenues that we incur
in IES. During the year 2003 we hedged revenues derived from the German National
Police in order to protect against a decrease in value of forecasted foreign
currency cash flows resulting from revenues payments denominated in Euro. We do
not hold or issue derivative financial instruments for trading or speculative
purposes
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Index to Financial Statements
Page
----
Consolidated Financial Statements
Report of Independent Auditors.................................................. F-2
Consolidated Balance Sheets..................................................... F-3
Consolidated Statements of Operations........................................... F-5
Statements of Changes in Shareholders' Equity................................... F-6
Consolidated Statements of Cash Flows........................................... F-9
Notes to Consolidated Financial Statements...................................... F-12
Supplementary Financial Data
Quarterly Financial Data (unaudited) for the two years ended December 31, 2003.. F-48
Financial Statement Schedule
Schedule II - Valuation and Qualifying Accounts................................. F-49
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
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ITEM 9A. CONTROLS AND PROCEDURES
During the fourth quarter of 2003, our management, including the
principal executive officer and principal financial officer, evaluated our
disclosure controls and procedures related to the recording, processing,
summarization, and reporting of information in our periodic reports that we file
with the SEC. These disclosure controls and procedures have been designed to
ensure that material information relating to us, including our subsidiaries, is
made known to our management, including these officers, by other of our
employees, and that this information is recorded, processed, summarized,
evaluated, and reported, as applicable, within the time periods specified in the
SEC's rules and forms. Due to the inherent limitations of control systems, not
all misstatements may be detected. These inherent limitations include the
realities that judgments in decision-making can be faulty and that breakdowns
can occur because of simple error or mistake. Additionally, controls can be
circumvented by the individual acts of some persons, by collusion of two or more
people, or by management override of the control. Our controls and procedures
can only provide reasonable, not absolute, assurance that the above objectives
have been met.
As of December 31, 2003, these officers concluded that the design of
the disclosure controls and procedures provides reasonable assurance that they
can accomplish their objectives. We intend to continually strive to improve our
disclosure controls and procedures to enhance the quality of our financial
reporting.
There have been no changes in our internal control over financial
reporting that occurred during our last fiscal quarter to which this Annual
Report on Form 10-K relates that have materially affected, or are reasonably
likely to materially affect, our internal control over financial reporting.
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PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Executive Officers, Directors and Significant Employees
Executive Officers and Directors
Our executive officers and directors and their ages as of February 29,
2004 were as follows:
Name Age Position
---- --- --------
Robert S. Ehrlich........... 65 Chairman of the Board, President and Chief Executive Officer
Steven Esses.................. 40 Executive Vice President, Chief Operating Officer and Director
Avihai Shen................. 36 Vice President - Finance and Chief Financial Officer
Dr. Jay M. Eastman.......... 57 Director
Jack E. Rosenfeld........... 64 Director
Lawrence M. Miller.......... 57 Director
Bert W. Wasserman........... 71 Director
Edward J. Borey 53 Director
Our by-laws provide for a board of directors of one or more directors.
There are currently seven directors. Under the terms of our certificate of
incorporation, the board of directors is composed of three classes of similar
size, each elected in a different year, so that only one-third of the board of
directors is elected in any single year. Dr. Eastman and Mr. Esses are
designated Class I directors and have been elected for a term expiring in 2006
and until their successors are elected and qualified; Messrs. Rosenfeld and
Miller are designated Class II directors elected for a term expiring in 2005 and
until their successors are elected and qualified; and Mr. Ehrlich is designated
a Class III director elected for a term that expires in 2004 and until his
successor is elected and qualified. Mr. Bert W. Wasserman and Mr. Edward J.
Borey have been appointed to the Board (in February 2003 and December 2003,
respectively) and proposed for election to the Board as Class III directors at
the next annual meeting of the shareholders in June 2004, along with Mr.
Ehrlich. A majority of the Board is "independent" under relevant SEC and Nasdaq
regulations.
Robert S. Ehrlich has been our Chairman of the Board since January 1993
and our President and Chief Executive Officer since October 2002. From May 1991
until January 1993, Mr. Ehrlich was our Vice Chairman of the Board, and from May
1991 until October 2002 he was our Chief Financial Officer. Mr. Ehrlich was a
director of Eldat, Ltd., an Israeli manufacturer of electronic shelf labels,
from June 1999 to July 2003. From 1987 to June 2003, Mr. Ehrlich served as a
director of PSC Inc. ("PSCX"), a manufacturer and marketer of laser diode bar
code scanners, and, between April 1997 and June 2003, Mr. Ehrlich was the
chairman of the board of PSCX. PSCX filed a voluntary petition for relief under
Chapter 11 of the Bankruptcy Code in November 2002; its pre-negotiated plan of
reorganization was confirmed by the Bankruptcy Court in June 2003. Mr. Ehrlich
received a B.S. and J.D. from Columbia University in New York, New York.
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Steven Esses has been a director since July 2002 and our Executive Vice
President since January 2003 and Chief Operating Officer since February 2003.
From 2000 till 2002, Mr. Esses was a principal with Stillwater Capital Partners,
Inc., a New York-based investment research and advisory company (hedge fund)
specializing in alternative investment strategies. During this time, Mr. Esses
also acted as an independent consultant to new and existing businesses in the
areas of finance and business development. From 1995 to 2000, Mr. Esses founded
Dunkin' Donuts in Israel and held the position of Managing Director and CEO.
Prior thereto, he was Director of Retail Jewelry Franchises with Hamilton
Jewelry, and before that he served as Executive Director of Operations for the
Conway Organization, a major off-price retailer with 17 locations.
Avihai Shen has been our Vice President - Finance since September 1999
and our Chief Financial Officer since October 2002, and served as our corporate
Secretary from September 1999 to December 2000. Mr. Shen was the CFO of
Commtouch Software Ltd., an internet company based in California that develops
e-mail solutions, from 1996 to early 1999, and worked previously at Ernst and
Young in Israel. Mr. Shen is a certified public accountant and has a B.A. in
Economics from Bar-Ilan University in Israel and an M.B.A. from the Hebrew
University of Jerusalem.
Dr. Jay M. Eastman has been one of our directors since October 1993.
Since November 1991, Dr. Eastman has served as President and Chief Executive
Officer of Lucid, Inc., which is developing laser technology applications for
medical diagnosis and treatment. Dr. Eastman has served as a director of PSCX
since April 1996 and served as Senior Vice President of Strategic Planning from
December 1995 through October 1997. PSCX filed a voluntary petition for relief
under Chapter 11 of the Bankruptcy Code in November 2002; its pre-negotiated
plan of reorganization was confirmed by the Bankruptcy Court in June 2003. Dr.
Eastman is also a director of Dimension Technologies, Inc., a developer and
manufacturer of 3D displays for computer and video displays, and Centennial
Technologies Inc., a manufacturer of PCMCIA cards. From 1981 until January 1983,
Dr. Eastman was Director of the University of Rochester's Laboratory for Laser
Energetics, where he was a member of the staff from September 1975 to 1981. Dr.
Eastman holds a B.S. and a Ph.D. in Optics from the University of Rochester in
New York.
Jack E. Rosenfeld has been one of our directors since October 1993. Mr.
Rosenfeld is also a director of Maurice Corporation and a director of PSCX. PSCX
filed a voluntary petition for relief under Chapter 11 of the Bankruptcy Code in
November 2002; its pre-negotiated plan of reorganization was confirmed by the
Bankruptcy Court in June 2003. Since April 1998, Mr. Rosenfeld has been
President and Chief Executive Officer of Potpourri Collection Inc., a specialty
catalog direct marketer. Mr. Rosenfeld was President and Chief Executive Officer
of Hanover Direct, Inc., formerly Horn & Hardart Co., which operates a direct
mail marketing business, from September 1990 until December 1995, and had been
President and Chief Executive Officer of its direct marketing subsidiary, since
May 1988. Mr. Rosenfeld holds a B.A. from Cornell University in Ithaca, New York
and an LL.B. from Harvard University in Cambridge, Massachusetts.
Lawrence M. Miller was elected to the board of directors in November
1996. Mr. Miller has been a senior partner in the Washington D.C. law firm of
Schwartz, Woods and Miller since 1990. He served from August 1993 through May
1996 as a member of the board of directors of The Phoenix Resource Companies,
Inc., a publicly traded energy exploration and production company, and as a
member of the Audit and Compensation Committee of that board. That company was
merged into Apache Corporation in May 1996. Mr. Miller holds a B.A. from
Dickinson College in Carlisle, Pennsylvania and a J.D. with honors from George
Washington University in Washington, D.C. He is a member of the District of
Columbia bar.
69
Bert W. Wasserman was added to the board in February 2003. Mr.
Wasserman served as Executive Vice President and Chief Financial Officer of Time
Warner, Inc. from 1990 until his retirement in 1995 and served on the Board of
Directors of Time Warner, Inc. and its predecessor company, Warner
Communications, Inc. from 1981 to 1995. He joined Warner Communications, Inc. in
1966 and had been an officer of that company since 1970. Mr. Wasserman is
director of several investment companies in the Dreyfus Family of Funds. He is
also a director of Malibu Entertainment, Inc., Lillian Vernon Corporation,
InforMedix, Inc. and PSCX. PSCX filed a voluntary petition for relief under
Chapter 11 of the Bankruptcy Code in November 2002; its pre-negotiated plan of
reorganization was confirmed by the Bankruptcy Court in June 2003. Mr. Wasserman
is a certified public accountant; he holds a B.A. from Baruch College in New
York City, of whose Board of Trustees he has served as Vice President and
President, and an LL.B from Brooklyn Law School.
Edward J. Borey was added to the board in December 2003. From December
2000 to September 2003, Mr. Borey served as President, Chief Executive Officer
and a director of PSCX. PSCX filed a voluntary petition for relief under Chapter
11 of the Bankruptcy Code in November 2002; its pre-negotiated plan of
reorganization was confirmed by the Bankruptcy Court in June 2003. Prior to
joining the Company, Mr. Borey was President and CEO of TranSenda (May 2000 to
December 2000). Previously, Mr. Borey held senior positions in the automated
data collection industry. At Intermec Technologies Corporation (1995-1999), he
was Executive Vice President and Chief Operating Officer and also Senior Vice
President/General Manager of the Intermec Media subsidiary. Currently, Mr. Borey
serves as a Board member at Centura Software, recently renamed MBrane, and he is
on the Advisory Board of TranSenda Software and NextRx. Mr. Borey holds a B.S.
in Economics from the State University of New York, College of Oswego; an M.A.
in Public Administration from the University of Oklahoma; and an M.B.A. in
Finance from Santa Clara University.
Committees of the Board of Directors
Our board of directors has an Audit Committee, a Compensation
Committee, a Nominating Committee and an Executive Committee.
Created in December 1993, the purpose of the Audit Committee is to
review with management and our independent auditors the scope and results of the
annual audit, the nature of any other services provided by the independent
auditors, changes in the accounting principles applied to the presentation of
our financial statements, and any comments by the independent auditors on our
policies and procedures with respect to internal accounting, auditing and
financial controls. The Audit Committee was established in accordance with
Section 3(a)(58)(A) of the Securities Exchange Act of 1934, as amended. In
addition, the Audit Committee is charged with the responsibility for making
decisions on the engagement of independent auditors. As required by law, the
Audit Committee operates pursuant to a charter. The Audit Committee consists of
Messrs. Wasserman (Chair), Miller and Rosenfeld. We have determined that Mr.
Wasserman qualifies as an "audit committee financial expert" under applicable
SEC and Nasdaq regulations. Mr. Wasserman, as well as all the other members of
the Audit Committee, is "independent," as independence is defined in Rule
4200(a)(15) of the National Association of Securities Dealers' listing standards
and under Item 7(d)(3)(iv) of Schedule 14A of the proxy rules under the Exchange
Act.
70
The Compensation Committee, also created in December 1993, recommends
annual compensation arrangements for the Chief Executive Officer and Chief
Financial Officer and reviews annual compensation arrangements for all officers
and significant employees. The Compensation Committee consists of Dr. Eastman
(Chair) and Messrs. Wasserman and Rosenfeld, all of whom are independent
non-employee directors.
The Executive Committee, created in July 2001, exercises the powers of
the Board during the intervals between meetings of the Board, in the management
of the property, business and affairs of the Company (except with respect to
certain extraordinary transactions). The Executive Committee consists of Messrs.
Ehrlich (Chair), Miller and Esses.
The Nominating Committee, created in March 2003, identifies and
proposes candidates to serve as members of the Board of Directors. Proposed
nominees for membership on the Board of Directors submitted in writing by
stockholders to the Secretary of the Company will be brought to the attention of
the Nominating Committee. The Nominating Committee consists of Mr. Miller
(Chair), Dr. Eastman and Mr. Rosenfeld, all of whom are independent non-employee
directors.
Code of Ethics
We have adopted a Code of Ethics, as required by Nasdaq listing
standards and the rules of the SEC, that applies to our principal executive
officer, our principal financial officer, and our principal accounting officer,
as well as a more general code of conduct that applies to our other employees.
The Code of Ethics is publicly available through a hyperlink located on the
investor relations page of our website, at
http://www.arotech.com/compro/investor.html. If we make substantive amendments
to the Code of Ethics or grant any waiver, including any implicit waiver, that
applies to anyone subject to the Code of Ethics, we will disclose the nature of
such amendment or waiver on the website or in a report on Form 8-K in accordance
with applicable Nasdaq and SEC rules
Voting Agreements
Messrs. Gross, Ehrlich and Yehuda Harats are parties to a Voting Rights
Agreement dated September 30, 1996, as amended, pursuant to which each of the
parties agrees to vote the shares of our common stock held by that person in
favor of the election of Messrs. Ehrlich, Harats and Miller until the earlier of
December 28, 2004 or our fifth annual meeting of stockholders after December 28,
1999. Mr. Harats resigned as a director in 2002; however, we believe that Mr.
Harats must continue to comply with the terms of this agreement.
Director Compensation
71
Non-employee members of our board of directors are paid $2,500 (plus
expenses) for each board of directors meeting attended, $2,000 (plus expenses)
for each meeting of the audit committee of the board of directors attended, and
$1,000 (plus expenses) for each meeting of all other committees of the board of
directors attended. In addition, we have adopted a Non-Employee Director Stock
Option Plan pursuant to which non-employee directors receive an initial grant of
options to purchase 25,000 shares of our common stock upon the effective date of
such plan or upon the date of his or her election as a director. Thereafter,
non-employee directors will receive options to purchase 10,000 shares of our
common stock for each year of service on the board. All such options are granted
at fair market value and vest ratably over three years from the date of the
grant. At our next annual meeting of shareholders in June 2004, we will propose
increasing these stock option grants to 40,000 shares of our common stock upon
the effective date of such plan or upon the date of a director's election as a
director and 25,000 shares of our common stock for each year of service on the
board.
Significant Employees
Our significant employees as of February 29, 2004, and their ages as of
December 31, 2003, are as follows:
Name Age Position
---- --- --------
Jonathan Whartman................. 49 Senior Vice President
Dr. Neal Naimer................... 45 Vice President and Chief Technology Officer
Yoel Gilon........................ 51 Vice President - Electric Vehicle Technologies
Yaakov Har-Oz..................... 46 Vice President, General Counsel and Secretary
Danny Waldner..................... 32 Controller
Greg Otte......................... 44 President, IES Interactive Training, Inc.
Alan G. Jordan.................... 50 President and CEO, FAAC Incorporated
Yosef Bar......................... 61 General Manager, MDT Protective Industries
Hezy Aspis........................ 53 General Manager, Epsilor Electronics Industries, Ltd.
Arik Arad......................... 51 Chairman, IES Interactive Training, Inc. and President, Arocon
Security Corporation
Jonathan Whartman has been Senior Vice President since December 2000,
and Vice President of Marketing from 1994 to December 2000. From 1991 until
1994, Mr. Whartman was our Director of Special Projects. Mr. Whartman was also
Director of Marketing of Amtec from its inception in 1989 through the merger of
Amtec into Arotech. Before joining Amtec, Mr. Whartman was Manager of Program
Management at Luz, Program Manager for desk-top publishing at ITT Qume in San
Jose, California from 1986 to 1987, and Marketing Director at Kidron Digital
Systems, an Israeli computer developer, from 1982 to 1986. Mr. Whartman holds a
B.A. in Economics and an M.B.A. from the Hebrew University, Jerusalem, Israel.
Dr. Neal Naimer has been a Vice President since June 1997 and our Chief
Technology Officer since December 2002. Dr. Naimer was previously Director of
Electrode Engineering of our Air Electrode development program. From 1987 to
1989, he was the Manager of the Chemical Vapor Deposition (Thin Films) Group at
Intel Electronics in Jerusalem, and was Project Manager of the photo voltaic IR
detector development program at Tadiran Semiconductor Devices in Jerusalem from
1984 to 1987. Dr. Naimer was educated at University College of London, England,
where he received his B.Sc. in Chemical Engineering and a Ph.D. in Chemical
Engineering.
72
Yoel Gilon has been our Vice President - Electric Vehicle Technologies
since 2001; prior to that, he served as Director of Electric Vehicle
Technologies at our Beit Shemesh facility since joining us in 1994. From 1991 to
1994, Mr. Gilon was Project Development Manager at Ormat Industries. Previously,
Mr. Gilon was Vice President of System Engineering Development at Luz
Industries. Mr. Gilon holds a B.Sc. in Mathematics and Physics and a M.Sc. in
Mathematics from the Hebrew University of Jerusalem. He also holds a B.A. in
Fine Arts from the Bezalel Academy in Jerusalem.
Yaakov Har-Oz has served as our Vice President and General Counsel
since October 2000 and as our corporate Secretary since December 2000. From 1994
until October 2000, Mr. Har-Oz was a partner in the Jerusalem law firm of
Ben-Ze'ev, Hacohen & Co. Prior to moving to Israel in 1993, he was an
administrative law judge and in private law practice in New York. Mr. Har-Oz
holds a B.A. from Brandeis University in Waltham, Massachusetts and a J.D. from
Vanderbilt Law School (where he was an editor of the law review) in Nashville,
Tennessee. He is a member of the New York bar and the Israel Chamber of
Advocates.
Danny Waldner has served as our Controller since March 2000 and as our
chief accounting officer since October 2002. Prior thereto, Mr. Waldner was an
accountant at KPMG in Israel from 1996 to 2000. Mr. Waldner is a Certified
Public Accountant and holds a B.A. in Accounting and Business Administration and
an M.B.A. from the Rishon Lezion College of Administration in Israel.
Greg Otte has served as IES's President since January 2001. From 1994
to 2001, Mr. Otte was in charge of IES's North American marketing efforts. Prior
to this, he was responsible for sales, product placement and national contracts
with Tuxall Uniform & Equipment, a national supplier of law enforcement
equipment. Mr. Otte holds a bachelor's degree in Marketing from the University
of Colorado.
Alan G. Jordan started at First Ann Arbor Corporation, the predecessor
of FAAC, in 1978 as a junior engineer. He subsequently was promoted to section
head, program manager, group head, director of operations, vice president, and
finally president, which position he has held for more than the past five years.
Prior to joining FAAC, Mr. Jordan was an engineer in the U.S. Navy civil
service. Mr. Jordan maintains Department of Defense "secret" clearance. Mr.
Jordan holds a bachelor's degree in Systems Science from Michigan State
University.
Yosef Bar established MDT Protective Industries in 1989 as one of the
first bulletproofing companies in Israel. Under the direction of Mr. Bar, MDT
moved from its initial emphasis on vandalism protection to bulletproofing not
just windshields but the entire vehicle, as a result of which MDT became
Israel's leader in the state-of-the art lightweight armoring of vehicles,
ranging from light tactical vehicles to passenger vehicles. Mr. Bar served in
the Israel Defense Forces, reaching the rank of Lieutenant Colonel of the
paratroop regiment with over 1,000 jumps to his credit. He also participated in
several anti-terrorism courses.
73
Hezy Aspis has headed Epsilor Electronic Industries, Ltd. since 1991.
Prior to this, he was an engineer with Tadiran Batteries Ltd., Israel's leading
lithium battery manufacturer. Mr. Aspis holds a B.Sc. in electric engineering
from the Technion Israel Institute of Technology in Haifa, Israel, and an M.B.A.
from Tel-Aviv University in Israel.
Arik Arad has served as IES's Chairman since August 2003 and as
Chairman of Arocon Security Consulting since September 2003. Mr. Arad has served
in the military, law enforcement and private-sector security business, servicing
clientele from among the Fortune 500(TM) companies. In that capacity, Mr. Arad
has participated in the process of reassessing security requirements, security
design, security implementation, security training programs and proactive
security follow-up. Mr. Arad has been exposed to issues pertinent to companies
whose worldwide operations pose potential for terrorist activity. He has also
gained worldwide experience in securing major airports, shopping centers and
other high profile facilities. Mr. Arad served as a Lieutenant Colonel in the
Israel Defense Forces. Mr. Arad is a graduate of the International Seminar
Management Program (ISMP) of the Harvard Business School and holds a B.Sc. in
psychology and political sciences from the Haifa University in Israel.
Section 16(a) Beneficial Ownership Reporting Compliance
Under the securities laws of the United States, our directors, certain
of our officers and any persons holding more than ten percent of our common
stock are required to report their ownership of our common stock and any changes
in that ownership to the Securities and Exchange Commission. Specific due dates
for these reports have been established and we are required to report any
failure to file by these dates during 2003. We are not aware of any instances
during 2003, not previously disclosed by us, where such "reporting persons"
failed to file the required reports on or before the specified dates, except as
follows:
(i) Mr. Borey was required to report his holdings of our
securities in a Form 3 that should have been filed on or prior
to December 15, 2003 in connection with his becoming a
director on December 4, 2003. Additionally, Mr. Borey was
required to file a Form 4 on or prior to January 2, 2004 in
connection with his receipt of 35,000 stock options on
December 30, 2003. He reported his holdings and this
transaction in a Form 5 filed on February 17, 2004.
(ii) Mr. Eastman was required to file a Form 4 on or prior to
January 2, 2004 in connection with his receipt of 10,000 stock
options on December 30, 2003. He reported this transaction in
a Form 5 filed on February 17, 2004.
(iii) Mr. Ehrlich was required to file a Form 4 on or prior to March
17, 2003 in connection with his receipt of 1,500,000 stock
options on March 14, 2003. He reported this transaction in a
Form 4 filed on August 11, 2003.
(iv) Mr. Ehrlich was required to file a Form 4 on or prior to June
30, 2003 in connection with his receipt of 500,000 stock
options on June 26, 2003. He reported this transaction in a
Form 4 filed on August 11, 2003.
74
(v) Mr. Ehrlich was required to file a Form 4 on or prior to
January 27, 2004 in connection with his receipt of 35,000
stock options on January 25, 2004. He reported this
transaction in a Form 5 filed on February 17, 2004.
(vi) Mr. Esses was required to file a Form 4 on or prior to
February 26, 2003 in connection with his receipt of 600,000
stock options on February 24, 2003. He reported this
transaction in a Form 4 filed on August 8, 2003.
(vii) Mr. Esses was required to file a Form 4 on or prior to July
11, 2003 in connection with his receipt of 100,000 stock
options on July 9, 2003, and a Form 4 on or prior to October
15, 2003 in connection with his receipt of 335,000 stock
options on October 13, 2003. He reported these transactions in
a Form 5 filed on February 17, 2004 (as amended on February
24, 2004).
(viii) Mr. Miller was required to file a Form 4 on or prior to
January 2, 2004 in connection with his receipt of 10,000 stock
options on December 30, 2003. He reported this transaction in
a Form 5 filed on February 17, 2004.
(ix) Mr. Rosenfeld was required to file a Form 4 on or prior to
January 2, 2004 in connection with his receipt of 10,000 stock
options on December 30, 2003. He reported this transaction in
a Form 5 filed on February 18, 2004 (after the required filing
date of February 17, 2004, due to a technical delay in filing
with the EDGAR system).
(x) Mr. Shen was required to file a Form 4 on or prior to February
26, 2003 in connection with his receipt of 120,000 stock
options on February 24, 2003. He reported this transaction in
a Form 4 filed on August 11, 2003.
(xi) Mr. Shen was required to file a Form 4 on or prior to July 11,
2003 in connection with his receipt of 120,000 stock options
on July 9, 2003, and a Form 4 on or prior to October 15, 2003
in connection with his receipt of 333,750 stock options on
October 13, 2003. He reported these transactions in a Form 5
filed on February 17, 2004 (as amended on February 24, 2004).
(xii) Mr. Wasserman was required to report his holdings of our
securities in a Form 3 that should have been filed on or prior
to March 6, 2003 in connection with his becoming a director on
February 24, 2003. Additionally, Mr. Wasserman was required to
file a Form 4 on or prior to January 2, 2004 in connection
with his receipt of 10,000 stock options on December 30, 2003.
He reported his holdings and this transaction in a Form 5
filed on February 19, 2004 (after the required filing date of
February 17, 2004, due to a technical delay in filing with the
EDGAR system).
75
ITEM 11. EXECUTIVE COMPENSATION
Cash and Other Compensation
General
Our Chief Executive Officer and the other highest paid executive
officers (of which there were two) who were compensated at a rate of more than
$100,000 in salary and bonuses during the year ended December 31, 2003
(collectively, the "Named Executive Officers") are Israeli residents, and thus
certain elements of the compensation that we pay them is structured as is
customary in Israel.
During 2002, 2001 and 2000, compensation to our Named Executive
Officers took several forms:
>> cash salary;
>> bonus, some of which was paid in cash in the year in which it
was earned and some of which was accrued in the year in which
it was earned but paid in cash in a subsequent year;
>> cash reimbursement for taxes paid by the Named Executive
Officer and reimbursed by us in accordance with Israeli tax
regulations;
>> accruals (but not cash payments) in respect of contractual
termination compensation in excess of the Israeli statutory
minimum;
>> accruals (but not cash payments) in respect of pension plans,
which consist of a savings plan, life insurance and statutory
severance pay benefits, and a continuing education fund (as is
customary in Israel);
>> stock options, including options issued in exchange for a
waiver of salary under the "options-for-salary" program
discussed in more detail below; and
>> other benefits, primarily consisting of annual statutory
holiday pay.
The specific amounts of each form of compensation paid to each Named
Executive Officer appear in the summary compensation table and the notes thereto
appearing under "Summary Compensation Table," below.
Summary Compensation Table
The following table, which should be read in conjunction with the
explanations provided above, shows the compensation that we paid (or accrued),
in connection with services rendered for 2003, 2002 and 2001, to our Named
Executive Officers.
76
SUMMARY COMPENSATION TABLE(1)
Long Term
Annual Compensation Compensation Compensation
---------------------------------- ---------- --------------------------------------
Changes in
Accruals for
Sick Days,
Vacation Payment to
Tax Securities Days, and Pension and
Name and Principal Reimburse- Underlying Termination Education
Position Year Salary Bonus ment Options Compensation Funds Others
- ------------------------- ---- -------- ------- ---------- ---------- ------------ ---------- --------
Robert S. Ehrlich 2003 259,989 $99,750(2) $ 27,211 2,035,000 $ 80,713(3) $ 48,228 $ 678
Chairman of the Board, 2002 $202,962 $99,750 $ 15,232 262,500(4) $ 170,691(5) $ 22,256 $ 654
President, Chief 2001 $211,644 $84,000 $ 17,201 521,000(6) $ 229,800(7) $ 52,841 $ 87,113(8)
Executive Officer and
director
Steven Esses
Executive Vice President, 2003 $ 0 $ 0 $ 0 $1,035,000 $ 0 $ 0 $ 0
Chief Operating Officer 2002 $ 0 $ 0 $ 0 0 $ 0 $ 0 $120,480(9)
and director* 2001 $ 0 $ 0 $ 0 0 $ 0 $ 0 $ 0
Avihai Shen
Vice President - Finance 2003 $123,988 $ 0 $ 8,653 608,750 $ 6,471(10) $ 23,133 $ 463
and Chief Financial 2002 $ 93,641 $ 0 $ 18,857 48,935 $ 9,847(11) $ 20,394 $ 6,894(12)
Officer 2001 $ 82,019 $ 0 $ 8,804 43,749 $ 1,629(13) $ 15,956 $ 674
- -------------------------------------
* Mr. Esses became an officer in January 2003. His compensation as an officer
during 2003 consisted solely of stock options. Prior to January 2003, Mr.
Esses was a director (from July 2002), in which position he received
certain compensation as a consultant, in addition to the stock options and
per-meeting fees payable to directors generally (which is not reflected
above).
(1) We paid the amounts reported for each named executive officer in U.S.
dollars and/or New Israeli Shekels (NIS). We have translated amounts paid
in NIS into U.S. dollars at the exchange rate of NIS into U.S. dollars at
the time of payment or accrual.
(2) We paid Mr. Ehrlich $67,370 during 2003 in satisfaction of the remainder of
bonuses from 2002 to which he was entitled according to his contract.
Additionally, we accrued $99,750 for Mr. Ehrlich in satisfaction of the
2003 bonus to which he was entitled according to his contract.
(3) Of this amount, $92,075 represents our accrual for severance pay that would
be payable to Mr. Ehrlich upon a "change of control" or upon the occurrence
of certain other events; $3,451 represents the increase of the accrual for
sick leave and vacation redeemable by Mr. Ehrlich; and $(14,813) represents
the decrease of our accrual for severance pay that would be payable to Mr.
Ehrlich under the laws of the State of Israel if we were to terminate his
employment.
(4) Of this amount, 262,500 options were in exchange for a total of $105,000 in
salary waived by Mr. Ehrlich during 2002 pursuant to the options-for-salary
program instituted by us beginning in May 2001. See "Options-for-Salary
Program," below.
(5) Of this amount, $109,935 represents our accrual for severance pay that
would be payable to Mr. Ehrlich upon a "change of control" or upon the
occurrence of certain other events; $17,571 represents the increase of the
accrual for sick leave and vacation redeemable by Mr. Ehrlich; and $43,725
represents the increase of our accrual for severance pay that would be
payable to Mr. Ehrlich under the laws of the State of Israel if we were to
terminate his employment.
(6) Of this amount, 80,000 options were in exchange for a total of $32,000 in
salary waived by Mr. Ehrlich during 2001 pursuant to the options-for-salary
program instituted by us beginning in May 2001. See "Options-for-Salary
Program," below.
(7) Of this amount, $172,360 represents our accrual for severance pay that
would be payable to Mr. Ehrlich upon a "change of control" or upon the
occurrence of certain other events; $50,548 represents the increase of the
accrual for sick leave and vacation redeemable by Mr. Ehrlich; and $6,892
represents the increase of our accrual for severance pay that would be
payable to Mr. Ehrlich under the laws of the State of Israel if we were to
terminate his employment.
(8) Of this amount, $86,434 represents benefit imputed to Mr. Ehrlich upon the
purchase by us of certain of his shares for treasury, and $679 represents
other benefits that we paid to Mr. Ehrlich in 2001. See "Item 13. Certain
Relationships and Related Transactions - Officer Loans," below.
77
(9) Represents consulting fees paid in 2002.
(10) Of this amount, $8,369 represents the increase of the accrual for vacation
redeemable by Mr. Shen; and $(1,628) represents the decrease of our accrual
for severance pay that would be payable to Mr. Shen under the laws of the
State of Israel if we were to terminate his employment.
(11) Of this amount, $1,062 represents the increase of the accrual for vacation
redeemable by Mr. Shen; and $8,785 represents the increase of our accrual
for severance pay that would be payable to Mr. Shen under the laws of the
State of Israel if we were to terminate his employment.
(12) Of this amount, $6,500 represents the value of shares issued to Mr. Shen as
a stock bonus and $394 represents other benefits that we paid to Mr. Shen
in 2002.
(13) Of this amount, $(1.099) represents the decrease of the accrual for
vacation redeemable by Mr. Shen; and $2,728 represents the increase of our
accrual for severance pay that would be payable to Mr. Shen under the laws
of the State of Israel if we were to terminate his employment.
Executive Loans
In 1999, 2000 and 2002, we extended certain loans to our Named
Executive Officers. These loans are summarized in the following table, and are
further described under "Item 13. Certain Relationships and Related Transactions
- - Officer Loans," below.
Original Amount
Principal Outstanding
Name of Borrower Date of Loan Amount of Loan as of 12/31/03 Terms of Loan
---------------- ------------ -------------- -------------- -------------
Ten-year non-recourse loan to purchase our
stock, secured by the shares of stock
Robert S. Ehrlich....... 12/28/99 $ 167,975 $ 201,570 purchased.
Twenty-five-year non-recourse loan to
purchase our stock, secured by the
Robert S. Ehrlich....... 02/09/00 $ 789,991 $ 657,146 shares of stock purchased.
Twenty-five-year non-recourse loan to
purchase our stock, secured by the
Robert S. Ehrlich....... 10/06/02 $ 36,500 $ 37,810 shares of stock purchased.
Options-for-Salary Program
Between May 2001 and December 2002, we conducted an options-for-salary
program designed to conserve our cash and to offer incentives to employees to
remain with us despite lower cash compensation. Under this program, most of our
salaried employees permanently waived a portion of their salaries in exchange
for options to purchase shares of our common stock, at a ratio of options to
purchase 2.5 shares of our stock for each dollar in salary waived. Social
benefits (such as pension) and contractual bonuses for such employees continued
to be calculated based on their salaries prior to reduction. The
options-for-salary program was ended on December 31, 2002.
During 2001, options were accrued quarterly in advance, but since no
employees requested the grant of their options during the third quarter, all
grants were deferred to the beginning of the fourth quarter, during the month of
October. During 2002, options were accrued quarterly in advance for the Named
Executive Officers, and annually in advance for other employees.
During 2001, in exchange for waiver of $265,597 in salary, our
employees other than the Named Executive Officers received a total of 663,992
options, which options were granted based on the lowest closing price of our
common stock during the month of October 2001 ($1.30). Named Executive Officers,
in exchange for waiver of $40,699 in salary, received a total of 101,747 options
during 2001, which options were granted based on the lowest closing prices of
our common stock during the month of October 2001 ($1.30), as set forth in the
table below.
78
During 2002, in exchange for waiver of $364,209 in salary, our
employees other than the Named Executive Officers received a total of 910,522
options, which options were granted based on the lowest closing price of our
common stock during the month of December 2002 ($0.61). Named Executive
Officers, in exchange for waiver of $119,774 in salary, received a total of
299,435 options during 2002, which options were granted based on the lowest
closing prices of our common stock during each quarter of 2002, as set forth in
the table below.
Following is a table setting forth the number of options that we issued
to each of our Named Executive Officers under the options-for-salary program
during each fiscal quarter in which the program was in effect, and the range of
trading prices for our common stock during each such fiscal quarter:
Low Trading High Trading Closing
Fiscal Amount of Number of Number of Average Price Price During Price
Quarter Salary Options Options Exercise During Quarter on Last Day
Named Executive Officer Ended Waived Accrued Issued Price Quarter of Quarter
- ------------------------ ---------------------------- -------------------------- ---------------------------------------------------
Robert S. Ehrlich...... 06/30/01 $ 8,000 20,000 0 - $2.18 $4.20 $2.54
09/30/01 $ 12,000 30,000 0 - $1.10 $3.05 $1.48
12/31/01 $ 12,000 30,000 80,000 $1.30 $1.30 $2.48 $1.66
03/31/02 $ 26,250 65,625 65,625 $1.42 $1.35 $2.41 $1.55
06/30/02 $ 26,250 65,625 65,625 $0.73 $0.73 $1.79 $0.91
09/30/02 $ 26,250 65,625 65,625 $0.85 $0.79 $1.70 $1.05
12/31/02 $ 26,250 65,625 65,625 $0.61 $0.61 $1.17 $0.64
Avihai Shen............ 06/30/01 $ 2,174 5,435 0 - $2.18 $4.20 $2.54
09/30/01 $ 3,262 8,153 0 - $1.10 $3.05 $1.48
12/31/01 $ 3,262 8,153 21,741 $1.30 $1.30 $2.48 $1.66
03/31/02 $ 3,262 8,153 8,153 $1.42 $1.35 $2.41 $1.55
06/30/02 $ 3,262 8,153 8,153 $0.73 $0.73 $1.79 $0.91
09/30/02 $ 3,262 12,476 12,476 $0.85 $0.79 $1.70 $1.05
12/31/02 $ 3,262 8,153 8,153 $0.61 $0.61 $1.17 $0.64
Stock Options
The table below sets forth information with respect to stock options
granted to the Named Executive Officers for the fiscal year 2003.
79
OPTION GRANTS IN LAST FISCAL YEAR
INDIVIDUAL GRANTS
----------------------------
% OF TOTAL POTENTIAL REALIZABLE VALUE
NUMBER OF OPTIONS OF ASSUMED ANNUAL RATES
SECURITIES GRANTED TO EXERCISE OF STOCK PRICE APPRECIATION
UNDERLYING EMPLOYEES OR BASE FOR OPTION TERM(1)
OPTIONS IN FISCAL PRICE EXPIRATION ------------------------------
NAME GRANTED YEAR ($/SH) DATE 5% ($) 10% ($)
--------------- ----------- ------------- ----------- ---------- ------------- -------------
Robert S. Ehrlich..... 1,500,000 27% $0.46 03/14/08 $ 190,634 $ 421,252
500,000 9% $0.85 06/26/08 $ 111,894 $ 247,257
35,000 6% $0.42 01/25/13 $ 9,245 $ 23,428
Steven Esses.......... 600,000 11% $0.43 02/24/08 $ 71,281 $ 157,512
100,000 2% $0.85 07/09/13 $ 53,456 $ 135,468
300,000 5% $1.28 12/31/08 $ 106,092 $ 234,436
35,000 1% $1.28 01/31/13 $ 28,174 $ 71,400
Avihai Shen........... 120,000 2% $0.43 02/24/08 $ 14,256 $ 31,503
120,000 2% $0.85 07/09/13 $ 64,147 $ 162,562
333,750 6% $1.28 07/09/13 $ 268,664 $ 680,847
35,000 1% $0.42 01/25/13 $ 9,245 $ 23,429
- ---------------------------------
(1) The potential realizable value illustrates value that might be realized
upon exercise of the options immediately prior to the expiration of
their terms, assuming the specified compounded rates of appreciation of
the market price per share from the date of grant to the end of the
option term. Actual gains, if any, on stock option exercise are
dependent upon a number of factors, including the future performance of
the common stock and the timing of option exercises, as well as the
executive officer's continued employment through the vesting period.
The gains shown are net of the option exercise price, but do not
include deductions for taxes and other expenses payable upon the
exercise of the option or for sale of underlying shares of common
stock. The 5% and 10% rates of appreciation are mandated by the rules
of the Securities and Exchange Commission and do not represent our
estimate or projection of future increases in the price of our stock.
There can be no assurance that the amounts reflected in this table will
be achieved, and unless the market price of our common stock
appreciates over the option term, no value will be realized from the
option grants made to the executive officers.
The table below sets forth information for the Named Executive Officers
with respect to aggregated option exercises during fiscal 2003 and fiscal 2003
year-end option values.
Aggregated Option Exercises and Fiscal Year-End Option Values
Shares Number of Securities Value of Unexercised
cquired on Value Underlying Unexercised In-the-Money Options
Name A Exercise Realized Options at Fiscal Year End at Fiscal-Year-End(1)
--------------------------------- ------------------ ------------------------------ ----------------------------------
Exercisable Unexercisable Exercisable Unexercisable
-------------- --------------- ---------------- -----------------
Robert S. Ehrlich.... - $ - 1,905,667 1,000,000 $ 1,826,171 $ 1,185,000
Steven Esses......... 99,860 $ 183,215 416,807 518,333 $ 317,362 $ 655,733
Avihai Shen.......... 75,000 $ 143,500 217,304 421,100 $ 119,283 $ 286,046
- -----------------------------------
(1) Options that are "in-the-money" are options for which the fair market value
of the underlying securities on December 31, 2003 ($1.82) exceeds the
exercise or base price of the option.
Employment Contracts
Mr. Ehrlich is party to an employment agreement with us effective as of
January 1, 2000. The term of this employment agreement, as extended, expires on
December 31, 2005, and is extended automatically for additional terms of two
years each unless either Mr. Ehrlich or we terminate the agreement sooner.
80
The employment agreement provides for a base salary of $20,000 per
month, as adjusted annually for Israeli inflation and devaluation of the Israeli
shekel against the U.S. dollar, if any. Additionally, the board may at its
discretion raise Mr. Ehrlich's base salary. In January 2002, the board raised
Mr. Ehrlich's base salary to $23,750 per month effective January 1, 2002; Mr.
Ehrlich has elected to waive this increase in his salary and to receive options
instead, under our salary for options program.
The employment agreement provides that if the results we actually
attain in a given year are at least 80% of the amount we budgeted at the
beginning of the year, we will pay a bonus, on a sliding scale, in an amount
equal to a minimum of 35% of Mr. Ehrlich's annual base salary then in effect, up
to a maximum of 90% of his annual base salary then in effect if the results we
actually attain for the year in question are 120% or more of the amount we
budgeted at the beginning of the year.
The employment agreement also contains various benefits customary in
Israel for senior executives (please see "Item 1. Business - Employees," above),
tax and financial planning expenses and an automobile, and contain
confidentiality and non-competition covenants. Pursuant to the employment
agreements, we granted Mr. Ehrlich demand and "piggyback" registration rights
covering shares of our common stock held by him.
We can terminate Mr. Ehrlich's employment agreement in the event of
death or disability or for "Cause" (defined as conviction of certain crimes,
willful failure to carry out directives of our board of directors or gross
negligence or willful misconduct). Mr. Ehrlich has the right to terminate his
employment upon a change in our control or for "Good Reason," which is defined
to include adverse changes in employment status or compensation, our insolvency,
material breaches and certain other events. Additionally, Mr. Ehrlich may retire
(after age 68) or terminate his agreement for any reason upon 150 days' notice.
Upon termination of employment, the employment agreement provides for payment of
all accrued and unpaid compensation, and (unless we have terminated the
agreement for Cause or Mr. Ehrlich has terminated the agreement without Good
Reason and without giving us 150 days' notice of termination) bonuses due for
the year in which employment is terminated and severance pay in the amount of
three years' base salary (or, in the case of termination by Mr. Ehrlich on 150
days' notice, a lump sum payment of $520,000). Furthermore, certain benefits
will continue and all outstanding options will be fully vested.
Mr. Esses is not a party to an employment agreement with us. Mr. Shen
has signed our standard employee employment agreement, described below.
Other employees (including Mr. Shen) have entered into individual
employment agreements with us. These agreements govern the basic terms of the
individual's employment, such as salary, vacation, overtime pay, severance
arrangements and pension plans. Subject to Israeli law, which restricts a
company's right to relocate an employee to a work site farther than sixty
kilometers from his or her regular work site, we have retained the right to
transfer certain employees to other locations and/or positions provided that
such transfers do not result in a decrease in salary or benefits. All of these
agreements also contain provisions governing the confidentiality of information
and ownership of intellectual property learned or created during the course of
the employee's tenure with us. Under the terms of these provisions, employees
must keep confidential all information regarding our operations (other than
information which is already publicly available) received or learned by the
employee during the course of employment. This provision remains in force for
five years after the employee has left our service. Further, intellectual
property created during the course of the employment relationship belongs to us.
81
A number of the individual employment agreements, but not all, contain
non-competition provisions which restrict the employee's rights to compete
against us or work for an enterprise which competes against us. Such provisions
remain in force for a period of two years after the employee has left our
service.
Under the laws of Israel, an employee of ours who has been dismissed
from service, died in service, retired from service upon attaining retirement
age, or left due to poor health, maternity or certain other reasons, is entitled
to severance pay at the rate of one month's salary for each year of service. We
currently fund this obligation by making monthly payments to approved private
provident funds and by its accrual for severance pay in the consolidated
financial statements. See Note 2.r of the Notes to the Consolidated Financial
Statements.
Compensation Committee Interlocks and Insider Participation
The Compensation Committee of our board of directors for the 2003
fiscal year consisted until May 8, 2003 of Dr. Jay M. Eastman, Jack E. Rosenfeld
and Lawrence M. Miller; thereafter, the Compensation Committee consisted of Dr.
Jay M. Eastman, Jack E. Rosenfeld and Bert W. Wasserman. None of the members has
served as our officers or employees.
Robert S. Ehrlich, our Chairman and Chief Financial Officer, serves as
Chairman and a director of PSCX, for which Dr. Eastman serves as director and
member of the Executive and Strategic Planning Committees and Mr. Rosenfeld
serves as director and member of the Executive Compensation Committees.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS
Security Ownership of Certain Beneficial Owners and Management
The following table sets forth information regarding the security
ownership, as of March 23, 2004, of those persons owning of record or known by
us to own beneficially more than 5% of our common stock and of each of our Named
Executive Officers and directors, and the shares of common stock held by all of
our directors and executive officers as a group.
Percentage of Total
Name and Address of Beneficial Owner(1) Shares Beneficially Owned(2)(3) Shares Outstanding(3)
--------------------------------------- ------------------------------- ---------------------
Leon S. Gross........................................... 3,482,534(4)(13) 5.6%
Robert S. Ehrlich....................................... 2,284,213(5)(13) 3.6%
Steven Esses............................................ 663,475(6) 1.1%
Avihai Shen............................................. 267,804(7) *
Dr. Jay M. Eastman...................................... 85,001(8) *
Jack E. Rosenfeld....................................... 87,001(9) *
Lawrence M. Miller...................................... 539,080(10) *
Bert W. Wasserman....................................... 8,334(11) *
Edward J. Borey......................................... 40,334(12) *
All of our directors and executive officers as a group
(10 persons**).......................................... 7,519,535(14) 11.5%
82
- ------------------------------------
* Less than one percent.
** Includes 3,482,534 shares owned by Mr. Leon Gross that are subject to
the Voting Rights Agreement described in footnote 9, below. Also
includes 508,924 shares held of record by Mr. Yehuda Harats that are
subject to the Voting Rights Agreement described in footnote 9, below.
(1) The address of each named beneficial owner other than Leon Gross is in
care of Arotech Corporation, 632 Broadway, New York, New York 10012.
(2) Unless otherwise indicated in these footnotes, each of the persons or
entities named in the table has sole voting and sole investment power
with respect to all shares shown as beneficially owned by that person,
subject to applicable community property laws.
(3) For purposes of determining beneficial ownership of our common stock,
owners of options exercisable within sixty days are considered to be
the beneficial owners of the shares of common stock for which such
securities are exercisable. The percentage ownership of the outstanding
common stock reported herein is based on the assumption (expressly
required by the applicable rules of the Securities and Exchange
Commission) that only the person whose ownership is being reported has
converted his options into shares of common stock.
(4) Includes 447,165 shares held by Leon S. Gross and Lawrence M. Miller as
co-trustees of the Rose Gross Charitable Foundation. Mr. Gross's
address is c/o Enterprises Inc., River Park House, 3600 Conshohocken
Avenue, Philadelphia, Pennsylvania 19131.
(5) Includes 50,000 shares held by Mr. Ehrlich's wife (in which shares Mr.
Ehrlich disclaims beneficial ownership), 161,381 shares held in Mr.
Ehrlich's pension plan, 3,000 shares held by children sharing the same
household (in which shares Mr. Ehrlich disclaims beneficial ownership),
and 1,905,667 shares issuable upon exercise of options exercisable
within 60 days.
(6) Consists of 663,475 shares issuable upon exercise of options
exercisable within 60 days.
(7) Includes 257,304 shares issuable upon exercise of options exercisable
within 60 days.
(8) Consists of 85,001 shares issuable upon exercise of options exercisable
within 60 days.
(9) Includes 85,001 shares issuable upon exercise of options exercisable
within 60 days.
(10) Includes 447,165 shares held by Leon S. Gross and Lawrence M. Miller as
co-trustees of the Rose Gross Charitable Foundation, and 80,001 shares
issuable upon exercise of options exercisable within 60 days.
(11) Consists of 8,334 shares issuable upon exercise of options exercisable
within 60 days.
(12) Includes 8,334 shares issuable upon exercise of options exercisable
within 60 days.
(13) Messrs. Ehrlich, Leon Gross and Yehuda Harats are parties to a Voting
Rights Agreement pursuant to which each of the parties agrees to vote
the shares of our common stock held by that person in favor of the
election of Messrs. Ehrlich, Harats and Miller until the earlier of
December 28, 2004 or our fifth annual meeting of stockholders after
December 28, 1999. Mr. Harats resigned as a director in 2002; however,
we believe that Mr. Harats must continue to comply with the terms of
this agreement. As of February 19, 2004, 4,370,004 shares of our common
stock were subject to this Voting Rights Agreement.
(14) Includes 3,093,117 shares issuable upon exercise of options exercisable
within 60 days.
83
Securities Authorized for Issuance Under Equity Compensation Plans
The following table sets forth certain information, as of December 31,
2003, with respect to our 1991, 1993, 1995 and 1998 stock option plans, as well
as any other stock options and warrants previously issued by us (including
individual compensation arrangements) as compensation for goods and services:
Equity Compensation Plan Information
Number of securities
remaining available
for future issuance
Number of securities under equity
to be issued upon Weighted-average compensation plans
exercise of exercise price of (excluding securities
outstanding options, outstanding options, reflected in column
warrants and rights warrants and rights (a))
Plan Category (a)(1) (b) (c)(1)
- ---------------------------- ------------------------ ----------------------- -----------------------
Equity compensation
plans approved by
security holders..... 6,150,677 $1.38 (352,708)
Equity compensation
plans not approved
by security
holders(2)(3)........ 3,481,236 $1.65 (299,374)
- -------------------------------------
(1) Numbers in parenthesis in column (c), which are included in the number
in column (a), indicate options that have been conditionally granted
pending expansion of certain of our stock option plans at our next
annual meeting of stockholders.
(2) In October 1998, the Board of Directors adopted the 1998 Non-Executive
Stock Option and Restricted Stock Purchase Plan, which under Delaware
law did not require shareholder approval since directors and executive
officers were ineligible to participate in it. Participation in the
1998 Plan is limited to those of our employees and consultants who are
neither executive officers nor otherwise subject to Section 16 of the
Securities Exchange Act of 1934, as amended, or Section 162(m) of the
Internal Revenue Code of 1986, as amended. The 1998 Plan is
administered by the Compensation Committee of our Board of Directors,
which determined the conditions of grant. Options issued under the 1998
Plan generally expire no more than ten years from the date of grant,
and incentive options issued under the 1998 Plan may be granted only at
exercise prices equal to the fair market value of our common stock on
the date the option is granted. A total of 4,750,000 shares of our
common stock were originally subject to the 1998 Plan, of which
3,181,862 options are outstanding, 1,568,138 options have been
exercised, and 299,374 options have been conditionally granted pending
expansion of this stock option plan at our next annual meeting of
stockholders.
(3) For a description of the material features of grants of options and
warrants other than options granted under our employee stock option
plans, please see Note 11.g.2 of the Notes to the Consolidated
Financial Statements.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Voting Agreements
84
Pursuant to a securities purchase agreement dated December 28, 1999
between a group of purchasers, including Mr. Gross, and us, Mr. Gross agreed
that for a period of five years, neither he nor his "affiliates" (as such term
is defined in the Securities Act) directly or indirectly or in conjunction with
or through any "associate" (as such term is defined in Rule 12b-2 of the
Exchange Act), will (i) solicit proxies with respect to any capital stock or
other voting securities of ours under any circumstances, or become a
"participant" in any "election contest" relating to the election of our
directors (as such terms are used in Rule 14a-11 of Regulation 14A of the
Exchange Act); (ii) make an offer for the acquisition of substantially all of
our assets or capital stock or induce or assist any other person to make such an
offer; or (iii) form or join any "group" within the meaning of Section 13(d)(3)
of the Exchange Act with respect to any of our capital stock or other voting
securities for the purpose of accomplishing the actions referred to in clauses
(i) and (ii) above, other than pursuant to the voting rights agreement described
below.
Pursuant to a voting rights agreement dated September 30, 1996 and as
amended December 10, 1997 and December 28, 1999, between Mr. Gross, Robert S.
Ehrlich, Yehuda Harats and us, Lawrence M. Miller, Mr. Gross's advisor, is
entitled to be nominated to serve on our board of directors so long as Mr.
Gross, his heirs or assigns retain at least 1,375,000 shares of common stock. In
addition, under the voting rights agreement, Mr. Gross and Messrs. Ehrlich and
Harats agreed to vote and take all necessary action so that Messrs. Ehrlich,
Harats and Miller shall serve as members of the board of directors until the
earlier of December 28, 2004 or our fifth annual meeting of stockholders after
December 28, 1999. Mr. Harats resigned as a director in 2002; however, we
believe that Mr. Harats must continue to comply with the terms of this
agreement. As of February 19, 2004, 4,370,004 shares of our common stock were
subject to this Voting Rights Agreement.
Officer Loans
On December 3, 1999, Robert S. Ehrlich purchased 125,000 shares of our
common stock out of our treasury at the closing price of the common stock on
December 2, 1999. Payment was rendered by Mr. Ehrlich in the form of
non-recourse promissory notes due in 2009 in the amount of $167,975 each,
secured by the shares of common stock purchased and other shares of common stock
previously held by him. As of December 31, 2003, the aggregate amount
outstanding pursuant to this promissory note was $201,570.
On February 9, 2000, Mr. Ehrlich exercised 131,665 stock options. Mr.
Ehrlich and Harats paid the exercise price of the stock options and certain
taxes that we paid on his behalf by giving us a non-recourse promissory note due
in 2025 in the amount of $789,991, secured by the shares of our common stock
acquired through the exercise of the options and certain compensation due to Mr.
Ehrlich upon termination. As of December 31, 2003, the aggregate amount
outstanding pursuant to this promissory note was $657,146.
On June 10, 2002, Mr. Ehrlich exercised 50,000 stock options. Mr.
Ehrlich paid the exercise price of the stock options by giving us a non-recourse
promissory note due in 2012 in the amount of $36,500, secured by the shares of
our common stock acquired through the exercise of the options. As of December
31, 2003, the aggregate amount outstanding pursuant to this promissory note was
$37,810.
85
Director Consulting Agreements
Beginning in February 2002, Mr. Steven Esses, who became one of our
directors in July 2002, entered into an oral consulting arrangement with us,
whereby he performed periodic financial and other consulting for us. We paid Mr.
Esses a total of $120,480 in consulting fees in 2002. Beginning in July 2002,
when Mr. Esses became a director, this consulting arrangement ceased.
Beginning in January 2004, Mr. Edward J. Borey, who became one of our
directors in December 2003, entered into a consulting agreement with us pursuant
to which he agreed to aid us in identifying potential acquisition candidates in
exchange for transaction fees in respect of acquisitions in which he plays a
"critical role" (as determined by us in our sole and absolute discretion) in
identifying and/or initiating and/or negotiating the transaction in the amount
of (i) 1.5% of the value of the transaction up to $10,000,000, plus (ii) 1.0% of
the value of the transaction in excess of $10,000,000 and up to $50,000,000,
plus (iii) 0.5% of the value of the transaction in excess of $50,000,000. We
also agreed to issue to Mr. Borey, at par value, a total of 32,000 shares of our
common stock, the value of which is to be deducted from any transaction fees
paid.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
In accordance with the requirements of the Sarbanes-Oxley Act of 2002
and the Audit Committee's charter, all audit and audit-related work and all
non-audit work performed by our independent accountants, Kost, Forer, Gabbay &
Kassierer, is approved in advance by the Audit Committee, including the proposed
fees for such work. The Audit Committee is informed of each service actually
rendered.
>> Audit Fees. Audit fees billed or expected to be billed to us
by Kost, Forer, Gabbay & Kassierer for the audit of the
financial statements included in our Annual Report on Form
10-K, and reviews of the financial statements included in our
Quarterly Reports on Form 10-Q, for the years ended December
31, 2002 and 2003 totaled approximately $151,375 and $177,000,
respectively.
>> Audit-Related Fees. Kost, Forer, Gabbay & Kassierer billed us
$383 and $34,500 for the fiscal years ended December 31, 2002
and 2003, respectively, for assurance and related services
that are reasonably related to the performance of the audit or
review of our financial statements and are not reported under
the caption "Audit Fees," above.
>> Tax Fees. Kost, Forer, Gabbay & Kassierer billed us an
aggregate of $12,000 and $24,320 for the fiscal years ended
December 31, 2002 and 2003, respectively, for tax services,
principally advice regarding the preparation of income tax
returns.
>> Other Matters. The Audit Committee of the Board of Directors
has considered whether the provision of the Audit-Related
Fees, Tax Fees and all other fees are compatible with
maintaining the independence of our principal accountant.
86
Applicable law and regulations provide an exemption that permits
certain services to be provided by our outside auditors even if they are not
pre-approved. We have not relied on this exemption at any time since the
Sarbanes-Oxley Act was enacted.
87
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) The following documents are filed as part of this report:
(1) Financial Statements - See Index to Financial Statements on page 66
above.
(2) Financial Statements Schedules - Schedule II - Valuation and
Qualifying Accounts. All schedules other than those listed above are
omitted because of the absence of conditions under which they are
required or because the required information is presented in the
financial statements or related notes thereto.
(3) Exhibits - The following Exhibits are either filed herewith or have
previously been filed with the Securities and Exchange Commission and
are referred to and incorporated herein by reference to such filings:
Exhibit No. Description
----------- -----------
(8)3.1 Amended and Restated Certificate of Incorporation
(15)3.1.1 Amendment to our Amended and Restated Certificate of
Incorporation
(24)3.1.2 Amendment to our Amended and Restated Certificate of
Incorporation
**3.1.3 Amendment to our Amended and Restated Certificate of
Incorporation
(2)3.2 Amended and Restated By-Laws
(1)4 Specimen Certificate for shares of common stock, $.01 par
value
+ (6)10.6 Amended and Restated 1993 Stock Option and Restricted Stock
Purchase Plan dated November 11, 1996
+ (1)10.7.1 Form of Management Employment Agreements
+ * 10.7.2 General Employee Agreements
(1)
* (1)10.8 Office of Chief Scientist documents
(2)10.8.1 Letter from the Office of Chief Scientist to us dated January
4, 1995
+ (3)10.12 Amended and Restated 1995 Non-Employee Director Stock Option
Plan
(4)10.14 Stock Purchase Agreement between us and Leon S. Gross ("Gross")
dated September 30, 1996
(4)10.15 Registration Rights Agreement between us and Gross dated
September 30, 1996
(4)10.16 Voting Rights Agreement between us, Gross, Robert S. Ehrlich
and Yehuda Harats dated September 30, 1996
+ (5)10.20 Amended and Restated Employment Agreement dated as of October
1, 1996 between us, EFL and Robert S. Ehrlich
+ (15)10.20.1 Second Amended and Restated Employment Agreement, effective as
of January 1, 2000 between us, EFL and Robert S. Ehrlich
+ (15)10.20.2 Letter dated January 12, 2001 amending the Second Amended and
Restated Employment Agreement, effective as of January 1, 2000
between us, EFL and Robert S. Ehrlich
(6)10.25 Amendment No. 1 to the Voting Rights Agreement between us,
Gross, Robert S. Ehrlich, and Yehuda Harats dated December 10,
1997
-88-
Exhibit No. Description
----------- -----------
(6)10.26 Amendment No. 2 to the Registration Rights Agreement between
us, Gross, Robert S. Ehrlich and Yehuda Harats dated December
10, 1997
(7)10.27 1998 Non-Executive Stock Option and Restricted Stock Purchase
Plan
(10)10.31 Form of Warrant dated December 28, 1999
(10)10.32 Amendment No. 1 to Voting Rights Agreement dated December 28,
1999, by and between us, Leon S. Gross, Robert S. Ehrlich,
Yehuda Harats and the Purchasers listed on Exhibit A to the
Securities Purchase Agreement dated December 28, 1999
(12)10.35.1 Promissory Note dated January 3, 1993, from Robert S. Ehrlich
to us
(12)10.35.2 Amendment dated April 1, 1998, to Promissory Note dated January
3, 1993 between Robert S. Ehrlich and us
(12)10.37 Promissory Note dated December 3, 1999, from Robert S. Ehrlich
to us
(12)10.39 Promissory Note dated February 9, 2000, from Robert S. Ehrlich
to us
(14)10.48 Series A Stock Purchase Warrant issued to Capital Ventures
International dated November 17, 2000
(14)10.49 Series B Stock Purchase Warrant issued to Capital Ventures
International dated November 17, 2000
(14)10.50 Stock Purchase Warrant issued to Josephthal & Co., Inc. dated
November 17, 2000
(15)10.52 Promissory Note dated January 12, 2001, from Robert S. Ehrlich
to us
(15)10.54 Agreement of Lease dated December 5, 2000 between us as tenant
and Renaissance 632 Broadway LLC as landlord
(16)10.55 Series C Stock Purchase Warrant issued to Capital Ventures
International dated May 3, 2001
(17)10.56 Form of Common Stock Purchase Warrant dated May 8, 2001
(23)10.63 Securities Purchase Agreement dated December 31, 2002 between
us and the Investors
(23)10.64 Form of 9% Secured Convertible Debenture due June 30, 2005
(23)10.65 Form of Warrant dated December 31, 2002
(23)10.66 Form of Security Agreement dated December 31, 2002
(23)10.67 Form of Intellectual Property Security Agreement dated December
31, 2002
+(24)10.68 Settlement Agreement and Release between us and Yehuda Harats
dated December 31, 2002
(24)10.69.1 Commercial lease agreement between Commerce Square Associates
L.L.C. and I.E.S. Electronics Industries U.S.A., Inc. dated
September 24, 1997
(24)10.69.2 Amendment to Commercial lease agreement between Commerce Square
Associates L.L.C. and I.E.S. Electronics Industries U.S.A.,
Inc. dated as of May 1, 2000
(24)10.70 Agreement of Lease dated December 6, 2000 between Janet Nissim
et al. and M.D.T. Protection (2000) Ltd. [English summary of
Hebrew original]
(24)10.71 Agreement of Lease dated August 22, 2001 between Aviod Building
and Earthworks Company Ltd. et al. and M.D.T. Protective
Industries Ltd. [English summary of Hebrew original]
-89-
Exhibit No. Description
----------- -----------
**10.72 Promissory Note dated July 1, 2002 from Robert S. Ehrlich to us
(25)10.73 Securities Purchase Agreement dated September 30, 2003 between
us and the Investors named therein
(25)10.74 Form of 8% Secured Convertible Debenture due September 30, 2006
(25)10.75 Form of Warrant dated September 30, 2003
(25)10.76 Form of Security Agreement dated September 30, 2003
(25)10.77 Form of Intellectual Property Security Agreement dated
September 30, 2003
(26)1010.78 Form of Amendment and Exercise Agreement dated December 10,
2003
(26)10.79 Form of Supplemental Warrant dated December 18, 2003
(27)10.80 Stock Purchase and Sale Agreement dated January 7, 2004 between
us and the shareholders of FAAC Incorporated
(27)10.81 Securities Purchase Agreement dated January 7, 2004 between us
and the Investors named therein
(27)10.82 Registration Rights Agreement dated January 7, 2004 between us
and the Investors named therein
(27)10.83 Form of Warrant dated January __, 2004
(28)10.84 Share Purchase Agreement dated January __, 2004 between us and
the shareholders of Epsilor Electronics Industries, Ltd.
(28)10.85 Management Agreement dated January __, 2004 among us, Office
Line Ltd. and Hezy Aspis
*(29)10.86 Settlement Agreement between us and I.E.S. Electronics
Industries, Ltd. dated February 4, 2004
+**10.86 Consulting agreement dated January 1, 2004 between us and
Edward J. Borey
**10.87 Lease dated April 8, 1997, between AMR Holdings, L.L.C. and
FAAC Incorporated
**10.88 Lease dated as of March 22, 2004 between us and Fisk Building
Associates L.L.C.
**14 Code of Ethics
**21 List of Subsidiaries of the Registrant
**23 Consent of Kost, Forer, Gabbay & Kassierer
**31.1 Certification of Principal Executive Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002
**31.2 Certification of Principal Financial Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002
**32.1 Certification of Principal Executive Officer pursuant to 18
U.S.C. Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002
**32.2 Certification of Principal Financial Officer pursuant to 18
U.S.C. Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002
- ----------
* English translation or summary from original Hebrew
** Filed herewith
+ Includes management contracts and compensation plans and arrangements
-90-
(1) Incorporated by reference to our Registration Statement on Form S-1
(Registration No. 33-73256), which became effective on February 23,
1994
(2) Incorporated by reference to our Registration Statement on Form S-1
(Registration No. 33-97944), which became effective on February 5, 1996
(3) Incorporated by reference to our Annual Report on Form 10-K for the
year ended December 31, 1995
(4) Incorporated by reference to our Current Report on Form 8-K dated
October 4, 1996
(5) Incorporated by reference to our Annual Report on Form 10-K for the
year ended December 31, 1996, as amended
(6) Incorporated by reference to our Annual Report on Form 10-K for the
year ended December 31, 1997, as amended
(7) Incorporated by reference to our Registration Statement on Form S-8
(Registration No. 333- 74197), which became effective on March 10, 1998
(8) Incorporated by reference to our Annual Report on Form 10-K for the
year ended December 31, 1998
(9) [Intentionally omitted]
(10) Incorporated by reference to our Current Report on Form 8-K filed
January 7, 2000
(11) [Intentionally omitted]
(12) Incorporated by reference to our Annual Report on Form 10-K for the
year ended December 31, 1999
(13) [Intentionally omitted]
(14) Incorporated by reference to our Current Report on Form 8-K filed
November 17, 2000
(15) Incorporated by reference to our Annual Report on Form 10-K for the
year ended December 31, 2000
(16) Incorporated by reference to our Current Report on Form 8-K filed May
7, 2001 (EDGAR Film No. 1623996)
(17) Incorporated by reference to our Current Report on Form 8-K filed May
7, 2001 (EDGAR Film No. 1623989)
(18) [Intentionally omitted]
(19) [Intentionally omitted]
(20) [Intentionally omitted]
(21) [Intentionally omitted]
(22) [Intentionally omitted]
(23) Incorporated by reference to our Current Report on Form 8-K filed
January 6, 2003
(24) Incorporated by reference to our Annual Report on Form 10-K for the
year ended December 31, 2002
(25) Incorporated by reference to our Current Report on Form 8-K filed
October 3, 2003
(26) Incorporated by reference to our Current Report on Form 8-K filed
December 23, 2003
(27) Incorporated by reference to our Current Report on Form 8-K filed
January 9, 2004
(28) Incorporated by reference to our Current Report on Form 8-K filed
February 4, 2004
(29) Incorporated by reference to our Current Report on Form 8-K filed
February 5, 2004 (b) Reports on Form 8-K.
The following reports on Form 8-K were filed during the fourth quarter of 2003
and thereafter:
Date Filed Item Reported
---------- -------------
Item 5 - Other Events and Regulation FD Disclosure; and Item 7 - Financial Statements,
October 3, 2003........... Pro Forma Financial Information and Exhibits
Item 7 - Financial Statements, Pro Forma Financial Information and Exhibits; and Item
November 3, 2003.......... 12 - Results of Operations and Financial Condition
Item 5 - Other Events and Regulation FD Disclosure; and Item 7 - Financial Statements,
December 23, 2003......... Pro Forma Financial Information and Exhibits
Item 2 - Acquisition or Disposition of Assets; 5 - Other Events and Regulation FD
Disclosure; and Item 7 - Financial Statements, Pro Forma Financial Information and
January 9, 2004........... Exhibits
Item 7 - Financial Statements, Pro Forma Financial Information and Exhibits; and Item
January 15, 2004.......... 12 - Results of Operations and Financial Condition
91
Item 5 - Other Events and Regulation FD Disclosure; and Item 7 - Financial Statements,
January 21, 2004.......... Pro Forma Financial Information and Exhibits
Item 2 - Acquisition or Disposition of Assets; and Item 7 - Financial Statements, Pro
February 4, 2004.......... Forma Financial Information and Exhibits
Item 5 - Other Events and Regulation FD Disclosure; and Item 7 - Financial Statements,
February 5, 2004.......... Pro Forma Financial Information and Exhibits
March 9, 2004............. Item 7 -Financial Statements, Pro Forma Financial Information and Exhibits (amendment)
Item 5 - Other Events and Regulation FD Disclosure; and Item 7 - Financial Statements,
March 9, 2004............. Pro Forma Financial Information and Exhibits
92
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized, on March 30 , 2004.
AROTECH CORPORATION
By: /s/ Robert S. Ehrlich
Name: Robert S. Ehrlich
Title: Chairman, President and Chief
Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
Signature Title Date
--------- ----- ----
Chairman, President, Chief Executive Officer and
/s/ Robert S. Ehrlich Director
-----------------------------
Robert S. Ehrlich (Principal Executive Officer) March 30 , 2004
/s/ Avihai Shen Vice President - Finance
------------------------------
Avihai Shen (Principal Financial Officer) March 30 , 2004
/s/ Danny Waldner Controller
------------------------------
Danny Waldner (Principal Accounting Officer) March 30 , 2004
/s/ Steven Esses Executive Vice President, Chief Operating Officer
------------------------------
Steven Esses and Director March 30 , 2004
/s/ Jay M. Eastman
------------------------------
Dr. Jay M. Eastman Director March 30 , 2004
/s/ Lawrence M. Miller
------------------------------
Lawrence M. Miller Director March 30 , 2004
/s/ Jack E. Rosenfeld
------------------------------
Jack E. Rosenfeld Director March 30 , 2004
/s/ Bert W. Wasserman
------------------------------
Bert W. Wasserman Director March 30 , 2004
/s/ Edward J. Borey
------------------------------
Edward J. Borey Director March 21 , 2004
ELECTRIC FUEL CORPORATION AND ITS SUBSIDIARIES
AROTECH CORPORATION AND ITS SUBSIDIARIES
CONSOLIDATED FINANCIAL STATEMENTS
AS OF DECEMBER 31, 2003
IN U.S. DOLLARS
INDEX
Page
-------------
Report of Independent Auditors 2
Consolidated Balance Sheets 3 - 4
Consolidated Statements of Operations 5
Statements of Changes in Shareholders' Equity 6 - 8
Consolidated Statements of Cash Flows 9 - 11
Notes to Consolidated Financial Statements 12 - 47
REPORT OF INDEPENDENT AUDITORS
To the Shareholders of
AROTECH CORPORATION
We have audited the accompanying consolidated balance sheets of Arotech
Corporation (formerly known as Electric Fuel Corporation) (the "Company") and
its subsidiaries as of December 31, 2003 and 2002, and the related consolidated
statements of operations, changes in shareholders' equity and cash flows for
each of the three years in the period ended December 31, 2003. Our audits also
included the financial statement schedule listed in Item 15(a)(2) of the
Company's 10-K. These financial statements and schedule are the responsibility
of the Company's management. Our responsibility is to express an opinion on
these financial statements and schedule based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States. Those standards require that we plan and perform
the audit to obtain reasonable assurance about whether the financial statements
are free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements. An
audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position of
the Company and its subsidiaries as of December 31, 2003 and 2002, and the
consolidated results of their operations and cash flows for each of the three
years in the period ended December 31, 2003, in conformity with accounting
principles generally accepted in the United States. Additionally, in our opinion
the related financial statement schedule, when considered in relation to the
basic financial statements and schedule taken as a whole, present fairly in all
material respects the information set forth therein.
Tel Aviv, Israel KOST, FORER, GABBAY & KASSIERER
March 9, 2004 A Member of Ernst & Young Global
F-2
AROTECH CORPORATION AND ITS SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
- --------------------------------------------------------------------------------
In U.S. dollars
December 31,
-----------------------------------------
2003 2002
------------------ ------------------
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 13,685,125 $ 1,457,526
Restricted collateral deposit and other restricted cash 706,180 633,339
Trade receivables (net of allowance for doubtful accounts in the
amounts of $61,282 and $40,636 as of December 31, 2003 and 2002,
respectively) 4,706,423 3,776,195
Other accounts receivable and prepaid expenses 1,187,371 1,032,311
Inventories 1,914,748 1,711,479
Assets of discontinued operations 66,068 349,774
------------------ ------------------
Total current assets 22,265,915 8,960,624
------------------ ------------------
SEVERANCE PAY FUND 1,023,342 1,025,071
PROPERTY AND EQUIPMENT, NET 2,292,741 2,555,249
GOODWILL 5,064,555 4,954,981
OTHER Intangible Assets, NET 2,375,195 2,567,457
------------------ ------------------
$ 33,021,748 $ 20,063,382
================== ==================
The accompanying notes are an integral part of the consolidated
financial statements.
F-3
AROTECH CORPORATION AND ITS SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
- --------------------------------------------------------------------------------
In U.S. dollars
December 31,
------------------------------------------
2003 2002
------------------- ------------------
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES:
Short term bank loans $ 40,849 $ 108,659
Trade payables 1,967,448 2,900,117
Other accounts payable and accrued expenses 4,321,347 2,009,109
Current portion of promissory note 150,000 1,200,000
Liabilities of discontinued operations 380,108 1,053,798
------------------- ------------------
Total current liabilities 6,859,752 7,271,683
LONG TERM LIABILITIES
Accrued severance pay 2,814,492 2,994,233
Convertible debenture 881,944 -
Deferred warranty revenue 220,143 -
Promissory note 150,000 516,793
------------------- ------------------
Total long-term liabilities 4,066,579 3,511,026
COMMITMENTS AND CONTINGENT LIABILITIES
MINORITY INTEREST 51,290 243,172
SHAREHOLDERS' EQUITY:
Share capital -
Common stock - $0.01 par value each;
Authorized: 100,000,000 shares as of December 31, 2002 and 2001;
Issued: 47,972,407 shares and 35,701,594 shares as of December 31,
2003 and 2002, respectively; Outstanding - 47,417,074 shares and
35,146,261 shares as of December 31, 2003 and 2002, respectively 479,726 357,017
Preferred shares - $0.01 par value each;
Authorized: 1,000,000 shares as of December 31, 2003 and 2002; No
shares issued and outstanding as of December 31, 2003 and 2002 -
Additional paid-in capital 135,891,316 114,082,584
Accumulated deficit (109,681,893) (100,673,619)
Deferred stock compensation (8,464) (12,000)
Treasury stock, at cost (common stock - 555,333 shares as of December 31,
2003 and 2002) (3,537,106) (3,537,106)
Notes receivable from shareholders (1,203,881) (1,177,589)
Accumulated other comprehensive loss 104,429 (1,786)
------------------- ------------------
Total shareholders' equity 22,044,127 9,037,501
------------------- ------------------
$ 33,021,748 $ 20,063,382
=================== ==================
The accompanying notes are an integral part of the consolidated
financial statements.
F-4
AROTECH CORPORATION AND ITS SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
- --------------------------------------------------------------------------------
In U.S. dollars
Year ended December 31,
---------------------------------------------------------------
2003 2002 2001
------------------- ------------------- -------------------
Revenues:
Products $ 16,918,480 $ 5,944,370 $ 1,670,634
Services 408,161 462,369 422,998
------------------- ------------------- -------------------
Total revenues 17,326,641 6,406,739 2,093,632
Cost of revenues 11,087,840 4,421,748 1,992,636
------------------- ------------------- -------------------
Gross profit 6,238,801 1,984,991 100,996
------------------- ------------------- -------------------
Operating expenses:
Research and development, net 1,053,408 685,919 455,845
Selling and marketing expenses 3,532,636 1,309,669 105,977
General and administrative expenses 6,196,779 4,023,103 3,827,544
Amortization of intangible assets 864,910 623,543 -
In-process research and development write-off - 26,000 -
------------------- ------------------- -------------------
Total operating costs and expenses 11,647,733 6,668,234 4,389,366
------------------- ------------------- -------------------
Operating loss (5,408,932) (4,683,243) (4,288,370)
Financial income (expenses), net (3,470,459) 100,451 262,581
------------------- ------------------- -------------------
Loss before minority interest in loss (earnings) of a
subsidiary and tax expenses (8,879,391) (4,582,792) (4,025,789)
Tax expenses (396,193) - -
Minority interest in loss (earnings) of a subsidiary 156,900 (355,360) -
------------------- ------------------- -------------------
Loss from continuing operations (9,118,684) (4,938,152) (4,025,789)
Income (loss) from discontinued operations (including
loss on disposal of $4,446,684 during 2002) 110,410 (13,566,206) (13,260,999)
------------------- ------------------- -------------------
Net loss $ (9,008,274) $ (18,504,358) $ (17,286,788)
=================== =================== ===================
Deemed dividend to certain shareholders of common stock $ - $ - $ (1,196,667)
------------------- ------------------- -------------------
Net loss attributable to shareholders of common stock $ (9,008,274) $ (18,504,358) $ (18,483,455)
=================== =================== ===================
Basic and diluted net loss per share from continuing
operations $ (0.23) $ (0.15) $ (0.21)
=================== =================== ===================
Basic and diluted net loss per share from discontinued
operations $ 0.00 $ (0.42) $ (0.55)
=================== =================== ===================
Basic and diluted net loss per share $ (0.23) $ (0.57) $ (0.76)
=================== =================== ===================
Weighted average number of shares used in computing
basic and diluted net loss per share 38,890,174 32,381,502 24,200,184
=================== =================== ===================
The accompanying notes are an integral part of the consolidated
financial statements.
F-5
AROTECH CORPORATION AND ITS SUBSIDIARIES
STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
In U.S. dollars
ADDITIONAL DEFERRED
COMMON STOCK PAID-IN ACCUMULATED STOCK TREASURY
SHARES AMOUNT CAPITAL DEFICIT COMPENSATION STOCK
-------------------------------------------------------------------------------------
Balance as of January 1, 2001 21,422,691 $ 214,227 $89,091,790 $ 64,882,473) $ (17,240) $ (37,731)
Repurchase of common shares
from shareholders and
repayment of the related
interest and principal of
notes from shareholders - - 228,674 - - (3,499,375)
Issuance of shares to investors,
net 6,740,359 67,405 14,325,941 - - -
Retirement of shares (3,000) (30) (17,970) - - -
Issuance of shares to service
providers 346,121 3,461 536,916 - - -
Exercise of options 219,965 2,200 512,089 - - -
Exercise of warrants 333,333 3,333 836,667 - - -
Deferred stock compensation - - 18,000 - (18,000) -
Amortization of deferred stock
compensation - - (6,193) - 17,240 -
Stock compensation related to
options issued to
consultants - - 139,291 - - -
Stock compensation related to
options to consultants
repriced - - 21,704 - - -
Comprehensive loss:
Net loss - - - (17,286,788) - -
----------- ------------ ------------ -------------- -------------- -------------
Total comprehensive loss
Balance as of December 31, 2001 29,059,469 $ 290,596 $105,686,909 $(82,169,261) $ (18,000) $ (3,537,106)
=========== ============ ============ ============== ============== =============
NOTES
TOTAL RECEIVABLE TOTAL
COMPREHENSIVE FROM SHAREHOLDERS
LOSS SHAREHOLDERS EQUITY
----------------------------------------------------------
Balance as of January 1, 2001 $ (4,290,204) $ 20,078,369
Repurchase of common shares
from shareholders and
repayment of the related
interest and principal of
notes from shareholders 3,470,431 199,730
Issuance of shares to investors,
net - 14,393,346
Retirement of shares 18,000 -
Issuance of shares to service
providers - 540,377
Exercise of options (43,308) 470,981
Exercise of warrants - - 840,000
Deferred stock compensation - -
Amortization of deferred stock
compensation - 11,047
Stock compensation related to
options issued to
consultants - 139,291
Stock compensation related to
options to consultants
repriced - 21,704
Comprehensive loss:
Net loss (17,286,788) - (17,286,788)
-------------- ------------------ -----------------
Total comprehensive loss $(17,286,788)
==============
Balance as of December 31, 2001 $ (845,081) $ 19,408,057
================== =================
The accompanying notes are an integral part of the consolidated
financial statements.
F-6
AROTECH CORPORATION AND ITS SUBSIDIARIES
STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
In U.S. dollars
ADDITIONAL DEFERRED
COMMON STOCK PAID-IN ACCUMULATED STOCK TREASURY
SHARES AMOUNT CAPITAL DEFICIT COMPENSATION STOCK
-------------------------------------------------------------------------------------
Balance as of January 1, 2002 29,059,469 $290,596 $105,686,909 $(82,169,261) $(18,000) $(3,537,106)
Adjustment of notes from
shareholders
Repayment of notes from
employees - - - - - -
Issuance of shares to investors 2,041,176 20,412 3,209,588
Issuance of shares to service
providers 368,468 3,685 539,068
Issuance of shares to lender
in respect of prepaid
interest expenses 387,301 3,873 232,377 - - -
Exercise of options by
employees 191,542 1,915 184,435
Amortization of deferred stock
compensation 6,000
Stock compensation related to
options issued to employees 13,000 130 12,870
Issuance of shares in respect
of acquisition 3,640,638 36,406 4,056,600
Accrued interest on notes
receivable 160,737
Other comprehensive loss
Foreign currency translation
adjustment
Net loss (18,504,358)
------------- ------------- ------------- -------------- -------------- -------------
Total comprehensive loss
Balance as of December 31, 2002 35,701,594 $ 357,017 $114,082,584 $(100,673,619) $ (12,000) $(3,537,106)
============= ============= ============= ============== ============== =============
NOTES
TOTAL RECEIVABLE TOTAL
COMPREHENSIVE FROM SHAREHOLDERS
LOSS SHAREHOLDERS EQUITY
----------------------------------------------------------
Balance as of January 1, 2002 $(845,081) - $19,408,057
Adjustment of notes from
shareholders (178,579) (178,579)
Repayment of notes from
employees 43,308 43,308
Issuance of shares to investors 3,230,000
Issuance of shares to service
providers 542,753
Issuance of shares to lender
in respect of prepaid
interest expenses - 236,250
Exercise of options by
employees (36,500) 149,850
Amortization of deferred stock
compensation 6,000
Stock compensation related to
options issued to employees 13,000
Issuance of shares in respect
of acquisition 4,093,006
Accrued interest on notes
receivable (160,737) -
Other comprehensive loss
Foreign currency translation
adjustment (1,786) (1,786) (1,786)
Net loss (18,504,358) (18,504,358)
--------------- ------------- -------------- --------------
Total comprehensive loss $ (18,506,144)
===============
Balance as of December 31, 2002 $(1,177,589) $ (1,786) $ 9,037,501
============= ============== ==============
The accompanying notes are an integral part of the consolidated
financial statements.
F-7
AROTECH CORPORATION AND ITS SUBSIDIARIES
STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
In U.S. dollars
COMMON STOCK ADDITIONAL DEFERRED
------------------------ PAID-IN ACCUMULATED STOCK TREASURY
SHARES AMOUNT CAPITAL DEFICIT COMPENSATION STOCK
--------------------------------------------------------------------------------------
Balance as of January 1, 2003 35,701,594 $ 357,017 $114,082,584 $(100,673,619) $ (12,000) $(3,537,106)
Compensation related to
warrants issued to the
holders of convertible
debentures 5,157,500
Compensation related to
beneficial conversion
feature of convertible
debentures 5,695,543
Issuance of shares on
conversion of convertible
debentures 6,969,605 69,696 6,064,981
Issuance of shares on exercise
of warrants 3,682,997 36,831 3,259,422
Issuance of shares to
consultants 223,600 2,236 159,711
Compensation related to
warrants and options issued
to consultants and investors 418,162
Compensation related to
non-recourse loan granted to
shareholder 38,500
Deferred stock compensation 4,750 (4,750)
Amortization of deferred stock
compensation 8,286
Exercise of options by
employees 689,640 6,896 426,668
Exercise of options by
consultants 15,000 150 7,200
Conversion of convertible
promissory note 563,971 5,640 438,720
Increase in investment in
subsidiary against common
stock issuance 126,000 1,260 120,960
Accrued interest on notes
receivable from shareholders 16,615
Other comprehensive loss -
foreign currency translation
adjustment
Net loss (9,008,274)
------------- ------------- ------------- -------------- -------------- -------------
Balance as of December 31, 2003 47,972,407 $ 479,726 $135,891,316 $(109,681,893) $ (8,464) $(3,537,106)
============= ============= ============= ============== ============== =============
ACCUMULATED
TOTAL NOTES RECEIVABLE OTHER COM- TOTAL
COMPREHENSIVE FROM PREHENSIVE SHAREHOLDERS'
LOSS SHAREHOLDERS LOSS EQUITY
-------------------------------------------------------------
Balance as of January 1, 2003 $(1,177,589) $ (1,786) $ 9,037,501
Compensation related to
warrants issued to the
holders of convertible
debentures 5,157,500
Compensation related to
beneficial conversion
feature of convertible
debentures 5,695,543
Issuance of shares on
conversion of convertible
debentures (9,677) 6,125,000
Issuance of shares on exercise
of warrants 3,296,253
Issuance of shares to
consultants 161,947
Compensation related to
warrants and options issued
to consultants and investors 418,162
Compensation related to
non-recourse loan granted to
shareholder 38,500
Deferred stock compensation -
Amortization of deferred stock
compensation 8,286
Exercise of options by
employees 433,564
Exercise of options by
consultants 7,350
Conversion of convertible
promissory note 444,360
Increase in investment in
subsidiary against common
stock issuance 122,220
Accrued interest on notes
receivable from shareholders (16,615) -
Other comprehensive loss -
foreign currency translation
adjustment 106,215 106,215 106,215
Net loss (9,008,274) (9,008,274)
------------ -------------- ---------------- --------------
(8,902,059)
================
Balance as of December 31, 2003 $(1,203,881) $ 104,429 $ 22,044,127
============ ============== ==============
The accompanying notes are an integral part of the consolidated
financial statements.
F-8
AROTECH CORPORATION AND ITS SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
- --------------------------------------------------------------------------------
In U.S. dollars
Year ended December 31,
-----------------------------------------------------------
2003 2002 2001
------------------ ------------------ -----------------
Cash flows from operating activities:
Net loss (9,008,274) (18,504,358) (17,286,788)
Less loss (profit) for the period from discontinued
operations (110,410) 13,566,206 13,260,999
Adjustments required to reconcile net loss to net cash used in operating
activities:
Minority interest in earnings (loss) of subsidiary (156,900) 355,360 -
Depreciation 730,159 473,739 530,013
Amortization of intangible assets 864,910 623,543 -
In-process research and development write-off - 26,000 -
Accrued severance pay, net 3,693 (357,808) 530,777
Amortization of deferred stock compensation 8,286 6,000 17,240
Impairment and write-off of loans to shareholders (12,519) 542,317 206,005
Compensation expenses related to repurchase of treasury
stock - 228,674
Write-off of inventories 96,350 116,008 -
Impairment of fixed assets 68,945 - -
Amortization of compensation related to beneficial
conversion feature and warrants issued to holders of
convertible debentures 3,359,987 - -
Amortization of deferred expenses related to convertible
debenture issuance 483,713 - -
Amortization of prepaid financial expenses 236,250 - -
Amortization of capitalized research and development
projects 14,401 - -
Stock-based compensation related to repricing of warrants
granted to investors and the grant of new warrants 388,403 - -
Stock-based compensation related to repricing of warrants
granted to consultants 29,759 - -
Stock-based compensation related to shares issued to
consultants 161,947 - -
Stock-based compensation related to non-recourse note
granted to stockholder 38,500 - -
Compensation expenses related to shares issued to
employees - 13,000 -
Accrued interest on notes receivable from shareholders - - 36,940
Interest accrued on promissory notes due to acquisition (66,793) 29,829 -
Interest accrued on restricted collateral deposit - (3,213) -
Capital (gain) loss from sale of property and equipment (11,504) (4,444) 815
Decrease (increase) in trade receivables (820,137) 389,516 (452,425)
Decrease in other accounts receivable and prepaid expenses 40,520 257,218 616,040
Increase in inventories (193,222) (520,408) (128,897)
Decrease in trade payables (986,022) (62,536) (301,075)
Increase (decrease) in other accounts payable and accrued
expenses 1,827,668 (423,664) 286,511
------------------ ------------------ -----------------
Net cash used in operating activities from continuing (3,012,290) (3,477,695) (2,455,171)
operations (reconciled from continuing operations)
Net cash used in operating activities from discontinued
operations (reconciled from discontinued operations) (313,454) (5,456,912) (10,894,660)
------------------ ------------------ -----------------
Net cash used in operating activities (3,325,744) (8,934,607) (13,349,831)
------------------ ------------------ -----------------
The accompanying notes are an integral part of the consolidated
financial statements.
F-9
AROTECH CORPORATION AND ITS SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
- --------------------------------------------------------------------------------
In U.S. dollars
Year ended December 31,
---------------------------------------------------------
2003 2002 2001
----------------- ----------------- -----------------
Cash flows from investing activities:
Purchase of property and equipment (580,949) (275,540) (513,746)
Increase in capitalized research and development projects (209,616) - -
Payment to suppliers for purchase of property and
equipment from previous year - (39,336) (43,883)
Loans granted to shareholders (13,737) (4,529) -
Repayment of loans granted to shareholders 9,280 - -
Proceeds from sale of property and equipment 16,753 8,199 40,217
Acquisition of IES (1) - (2,958,083) -
Acquisition of MDT (2) - (1,201,843) -
Repayment of promissory note related to acquisition of
subsidiary (750,000) - -
Purchase of intangible assets and inventory (196,331) - -
Increase in restricted cash (72,840) (595,341) -
Net cash used in discontinued operations (purchase of
property and equipment) - (290,650) (761,555)
----------------- ----------------- -----------------
Net cash used in investing activities (1,797,440) (5,357,123) (1,278,967)
----------------- ----------------- -----------------
Cash flows from financing activities:
Proceeds from issuance of shares, net (6,900) 3,230,000 14,393,346
Proceeds from exercise of options to employees and
consultants 440,914 113,350 470,981
Proceeds from exercise of warrants 3,296,254 - 840,000
Proceeds from the sale of convertible debentures, net 13,708,662 - -
Payment of interest and principal on notes receivable from
shareholders - 43,308 -
Profit distribution to minority - (412,231) -
Increase (decrease) in short term bank credit (74,158) 108,659 -
Payment on capital lease obligation (4,427) (5,584) -
----------------- ----------------- -----------------
Net cash provided by financing activities 17,360,345 3,077,502 15,704,327
----------------- ----------------- -----------------
Increase (decrease) in cash and cash equivalents 12,237,161 (11,214,228) 1,075,529
Cash erosion due to exchange rate differences (9,562) - -
Cash and cash equivalents at the beginning of the year 1,457,526 12,671,754 11,596,225
----------------- ----------------- -----------------
Cash and cash equivalents at the end of the year $ 13,685,125 $ 1,457,526 $ 12,671,754
================= ================= =================
Supplementary information on non-cash transactions:
Purchase of property and equipment against trade payables $ - $ - $ 39,336
================= ================= =================
Purchase of treasury stock in respect of notes receivable from
shareholders $ - $ - $ 3,499,375
================= ================= =================
Retirement of shares issued under notes receivables $ - $ - $ 18,000
================= ================= =================
Issuance of shares to consultants in respect of prepaid
interest expenses $ - $ 236,250 $ -
================= ================= =================
Exercise of options against notes receivable $ - $ 36,500 $ 43,308
================= ================= =================
Purchase of intangible assets against note receivable $ 300,000 $ - $ -
================= ================= =================
Increase of investment in subsidiary against issuance of
shares of common stock $ 123,480 $ - $ -
================= ================= =================
Conversion of promissory note to shares of common stock $ 450,000 $ - $ -
================= ================= =================
Conversion of convertible debenture to shares of common stock $ 6,125,000 $ - $ -
================= ================= =================
Benefit due to convertible debentures and warrants $ 10,853,043 $ - $ -
================= ================= =================
Supplemental disclosure of cash flows activities:
Cash paid during the year for:
Interest $ 39,412 $ 10,640 $ 19,106
================ ================ ================
The accompanying notes are an integral part of the consolidated
financial statements.
F-10
AROTECH CORPORATION AND ITS SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (Cont.)
- --------------------------------------------------------------------------------
In U.S. dollars
(1) In July 2002, the Company acquired substantially all of the assets of
I.E.S. Electronics Industries U.S.A., Inc. ("IES"). The net fair value
of the assets acquired and the liabilities assumed, at the date of
acquisition, was as follows:
Working capital, excluding cash and $ 1,233,000
cash equivalents
Property and equipment, net 396,776
Capital lease obligation (15,526)
Technology 1,515,000
Existing contracts 46,000
Covenants not to compete 99,000
In process research and development 26,000
Customer list 527,000
Trademarks 439,000
Goodwill 4,032,726
-----------
8,298,976
Issuance of shares (3,653,929)
Issuance of promissory note (1,686,964)
-----------
$ 2,958,083
===========
(2) In July 2002, the Company acquired 51% of the outstanding ordinary
shares of MDT Protective Industries Ltd. ("MDT"). The fair value of the
assets acquired and liabilities assumed was as follows:
Working capital, excluding cash and $ 350,085
cash and cash equivalents
Property, and equipment, net 139,623
Minority rights (300,043)
Technology 280,000
Customer base 285,000
Goodwill 886,255
-----------
1,640,920
Issuance of shares (439,077)
-----------
$ 1,201,843
===========
The accompanying notes are an integral part of the consolidated
financial statements.
F-11
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
In U.S. dollars
NOTE 1: - GENERAL
a. Arotech Corporation, f/k/a Electric Fuel Corporation ("Arotech" or the
"Company") and its subsidiaries are engaged in the development, manufacture and
marketing of defense and security products, including advanced hi-tech
multimedia and interactive digital solutions for training of military, law
enforcement and security personnel and sophisticated lightweight materials and
advanced engineering processes to armor vehicles, and in the design, development
and commercialization of its proprietary zinc-air battery technology for
electric vehicles and defense applications. The Company is primarily operating
through Electric Fuel Ltd. ("EFL") a wholly-owned Israeli subsidiary; IES
Interactive Training, Inc. ("IES"), a wholly-owned U.S. subsidiary; Arocon
Security Corporation, a wholly-owned U.S. subsidiary; Electric Fuel Battery
Corporation, a wholly-owned U.S. subsidiary; MDT Protective Industries ("MDT"),
an Israeli subsidiary in which the Company has a 75.5% interest; and MDT Armor
Corporation, a U.S. subsidiary in which the Company has an 88% interest. The
Company's production and research and development operations are primarily
located in Israel and in the United States.
b. Acquisition of IES:
In August 2, 2002, the Company entered into an asset purchase agreement among
I.E.S. Electronics Industries U.S.A., Inc. ("IES"), its direct and certain of
its indirect shareholders, and its wholly-owned Israeli subsidiary, EFL,
pursuant to the terms of which it acquired substantially all the assets, subject
to substantially all the liabilities, of IES, a developer, manufacturer and
marketer of advanced hi-tech multimedia and interactive digital solutions for
training of military, law enforcement and security personnel. The Company
intends to continue to use the assets purchased in the conduct of the business
formerly conducted by IES (the "Business"). The acquisition has been accounted
under the purchase method of accounting. Accordingly, all assets and liabilities
were acquired as at the values on such date, and the Company consolidated IES's
results with its own commencing at such date.
The assets purchased consisted of the current assets, property and equipment,
and other intangible assets used by IES in the conduct of the Business. The
consideration for the assets and liabilities purchased consisted of (i) cash and
promissory notes in an aggregate amount of $4,800,000 ($3,000,000 in cash and
$1,800,000 in promissory notes, which was recorded at its fair value in the
amount of $1,686,964) (see Note 9), and (ii) the issuance, with registration
rights, of a total of 3,250,000 shares of our common stock, $.01 par value per
share, having a value of approximately $3,653,929, which shares are the subject
of a voting agreement on the part of IES and certain of its affiliated
companies. The value of 3,250,000 shares issued was determined based on the
average market price of Arotech's Common stock over the period including two
days before and after the terms of the acquisition were agreed to and announced.
The total consideration of $8,354,893 (including $14,000 of transaction costs)
was determined based upon arm's-length negotiations between the Company and IES
and IES's shareholders.
F-12
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
In U.S. dollars
NOTE 1: - GENERAL (Cont.)
Based upon a valuation of tangible and intangible assets acquired, Arotech has
allocated the total cost of the acquisition to IES's assets as follows:
Tangible assets acquired $ 2,856,951
Intangible assets
Technology (four year useful life) 1,515,000
Existing contracts (one year useful life) 46,000
Covenants not to compete (five year useful
life) 99,000
In process research and development 26,000
Customer list (seven year useful life) 527,000
Trademarks (indefinite useful life) 439,000
Goodwill 4,032,726
Liabilities assumed (1,186,784)
----------------------
Total consideration $ 8,354,893
======================
In accordance with SFAS No. 142, "Goodwill and Other Intangible Assets,"
goodwill arising from acquisitions will not be amortized. In lieu of
amortization, Arotech is required to perform an annual impairment review. If
Arotech determines, through the impairment review process, that goodwill has
been impaired, it will record the impairment charge in its statement of
operations. Arotech will also assess the impairment of goodwill whenever events
or changes in circumstances indicate that the carrying value may not be
recoverable.
The value assigned to the tangible, intangibles assets and liabilities was
determined as follows:
1. To determine the value of the Company's net current assets, property
and equipment, and net liabilities; the Cost Approach was used, which
requires that the assets and liabilities in question be restated to
their market values. Per estimation made by the independent appraisal
the book values for the current assets and liabilities were reasonable
proxies for their market values.
2. The amount of the excess cost attributable to technology of Range 2000,
3000 and A2Z Systems is $1,515,000 and was determined using the Income
Approach.
3. The value assigned to purchased in-process technology relates to two
projects "Black Box" and A2Z trainer. The estimated fair value of the
acquired in-process research and development platforms that had not yet
reached technological feasibility and had no alternative future use
amounted to $26,000. Technological feasibility or commercial viability
of these projects was established at the acquisition date. These
products were considered to have no alternative future use other than
the technological indications for which they were in development.
Accordingly, these amounts were immediately expensed in the
consolidated statement of operations on the acquisition date in
accordance with FASB Interpretation No. 4, "Applicability of FASB
Statement No. 2 to Business Combinations Accounted for by the Purchase
Method." The estimated fair values of these platforms were determined
using discounted cash flow models. Projects were estimated to be 4%
complete; estimated costs to completion of these platforms were
approximately $200,000 and $25,000, respectively, and discount rate of
25% was used.
F-13
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
In U.S. dollars
NOTE 1: - GENERAL (Cont.)
4. The value assigned to the customer list is amounted to $527,000.
Management states that its customers have generally been very loyal to
IES's products; most present customers are expected to purchase add-ons
or up-grades to their IES simulator systems in the future, and some
will purchase additional warranties for the systems they possess.
Independent appraisal has therefore valued the Company's customer list
using the Income Approach.
5. The value assigned to the trademarks amounted to $439,000 and was
determined based on the Cost Approach. In doing so, it is assumed that
historical expenditures for advertising are a reasonable proxy for the
future benefits expected from the Trademarks and Trade names.
6. Value of IES's Covenant Not to Compete (CNC) was valued at the amount
of $99,000. One of IES's intangible assets is its covenant not to
compete. Asset Purchase Agreement precludes the former parent company,
and its principals and key employees from competing with IES for five
years from the Valuation Date. According to management, among the
individuals covered by the CNC are the original developers of the Range
2000 and A2Z systems. Estimated CNC's value was determined using the
Income Approach. The estimated value of the CNC is the sum of the
present value of the cash flows that would be lost if the CNC was not
in place. Specifically, the value of the CNC is calculated as the
difference between the projected cash flows if the former parent
company or its principals were to start competing immediately and the
projected cash flows if those parties start competing after five years,
when the CNC expires.
In September 2003, the Company's IES subsidiary purchased selected assets of
Bristlecone Corporation. The assets purchased consisted of inventories, customer
lists, and certain other assets (including intangible assets such as
intellectual property and customer lists), including the name "Bristlecone
Training Products" and the patents for the Heads Up Display (HUD) and a remote
trigger device, used by Bristlecone in connection with its designing and
manufacturing firearms training devices, for a total consideration of $183,688
in cash and $300,000 in promissory notes, payable in four equal semi-annual
payments of $75,000 each, to become due and payable on March 1, 2004, August 31,
2004, February 28, 2005 and August 31, 2005. The acquired patents are used in
the IES's Range FDU (firearm diagnostics unit).
The purchase consideration was estimated as follows:
F-14
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
In U.S. dollars
NOTE 1: - GENERAL (Cont.)
U.S. Dollars
--------
Cash consideration $ 33,668
$183,688
Present value of promissory notes 289,333
Transaction expenses 12,643
--------
Total consideration $485,664
========
Based upon a valuation of tangible and intangible assets acquired, the Company
has allocated the total cost of the acquisition of Bristlecone's assets as
follows:
U.S. Dollars
------------
Tangible assets acquired $ 33,668
$ 33,668
Intangible assets
Technology and patents 436,746
Customer list 15,250
--------
Total consideration $485,664
========
The Company believes that the acquisition of Bristlecone is not material to its
business.
c. Acquisition of MDT:
On July 1, 2002, the Company entered into a stock purchase agreement with all of
the shareholders of M.D.T. Protective Industries Ltd. ("MDT"), pursuant to the
terms of which the Company purchased 51% of the issued and outstanding shares of
MDT, a privately-held Israeli company that specializes in using sophisticated
lightweight materials and advanced engineering processes to armor vehicles. The
Company also entered into certain other ancillary agreements with MDT and its
shareholders and other affiliated companies. The Acquisition was accounted under
the purchase method accounting and results of MDT's operations have been
included in the consolidated financial statements since that date. The total
consideration of $1,767,877 for the shares purchased consisted of (i) cash in
the aggregate amount of 5,814,000 New Israeli Shekels ($1,231,780), and (ii) the
issuance, with registration rights, of an aggregate of 390,638 shares of our
common stock, $0.01 par value per share, having a value of approximately
$439,077. The value of 390,638 shares issued was determined based on the average
market price of Arotech's Common stock over the period including two days before
and after the terms of the acquisition were agreed to and announced.
Based upon a valuation of tangible and intangible assets acquired, Arotech has
allocated the total cost of the acquisition to MDT's assets as follows:
Tangible assets acquired $ 1,337,048
Intangible assets
Technology (five year weighted
average useful life) 280,000
Customer base (five year weighted
average useful life) 285,000
Goodwill 886,255
Liabilities assumed (1,020,426)
-----------------------
Total consideration $ 1,767,877
=======================
F-15
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
In U.S. dollars
NOTE 1: - GENERAL (Cont.)
In accordance with SFAS No. 142, "Goodwill and Other Intangible Assets,"
goodwill arising from acquisitions will not be amortized. In lieu of
amortization, Arotech is required to perform an annual impairment review. If
Arotech determines, through the impairment review process, that goodwill has
been impaired, it will record the impairment charge in its statement of
operations. Arotech will also assess the impairment of goodwill whenever events
or changes in circumstances indicate that the carrying value may not be
recoverable.
The value assigned to the tangible, intangibles assets and liabilities was
determined as follows:
1. To determine the value of the Company's net current assets, net
property, and equipment and net liabilities; the Cost Approach was
used, which requires that the assets and liabilities in question be
restated to their market values. Per estimation made by the independent
appraisal the book values for the current assets and liabilities were
reasonable proxies for their market values.
2. The amount of the excess cost attributable to technology of optimal
bulletproofing material and power mechanism for bulletproofed windows
is $280,000 and was determined using the Income Approach.
3. The value assigned to the customer base is amounted to $285,000.
Independent appraisal has valued the Company's customer base using the
Income Approach. The valuation of the customers' base derives mostly
from relations with customers with no contracts. Most of the customers
of MDT are from defense sector and usually have longstanding
relationships and tend to reorder from the Company.
In September 2003, the Company increased its holdings in both of its vehicle
armoring subsidiaries. The Company now holds 88% of MDT Armor Corporation
(compared to 76% before this transaction) and 75.5% of MDT Protective Industries
Ltd. (compared to 51% before this transaction). The Company acquired the
additional stake in MDT from AGA Means of Protection and Commerce Ltd. in
exchange for the issuance to AGA of 126,000 shares of its common stock, valued
at $0.98 per share based on the closing price of the Company's common stock on
the closing date of September 4, 2003, or a total of $123,480. Of this amount, a
total of $75,941 was allocated to intangible assets. The Company did not obtain
a valuation due to the immaterial nature of this acquisition.
d. Pro forma results:
The following unaudited proforma information does not purport to represent what
the Company's results of operations would have been had the acquisitions
occurred on January 1, 2001 and 2002, nor does it purport to represent the
results of operations of the Company for any future period.
F-16
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
In U.S. dollars
NOTE 1: - GENERAL (Cont.)
Year ended December 31,
-----------------------------------
2002 2001
--------------- ----------------
Revenues $12,997,289 $12,369,749
=============== ================
Net loss from continuing operations $(6,103,771) $(5,757,675)
=============== ================
Basic and diluted net loss per share for continuing operations $ (0.18) $ (0.21)
=============== ================
Weighted average number of shares of common stock in
computation of basic and diluted net loss per share 34,495,185 27,840,822
=============== ================
The amount of the excess cost attributable to in-process research and
development of IES and MDT in the amount of $26,000 has not been included in the
pro forma information, as it does not represent a continuing expense.
e. Discontinued operations:
In September 2002, the Company committed to a plan to discontinue the operations
of its retail sales of consumer battery products. The Company ceased the
operation and disposed of all assets related to this segment by an abandonment.
The operations and cash flows of consumer battery business have been eliminated
from the operations of the entity as a result of the disposal transactions. The
Company has no intent of continuing its activity in the consumer battery
business. The Company's plan of discontinuance involved (i) termination of all
employees whose time was substantially devoted to the consumer battery line and
who could not be used elsewhere in the Company's operations, including payment
of all statutory and contractual severance sums, by the end of the fourth
quarter of 2002, and (ii) disposal of the raw materials, equipment and inventory
used exclusively in the consumer battery business, since the Company has no
reasonable expectation of being able to sell such raw materials, equipment or
inventory for any sum substantially greater than the cost of disposal or
shipping, by the end of the first quarter of 2003. The Company had previously
reported its consumer battery business as a separate segment (Consumer
Batteries) as called for by Statement of Financial Standards No. 131,
"Disclosures About Segments of an Enterprise and Related Information" ("SFAS No.
131").
The results of operations including revenue, operating expenses, other income
and expense of the retail sales of consumer battery products business unit for
2002 and 2001 have been reclassified in the accompanying statements of
operations as a discontinued operation. The Company's balance sheets at December
31, 2002 and 2001 reflect the net liabilities of the retail sales of consumer
battery products business as net liabilities and net assets of discontinued
operation within current liabilities and current assets.
At December 31, 2002, the estimated net losses associated with the disposition
of the retail sales of consumer battery products business were approximately
$13,566,206 for 2002. These losses included approximately $6,508,222 in losses
from operations for the period from January 1, 2002 through the measurement date
of December 31, 2002 and $7,057,684, reflecting a write-down of inventory and
net property and equipment of the retail sales of consumer battery products
business, as follows:
F-17
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
In U.S. dollars
NOTE 1: - GENERAL (Cont.)
December 31, 2002
--------------------------
Write-off of inventories $ 2,611,000
Impairment of property and equipment 4,446,684
----------------
$ 7,057,684
================
As a result of the discontinuance of consumer battery segment, the Company
ceased to use property and equipment related to this segment. In accordance with
Statement of Financial Accounting Standard No. 144 "Accounting for the
Impairment or Disposal of Long- Lived Assets" ("SFAS No. 144") such assets was
considered to be impaired, the impairment to be recognized was measured by the
amount by which the carrying amount of the assets exceeds the fair value of the
assets.
Obligations to employees for severance and other benefits resulting from the
discontinuation have been reflected in the financial statements on an accrual
basis.
Summary operating results from the discontinued operation for the years ended
December 31, 2003, 2002 and 2001 are as follows:
Year Ended December 31,
-------------------------------------------------------------
2003 2002 2001
----------------- ---------------- -----------------
Revenues $ 117,267 $ 1,100,442 $ 1,939,256
Cost of sales (1) - (5,293,120) (5,060,966)
----------------- ---------------- -----------------
Gross profit (loss) 117,267 (4,192,678) (3,121,710)
Operating expenses, net 6,857 4,926,844 10,139,289
Impairment of fixed assets - 4,446,684 -
----------------- ---------------- -----------------
Operating profit (loss) $ 110,410 $ (13,566,206) $ (13,260,999)
================= ================ =================
(1) Including write-off of inventory in the amount of $0, $2,611,000 and
$441,000 for the years ended December 31, 2003, 2002 and 2001.
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
In U.S. dollars
NOTE 2: - SIGNIFICANT ACCOUNTING POLICIES
The consolidated financial statements have been prepared in accordance with
generally accepted accounting principles in the United States ("U.S. GAAP").
a. Use of estimates:
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the amounts reported in the financial statements and accompanying notes.
Actual results could differ from those estimates.
b. Financial statements in U.S. dollars:
A majority of the revenues of the Company and most of its subsidiaries is
generated in U.S. dollars. In addition, a substantial portion of the Company's
and most of its subsidiaries costs are incurred in U.S. dollars ("dollar").
Management believes that the dollar is the primary currency of the economic
environment in which the Company and most of its subsidiaries operate. Thus, the
functional and reporting currency of the Company and most of its subsidiaries is
the dollar. Accordingly, monetary accounts maintained in currencies other than
the U.S. dollar are remeasured into U.S. dollars in accordance with Statement of
Financial Accounting Standards No. 52 "Foreign Currency Translation" ("SFAS No.
52"). All transaction, gains and losses from the remeasured monetary balance
sheet items are reflected in the consolidated statements of operations as
financial income or expenses, as appropriate.
The majority of financial transactions of MDT is in New Israel Shekel ("NIS")
and a substantial portion of MDT's costs is incurred in NIS. Management believes
that the NIS is the functional currency of MDT. Accordingly, the financial
statements of MDT have been translated into U.S. dollars. All balance sheet
accounts have been translated using the exchange rates in effect at the balance
sheet date. Statement of operations amounts has been translated using the
weighted average exchange rate for the period. The resulting translation
adjustments are reported as a component of accumulated other comprehensive loss
in shareholders' equity
c. Principles of consolidation:
The consolidated financial statements include the accounts of the Company and
its wholly and majority owned subsidiaries. Intercompany balances and
transactions have been eliminated upon consolidation.
d. Cash equivalents:
Cash equivalents are short-term highly liquid investments that are readily
convertible to cash with maturities of three months or less when acquired.
e. Inventories:
Inventories are stated at the lower of cost or market value. Inventory
write-offs and write-down provisions are provided to cover risks arising from
slow-moving items or technological obsolescence and for market prices lower than
cost. The Company periodically evaluates the quantities on hand relative to
current and historical selling prices and historical and projected sales volume.
Based on this evaluation, provisions are made to write inventory down to its
market value. In 2003, the Company wrote off $96,350 of obsolete inventory,
which has been included in the cost of revenues.
F-18
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
In U.S. dollars
NOTE 2: - SIGNIFICANT ACCOUNTING POLICIES (Cont.)
Cost is determined as follows:
Raw and packaging materials - by the average cost method.
Work in progress - represents the cost of manufacturing with the addition of
allocable indirect manufacturing cost.
Finished products - on the basis of direct manufacturing costs with the addition
of allocable indirect manufacturing costs.
f. Property and equipment:
Property and equipment are stated at cost net of accumulated depreciation and
investment grants (no investment grants were received during 2003, 2002 and
2001).
Depreciation is calculated by the straight-line method over the estimated useful
lives of the assets, at the following annual rates:
%
--------------------------
Computers and related equipment 33
Motor vehicles 15
Office furniture and equipment 6 - 10
Machinery, equipment and installation 10 - 25 (mainly 10)
Leasehold improvements Over the term of the lease
g. Goodwill:
Goodwill represents the excess of cost over the fair value of the net assets of
businesses acquired. Under Statement of Financial Accounting Standard No. 142,
"Goodwill and Other Intangible Assets" ("SFAS No, 142") goodwill acquired in a
business combination on or after July 1, 2001, is not amortized.
SFAS No. 142 requires goodwill to be tested for impairment on adoption of the
Statement and at least annually thereafter or between annual tests in certain
circumstances, and written down when impaired, rather than being amortized as
previous accounting standards required. Goodwill is tested for impairment by
comparing the fair value of the Company's reportable units with their carrying
value. Fair value is determined using discounted cash flows, market multiples
and market capitalization. Significant estimates used in the methodologies
include estimates of future cash flows, future short-term and long-term growth
rates, weighted average cost of capital and estimates of market multiples for
the reportable units.
h. Other intangible assets:
Intangible assets acquired in a business combination that are subject to
amortization are amortized over their useful life using a method of amortization
that reflects the pattern in which the economic benefits of the intangible
assets are consumed or otherwise used up, in accordance with SFAS No. 142.
Intangible assets are amortized over their useful life (See Note 1b. and c).
F-19
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
In U.S. dollars
NOTE 2: - SIGNIFICANT ACCOUNTING POLICIES (Cont.)
i. Impairment of indefinite-lived intangible asset
The acquired IES trademark is deemed to have an indefinite useful life because
it is expected to contribute to cash flows indefinitely. Therefore, the
trademark will not be amortized until its useful life is no longer indefinite.
The trademark is tested annually for impairment in accordance FAS 142.
j. Impairment of long-lived assets:
The Company and its subsidiaries' long-lived assets and certain identifiable
intangibles are reviewed for impairment in accordance with Statement of
Financial Accounting Standard No. 144 "Accounting for the Impairment or Disposal
of Long-Lived Assets" ("SFAS No. 144") whenever events or changes in
circumstances indicate that the carrying amount of an asset may not be
recoverable. Recoverability of the carrying amount of assets to be held and used
is measured by a comparison of the carrying amount of the assets to the future
undiscounted cash flows expected to be generated by the assets. If such assets
are considered to be impaired, the impairment to be recognized is measured by
the amount by which the carrying amount of the assets exceeds the fair value of
the assets. As of December 31, 2003 no impairment losses have been identified.
k. Revenue recognition:
The Company generates revenues primarily from sales of multimedia and
interactive digital training systems and use-of-force simulators specifically
targeted for law enforcement and firearms training and from service contracts
related to such sales (through IES), from providing lightweight armoring
services of vehicles (through MDT), and from sale of zinc-air battery products
for defense applications. To a lesser extent, revenues are generated from
development services and long-term arrangements subcontracted by the U.S
Government.
Revenues from products, training and simulation systems are recognized in
accordance with SEC Staff Accounting Bulletin No. 104, "Revenue Recognition"
("SAB No. 104") when persuasive evidence of an agreement exists, delivery has
occurred, the fee is fixed or determinable, collectability is probably, and no
further obligation remains.
The Company does not grant a right of return to its customers.
Revenues from long-term agreements, subcontracted by the U.S. government, are
recorded on a cost-sharing basis, when services are rendered and products
delivered, as prescribed in the related agreements. Provisions for estimated
losses are recognized in the period in which the likelihood of such losses is
determined. As of December 31, 2003, no such estimated losses were identified.
F-20
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
In U.S. dollars
NOTE 2: - SIGNIFICANT ACCOUNTING POLICIES (Cont.)
Deferred warranty revenues includes unearned amounts received from customers,
but not recognized as revenues.
Revenues from development services are recognized based on Statement of Position
No. 81-1 "Accounting for Performance of Construction - Type and Certain
Production - Type Contracts" ("SOP 81-1"), using contract accounting on a
percentage of completion method, based on completion of agreed-upon milestones
and in accordance with the "Output Method" or based on the time and material
basis. Provisions for estimated losses on uncompleted contracts are recognized
in the period in which the likelihood of such losses is determined. As of
December 31, 2003, no such estimated losses were identified.
F-21
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
In U.S. dollars
NOTE 2: - SIGNIFICANT ACCOUNTING POLICIES (Cont.)
Revenues from lightweight armoring services of vehicles are recorded when
services are rendered and vehicle is delivered and no additional obligations
exists.
Revenues from products not delivered upon customers' request due to lack of
storage space at the customers' facilities during the integration are recognized
when the criteria of Staff Accounting Bulletin No. 104 ("SAB No. 104") for
bill-and-hold transactions are met.
l. Research and development cost:
Research and development costs, net of grants received, are charged to the
statements of operations as incurred.
Significant software development costs incurred by the Company's subsidiaries
between completion of the working model and the point at which the product is
ready for general release, are capitalized.
Capitalized software costs are amortized by using the straight-line method over
the estimated useful life of the product (three to five years). The Company
assesses the recoverability of this intangible asset on a regular basis by
determining whether the amortization of the asset over its remaining life can be
recovered through future gross revenues from the specific software product sold.
Based on its most recent analyses, management believes that no impairment of
capitalized software development costs exists as of December 31, 2003.
m. Royalty-bearing grants:
Royalty-bearing grants from the Office of the Chief Scientist ("OCS") of the
Israeli Ministry of Industry and Trade and from the Israel-U.S. Bi-national
Industrial Research and Development Foundation ("BIRD-F") for funding approved
research and development projects are recognized at the time the Company is
entitled to such grants on the basis of the costs incurred, and included as a
deduction of research and development costs.
n. Income taxes:
The Company and its subsidiaries account for income taxes in accordance with
Statement of Financial Accounting Standards No. 109, "Accounting for Income
Taxes" ("SFAS No. 109"). This Statement prescribes the use of the liability
method, whereby deferred tax assets and liability account balances are
determined based on differences between financial reporting and tax bases of
assets and liabilities and are measured using the enacted tax rates and laws
that will be in effect when the differences are expected to reverse. The Company
and its subsidiaries provide a valuation allowance, if necessary, to reduce
deferred tax assets to their estimated realizable value.
o. Concentrations of credit risk:
Financial instruments that potentially subject the Company and its subsidiaries
to concentrations of credit risk consist principally of cash and cash
equivalents, restricted collateral deposit and other restricted cash and trade
receivables. Cash and cash equivalents are invested in U.S. dollar deposits with
major Israeli and U.S. banks. Such deposits in the U.S. may be in excess of
insured limits and are not insured in other jurisdictions. Management believes
that the financial institutions that hold the Company's investments are
financially sound and, accordingly, minimal credit risk exists with respect to
these investments.
F-22
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
In U.S. dollars
NOTE 2: - SIGNIFICANT ACCOUNTING POLICIES (Cont.)
The trade receivables of the Company and its subsidiaries are mainly derived
from sales to customers located primarily in the United States, Europe and
Israel. Management believes that credit risks are moderated by the diversity of
its end customers and geographical sales areas. The Company performs ongoing
credit evaluations of its customers' financial condition. An allowance for
doubtful accounts is determined with respect to those accounts that the Company
has determined to be doubtful of collection.
The Company and its subsidiaries had no off-balance-sheet concentration of
credit risk such as foreign exchange contracts, option contracts or other
foreign hedging arrangements.
p. Basic and diluted net loss per share:
Basic net loss per share is computed based on the weighted average number of
shares of common stock outstanding during each year. Diluted net loss per share
is computed based on the weighted average number of shares of common stock
outstanding during each year, plus dilutive potential shares of common stock
considered outstanding during the year, in accordance with Statement of
Financial Standards No. 128, "Earnings Per Share" ("SFAS No. 128").
All outstanding stock options and warrants have been excluded from the
calculation of the diluted net loss per common share because all such securities
are anti-dilutive for all periods presented. The total weighted average number
of shares related to the outstanding options and warrants excluded from the
calculations of diluted net loss per share was 22,194,211 and 4,394,803 and
3,170,334 for the years ended December 31, 2003, 2002 and 2001, respectively.
q. Accounting for stock-based compensation:
The Company has elected to follow Accounting Principles Board Opinion No. 25
"Accounting for Stock Issued to Employees" ("APB No. 25") and Interpretation No.
44 "Accounting for Certain Transactions Involving Stock Compensation" ("FIN No.
44") in accounting for its employee stock option plans. Under APB No. 25, when
the exercise price of the Company's share options is less than the market price
of the underlying shares on the date of grant, compensation expense is
recognized. Under Statement of Financial Accounting Standard No. 123,
"Accounting for Stock-Based Compensation" ("SFAS No. 123"), pro-forma
information regarding net income and net income per share is required, and has
been determined as if the Company had accounted for its employee stock options
under the fair value method of SFAS No. 123.
The Company applies SFAS No. 123 and Emerging Issue Task Force No. 96-18
"Accounting for Equity Instruments that are Issued to Other than Employees for
Acquiring, or in Conjunction with Selling, Goods or Services" ("EITF 96-18")
with respect to options issued to non-employees. SFAS No. 123 requires use of an
option valuation model to measure the fair value of the options at the grant
date.
The fair value for the options to employees was estimated at the date of grant,
using the Black-Scholes Option Valuation Model, with the following
weighted-average assumptions: risk-free interest rates of 2.54%, 3.5% and
3.5-4.5% for 2003, 2002 and 2001, respectively; a dividend yield of 0.0% for
each of those years; a volatility factor of the expected market price of the
common stock of 0.67 for 2003, 0.64 for 2002 and 0.82 for 2001; and a
weighted-average expected life of the option of 5 years for 2003, 2002 and 2001.
F-23
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
In U.S. dollars
NOTE 2: - SIGNIFICANT ACCOUNTING POLICIES (Cont.)
The following table illustrates the effect on net income and earnings
per share, assuming that the Company had applied the fair value recognition
provision of SFAS No. 123 on its stock-based employee compensation:
Year ended December 31,
2003 2002 2001
------------ ------------ ------------
Net loss as reported $ (9,008,274) $(18,504,358) $(18,483,455)
Add: Stock-based compensation expenses included in
reported net loss 8,286 6,000 17,240
Deduct: Stock-based compensation expenses
determined under fair value method for all awards (1,237,558) (2,072,903) (2,906,386)
$(10,237,546) $(20,571,261) $ 21,372,601
============ ============ ============
Loss per share:
Basic and diluted, as reported $ (0.23) $ (0.57) $ (0.76)
============ ============ ============
Diluted, pro forma $ (0.26) $ (0.64) $ (0.88)
============ ============ ============
r. Fair value of financial instruments:
The following methods and assumptions were used by the Company and its
subsidiaries in estimating their fair value disclosures for financial
instruments:
The carrying amounts of cash and cash equivalents, restricted collateral deposit
and other restricted cash, trade receivables, short-term bank credit, and trade
payables approximate their fair value due to the short-term maturity of such
instruments.
Long-terms liabilities are estimated by discounting the future cash flows using
current interest rates for loans or similar terms and maturities. The carrying
amount of the long-term liabilities approximates their fair value.
s. Severance pay:
The Company's liability for severance pay is calculated pursuant to Israeli
severance pay law based on the most recent salary of the employees multiplied by
the number of years of employment as of the balance sheet date. Employees are
entitled to one month's salary for each year of employment, or a portion
thereof. The Company's liability for all of its employees is fully provided by
monthly deposits with severance pay funds, insurance policies and by an accrual.
The value of these policies is recorded as an asset in the Company's balance
sheet.
In addition and according to certain employment agreements, the Company is
obligated to provide for a special severance pay in addition to amounts due to
certain employees pursuant to Israeli severance pay law. The Company has made a
provision for this special severance pay in accordance with Statement of
Financial Accounting Standard No. 106, "Employer's Accounting for Post
Retirement Benefits Other than Pensions" ("SFAS No. 106"). As of December 31,
2003 and 2002, the accumulated severance pay in that regard amounted to $
1,699,260 and $1,630,366, respectively.
F-24
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
In U.S. dollars
NOTE 2: - SIGNIFICANT ACCOUNTING POLICIES (Cont.)
The deposited funds include profits accumulated up to the balance sheet date.
The deposited funds may be withdrawn only upon the fulfillment of the obligation
pursuant to Israeli severance pay law or labor agreements. The value of the
deposited funds is based on the cash surrendered value of these policies and
includes immaterial profits.
Severance expenses for the year ended December 31, 2003 amounted to $ 219,857 as
compared to severance income and expenses for the years ended December 31, 2002
and 2001, which amounted to $338,574 and $653,885, respectively.
t. Advertising costs:
The Company and its subsidiaries expense advertising costs as incurred.
Advertising expense for the years ended December 31, 2003, 2002 and 2001 was
approximately $34,732, $294,599 and $1,676,280 respectively.
NOTE 3:- RESTRICTED COLLATERAL DEPOSIT AND OTHER RESTRICTED CASH
The restricted collateral deposit is invested in a $706,180 certificate of
deposit that is used to secure certain real property lease arrangements, and a
currency hedging arrangement to protect the Company against change in the euro
versus the dollar in connection with IES's contract with the German police,
which is denominated in euros; a portion was also on deposit with an arbitrator
in connection with the Company's litigation with IES Electronic Industries, Ltd.
December 31, 2003
IES Deposit $ 450,000
Forward Deal 205,489
Property Lease 41,412
Other 9,279
-----------------
$ 706,180
=================
NOTE 4: - OTHER ACCOUNTS RECEIVABLE AND PREPAID EXPENSES
December 31,
------------------------------------
2003 2002
---------------- ----------------
Government authorities $ 65,402 $ 348,660
Employees 246,004 23,959
Prepaid expenses 551,010 591,008
Other 324,955 68,684
---------------- ----------------
$ 1,187,371 $ 1,032,311
================ ================
F-25
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
In U.S. dollars
NOTE 5:- INVENTORIES
December 31,
--------------------------------------
2003 2002
----------------- -----------------
Raw and packaging materials $ 657,677 $ 893,666
Work in progress 634,221 296,692
Finished products 622,850 521,121
----------------- -----------------
$ 1,914,748 $ 1,711,479
================= =================
NOTE 6:- PROPERTY AND EQUIPMENT, NET
a. Composition of property and equipment is as follows:
December 31,
-------------------------------------
2003 2002
----------------- -----------------
Cost:
Computers and related equipment $ 1,015,836 $ 815,759
Motor vehicles 288,852 335,286
Office furniture and equipment 402,726 519,092
Machinery, equipment and
installations 4,866,904 4,715,182
Leasehold improvements 882,047 442,482
Demo inventory 150,996 154,689
---------------- ----------------
7,607,361 6,982,490
---------------- ----------------
Accumulated depreciation:
Computers and related equipment 753,593 669,258
Motor vehicles 95,434 39,281
Office furniture and equipment 173,301 255,829
Machinery, equipment and installations 3,637,111 3,106,389
Leasehold improvements 655,181 356,484
---------------- ----------------
5,314,620 4,427,241
---------------- ----------------
Depreciated cost $ 2,292,741 $ 2,555,249
================ ================
b. Depreciation expense amounted to $730,159, $473,739 and $530,013, for the
years ended December 31, 2003, 2002 and 2001, respectively.
As for liens, see Note 10.d.
F-26
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
In U.S. dollars
NOTE 7: - OTHER INTANGIBLE ASSETS, NET
a.
Year ended December 31,
--------------------------------
2003 2002
----------- -----------
Cost:
Technology $ 2,231,746 $ 1,795,000
Capitalized research and
development 209,615 --
Existing contracts 46,000 46,000
Covenants not to compete 99,000 99,000
Customer list 827,250 812,000
----------- -----------
3,413,611 2,752,000
Exchange differences 25,438 --
Less - accumulated amortization (1,502,854) 623,543
----------- -----------
Amortized cost 1,936,195 2,128,457
Trademarks 439,000 439,000
----------- -----------
$ 2,375,195 $ 2,567,457
=========== ===========
b. Amortization expenses amounted to $879,311 for the year ended December 31,
2003.
c. Estimated amortization expenses for the years ended:
Year ended December 31,
- ------------------------------------
2004 $ 552,443
2005 541,466
2006 366,421
2007 244,734
2008 and forward 231,131
---------------
$ 1,936,195
===============
NOTE 8: - PROMISSORY NOTES
In connection with the acquisition discussed in Note 1b, the Company issued
promissory notes in the face amount of an aggregate of $1,800,000, one of which
was a note for $400,000 that was convertible into an aggregate of 200,000 shares
of the Company's common stock. The Company has accounted for these notes in
accordance with Accounting Principles Board Opinion No. 21, "Interest on
Receivables and Payables," and recorded the notes at its present value in the
amount of $1,686,964. In December 2002, the terms of these promissory notes were
amended to (i) extinguish the $1,000,000 note due at the end of June 2003 in
exchange for prepayment of $750,000, (ii) amend the $400,000 note due at the end
of December 2003 to be a $450,000 note, and (iii) amend the convertible $400,000
note due at the end of June 2004 to be a $450,000 note convertible at $0.75 as
to $150,000, at $0.80 as to $150,000, and at $0.85 as to $150,000. In accordance
with EITF 96-19, "Debtor's Accounting for a Modification or Exchange of Debt
Instruments," the terms of the promissory notes are not treated as changed or
modified when the cash flow effect on a present value basis is less than 10% and
therefore the Company did not record any compensation related to these changes.
The $450,000 note due at the end of June 2004 was converted into an aggregate of
563,971 shares of common stock in August 2003. With reference to the $450,000
note due at the end of December 2003, see Note 17.f.
F-27
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
In U.S. dollars
NOTE 9: - OTHER ACCOUNTS PAYABLE AND ACCRUED EXPENSES
December 31,
------------------------------------
2003 2002
---------------- -----------------
Employees and payroll accruals $ 1,232,608 $ 615,292
Accrued vacation pay 216,768 137,179
Accrued expenses 842,760 342,793
Minority balance 149,441 289,451
Government authorities 357,095 497,428
Deferred warranty revenues 40,936 95,831
Litigation settlement accrual(1) 1,313,642 -
Other 168,097 31,135
--------------- -----------------
$ 4,321,347 $ 2,009,109
=============== =================
(1) See Note 17.f.
NOTE 10: - COMMITMENTS AND CONTINGENT LIABILITIES
a. Royalty commitments:
1. Under EFL's research and development agreements with the Office of the Chief
Scientist ("OCS"), and pursuant to applicable laws, EFL is required to pay
royalties at the rate of 3%-3.5% of net sales of products developed with funds
provided by the OCS, up to an amount equal to 100% of research and development
grants received from the OCS (linked to the U.S. dollars. Amounts due in respect
of projects approved after year 1999 also bear interest of the Libor rate). EFL
is obligated to pay royalties only on sales of products in respect of which OCS
participated in their development. Should the project fail, EFL will not be
obligated to pay any royalties.
Royalties paid or accrued for the years ended December 31, 2003, 2002 and 2001,
to the OCS amounted to $435, $32,801 and $75,791, respectively.
As of December 31, 2003, the total contingent liability to the OCS was
approximately $10,057,000. The Company regards the probability of this
contingency coming to pass in any material amount to be low.
2. EFL, in cooperation with a U.S. participant, has received approval from the
BIRD-F for 50% funding of a project for the development of a hybrid propulsion
system for transit buses. The maximum approved cost of the project is
approximately $1.8 million, and the Company's share in the project costs is
anticipated to amount to approximately $1.1 million, which will be reimbursed by
BIRD-F at the aforementioned rate of 50%. Royalties at rates of 2.5%-5% of sales
are payable up to a maximum of 150% of the grant received, linked to the U.S.
Consumer Price Index. Accelerated royalties are due under certain circumstances.
EFL is obligated to pay royalties only on sales of products in respect of which
BIRD-F participated in their development. Should the project fail, EFL will not
be obligated to pay any royalties.
No royalties were paid or accrued to the BIRD-F in each of the three years in
the period ended December 31, 2003.
F-28
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
In U.S. dollars
NOTE 10: - COMMITMENTS AND CONTINGENT LIABILITIES(Cont.)
As of December 31, 2003, the total contingent liability to pay BIRD-F (150%) was
approximately $772,000. The Company regards the probability of this contingency
coming to pass in any material amount to be low.
b. Lease commitments:
The Company and its subsidiaries rent their facilities under various operating
lease agreements, which expire on various dates, the latest of which is in 2005.
The minimum rental payments under non-cancelable operating leases are as
follows:
Year ended December 31,
-----------------------------------
2004 $ 393,512
2005 197,266
------------------
$ 590,778
==================
Total rent expenses for the years ended December 31, 2003, 2002 and 2001, were
approximately $484,361, $629,101 and $456,701, respectively.
c. Guarantees:
The Company obtained bank guarantees in the amount of $51,082 in connection with
(i) a lease agreement of one of the Company's subsidiaries, (ii) a sales
obligation to a customer of one of the Company's subsidiaries, and (iii)
obligations of one of the Company's subsidiaries to the Israeli customs
authorities.
d. Liens:
As security for compliance with the terms related to the investment grants from
the state of Israel, EFL has registered floating liens on all of its assets, in
favor of the State of Israel.
The Company has granted to the holders of its 8% secured convertible debentures
a first position security interest in (i) the shares of MDT Armor Corporation,
(ii) the assets of its IES Interactive Training, Inc. subsidiary, (iii) the
shares of all of its subsidiaries, and (iv) any shares that the Company acquires
in future Acquisitions (as defined in the securities purchase agreement).
EFL has granted to its former CEO a security interest in certain of its property
located in Beit Shemesh, Israel, to secure sums due to him pursuant to the terms
of the settlement agreement with him.
F-29
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
In U.S. dollars
NOTE 11: - SHAREHOLDERS' EQUITY
a. Shareholders' rights:
The Company's shares confer upon the holders the right to receive notice to
participate and vote in the general meetings of the Company and right to receive
dividends, if and when declared.
b. Issuance of common stock to investors:
1. In May 2001, the Company issued a total of 4,045,454 shares of its common
stock to a group of institutional investors at a price of $2.75 per share, or a
total purchase price of $11,125,000. (See also Note 11.f.1 and 11.f.2.)
2. On November 21, 2001, the Company issued a total of 1,503,759 shares of its
common stock at a purchase price of $1.33 per share, or a total purchase price
of $2,000,000, to a single institutional investor.
3. On December 5, 2001, the Company issued a total of 1,190,476 shares of its
common stock at a purchase price of $1.68 per share, or a total purchase price
of $2,000,000, to a single institutional investor.
4. On January 18, 2002, the Company issued a total of 441,176 shares of its
common stock at a purchase price of $1.70 per share, or a total purchase price
of $750,000, to an investor (see also Note 11.f.3).
5. On January 24, 2002, the Company issued a total of 1,600,000 shares of its
common stock at a purchase price of $1.55 per share, or a total purchase price
of $2,480,000, to a group of investors.
c. Issuance of common stock to service providers and employees:
1. On June 17, 2001 the Company issued a consultant a total of 8,550 shares of
its common stock in compensation for services rendered by such consultant for
the Company for preparation of certain video point-of-purchase and sales
demonstration materials. At the issuance date the fair value of these shares was
determined both by the value of the shares issued as reflected by fair market
price at the issuance date and by the value of the services provided and
amounted to $15,488 in accordance with EITF 96-18. In accordance with EITF
00-18, the Company recorded this compensation expense as marketing expenses in
the amount of $15,488.
2. On September 17, 2001 the Company issued to selling and marketing consultants
a total of 337,571 shares of its common stock in compensation for distribution
services rendered by such consultant. At the issuance date the fair value of
these shares was determined both by the value of the shares issued as reflected
by fair market price at the issuance date and by the value of the services
provided and amounted to $524,889 in accordance with EITF 96-18 and in
accordance with EITF 00-18. The Company recorded this compensation expense as
marketing expenses in the amount of $524,889.
3. On February 15, 2002 and September 10, 2002, the Company issued 318,468 and
50,000 shares, respectively, of common stock at par consideration to a
consultant for providing business development and marketing services in the
United Kingdom. At the issuance date, the fair value of these shares was
determined both by the value of the shares issued as reflected by fair market
price at the issuance date and by the value of the services provided and
amounted to $394,698 and $63,000, respectively, in accordance with EITF 96-18.
In accordance with EITF 00-18, the Company recorded this compensation expense of
$394,698 and $63,000, respectively, during the year 2002 and included this
amount in marketing expenses.
F-30
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
In U.S. dollars
NOTE 11: - SHAREHOLDERS' EQUITY (Cont.)
4. On September 10, 2002, the Company issued an aggregate of 13,000 shares of
common stock at par consideration to two of its employees as stock bonuses. At
the issuance date, the fair value of these shares was determined by the fair
market value of the shares issued as reflected by fair market price at the
issuance date in accordance with APB No. 25. In accordance with APB No. 25, the
Company recorded this compensation expense of $13,000 during the year 2002 and
included this amount in general and administrative expenses.
5. In July 2003, the Company issued 215,294 shares of common stock to a
consultant as commissions on battery orders. At the issuance date, the fair
value of these shares was determined both by the value of the shares issued as
reflected by fair market price at the issuance date and by the value of the
services provided and amounted to $154,331 in accordance with EITF 96-18. In
accordance with EITF 00-18, the Company recorded this compensation expense of
$154,331 during the year 2003 and included this amount in marketing expenses.
6. In November 2003, the Company issued 8,306 shares of common stock to a
consultant as commissions on battery orders. At the issuance date, the fair
value of these shares was determined by the fair market value of the shares
issued as reflected by fair market price at the issuance date and by the value
of the services provided and amounted to $7,616 in accordance with EITF 96-18.
In accordance with EITF 96-18, the Company recorded this compensation expense of
$7,616 during the year 2003 and included this amount in marketing expenses.
d. Issuance of shares to lenders
As part of the securities purchase agreement on December 31, 2002 (see Note
16.a), the Company issued 387,301 shares at par as consideration to lenders for
the first nine months of interest expenses. At the issuance date, the fair value
of these shares was determined both by the value of the shares issued as
reflected by fair market price at the issuance date and by the value of the
interest and amounted to $236,250 in accordance with APB 14. During 2003 the
company recorded this amount as financial expenses.
e. Issuance of notes receivable:
1. As part of its purchase of the assets of IES Interactive Training, Inc. (see
Note 1.b.), the Company issued a $450,000 convertible promissory note (see Note
8). This note was converted into an aggregate of 563,971 shares of common stock
in August 2003.
f. Warrants:
1. As part of an investment agreement in November 2000, the Company issued
warrants to purchase an additional 1,000,000 shares of common stock to the
investor, with exercise prices of $11.31 for 333,333 of these warrants and
$12.56 per share for 666,667 of these warrants. In addition, the Company issued
warrants to purchase 150,000 shares of common stock, with exercise prices of
$9.63 for 50,000 of these warrants and $12.56 per share for 100,000 of these
warrants to an investment banker involved in this agreement. Out of these
warrants issued to the investor, 666,667 warrants expire on November 17, 2005
and 333,333 warrants were to expire on August 17, 2001.
F-31
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
In U.S. dollars
NOTE 11: - SHAREHOLDERS' EQUITY (Cont.)
As part of the transaction in May 2001 (see Note 11.b.1), the Company repriced
these warrants in the following manner:
>> Of the 1,000,000 warrants granted to the investor, the
exercise price of 666,667 warrants was reduced from $12.56 to
$3.50 and of 333,333 warrants was reduced from $11.31 to
$2.52. In addition, the 333,333 warrants that were to expire
on August 17, 2001, were immediately exercised for a total
consideration of $840,000.
>> Moreover, the Company issued to this investor an additional
warrant to purchase 250,000 shares of common stock at an
exercise price of $3.08 per share, to expire on May 3, 2006.
>> Of the 150,000 warrants granted to the investment banker the
exercise price of 100,000 warrants was reduced from $12.56 to
$3.08 and of 50,000 warrants was reduced from $9.63 to $3.08.
In addition, the 50,000 warrants that were to expire on August
17, 2001 were extended to November 17, 2005.
As a result of the aforesaid modifications, including the repricing of the
warrants to the investors and to the investment banker and the additional grant
of warrants to the investor, the Company has recorded a deemed dividend in the
amount of $1,196,667, to reflect the additional benefit created for these
certain investors. The fair value of the repriced warrants was calculated as a
difference measured between (1) the fair value of the modified warrant
determined in accordance with the provisions of SFAS No. 123, and (2) the value
of the old warrant immediately before its terms are modified, determined based
on the shorter of (a) its remaining expected life or (b) the expected life of
the modified option. The deemed dividend increased the loss applicable to common
stockholders in the calculation of basic and diluted net loss per share for the
year ended December 31, 2001, without any effect on total shareholder's equity.
2. As part of the investment agreement in May 2001 (see Note 11.b.1), the
Company issued to the investors a total of 2,696,971 warrants (the "May 2001
Warrants") to purchase shares of common stock at a price of $3.22 per share;
these warrants are exercisable by the holder at any time after November 8, 2001
and will expire on May 8, 2006. The Company also issued to a financial
consultant that provided investment banking services concurrently with this
transaction a total of 125,000 warrants to purchase shares of common stock at a
price of $3.22 per share; these warrants are exercisable by the holder at any
time and will expire on June 12, 2006. In addition the Company paid
approximately $562,000 in cash, which was recorded as deduction from additional
paid in capital.
In June 2003, the Company adjusted the purchase price of 1,357,577 of the May
2001 Warrants to $0.82 per share in exchange for immediate exercise of these
warrants, and issued to the holders of these exercised warrants new warrants to
purchase a total of 905,052 shares of common stock at a purchase price of $1.45
per share (the "June 2003 Warrants"). The June 2003 Warrants were originally
exercisable at any time from and after December 31, 2003 to June 30, 2008;
however, in September 2003, the exercise period of 638,385 of these June 2003
Warrants was adjusted to make them exercisable at any time from and after
December 31, 2004 to June 30, 2009. As a result the company recorded during 2003
an expense of $244,810 and included this amount in general and administrative
expenses.
F-32
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
In U.S. dollars
NOTE 11: - SHAREHOLDERS' EQUITY (Cont.)
In addition, with respect to an additional 387,879 May 2001 Warrants, in
December 2003 the Company adjusted the purchase price to $1.60 per share in
exchange for immediate exercise of these warrants, and issued to the holders of
these exercised warrants new warrants to purchase a total of 193,940 shares of
common stock at a purchase price of $2.25 per share .As a result the company
recorded during 2003 an expense of $74,384 and included this amount in general
and administrative expenses.
Additionally, in October 2003 the Company granted to three of these investors
additional new warrants to purchase a total of 150,000 shares of common stock at
a purchase price of $1.20 per share. As a result the company recorded during
2003 an expense of $69,209 and included this amount in general and
administrative expenses.
3. As part of the investment agreement in January 2002 (see Note 11.b.4), the
Company, in January 2002, issued to a financial consultant that provided
investment banking services concurrently with this transaction a warrants to
acquire (i) 150,000 shares of common stock at an exercise price of $1.68 per
share, and (ii) 119,000 shares of common stock at an exercise price of $2.25 per
share; these warrants are exercisable by the holder at any time and will expire
on January 4, 2007.
4. As part of the securities purchase agreement on December 31, 2002 (see Note
16.a), the Company issued to the purchasers of its 9% secured convertible
debentures due June 30, 2005, warrants, as follows: (i) Series A Warrants to
purchase an aggregate of 1,166,700 shares of common stock at any time prior to
December 31, 2007 at a price of $0.84 per share; (ii) Series B Warrants to
purchase an aggregate of 1,166,700 shares of common stock at any time prior to
December 31, 2007 at a price of $0.89 per share; and (iii) Series C Warrants to
purchase an aggregate of 1,166,700 shares of common stock at any time prior to
December 31, 2007 at a price of $0.93 per share. The exercise price of these
warrants was adjusted to $0.64 per share in April 2003.
In connection with these warrants, the Company recorded a deferred debt discount
of $1,290,000, which will be amortized ratably over the life of the convertible
debentures (3 years), unless these warrants are exercised, in which case any
remaining financial expense will be taken in the quarter in which the exercise
occurs. This transaction was accounted according to APB No. 14 "Accounting for
Convertible debt and Debt Issued with Stock Purchase Warrants" and Emerging
Issue Task Force No. 00-27 "Application of Issue No. 98-5 to Certain Convertible
Instruments" ("EITF 00-27"). The fair value of these warrants was determined
using Black-Scholes pricing model, assuming a risk-free interest rate of 3.5%, a
volatility factor 64%, dividend yields of 0% and a contractual life of 5 years.
During 2003, an aggregate of 1,500,042 shares were issued pursuant to exercises
of these warrants.
During 2003, the Company recorded an expense of $847,714, of which $423,857 was
attributable to amortization of the convertible debentures over their term and
$423,857 was attributable to accelerated amortization due to the exercise of
warrants. Those expenses were included in the financial expenses.
5. As part of the securities purchase agreement on September 30, 2003 (see Note
16.b), the Company issued to the purchasers of its 8% secured convertible
debentures due September 30, 2006, warrants to purchase an aggregate of
1,250,000 shares of common stock at any time prior to September 30, 2006 at a
price of $1.4375 per share.
F-33
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
In U.S. dollars
NOTE 11: - SHAREHOLDERS' EQUITY (Cont.)
In connection with these warrants, the Company recorded a deferred debt discount
of $1,025,000, which will be amortized ratably over the life of the convertible
debentures (3 years). This transaction was accounted according to APB No. 14
"Accounting for Convertible debt and Debt Issued with Stock Purchase Warrants"
and Emerging Issue Task Force No. 00-27 "Application of Issue No. 98-5 to
Certain Convertible Instruments" ("EITF 00-27"). The fair value of these
warrants was determined using Black-Scholes pricing model, assuming a risk-free
interest rate of 1.95%, a volatility factor 98%, dividend yields of 0% and a
contractual life of 3 years.
During 2003, an aggregate of 437,500 shares were issued pursuant to exercises of
these warrants.
During 2003 the Company recorded an expense of $414,676, of which $78,512 was
attributable to amortization of the debt discount over their term and $336,164
was attributable to amortization due to accelerated exercise of warrants. Those
expenses were included in the financial expenses.
6. As a further part of the securities purchase agreement on September 30, 2003
(see Note 16.c), the Company issued to the purchasers of its 8% secured
convertible debentures due December 31, 2006, warrants to purchase an aggregate
of 1,500,000 shares of common stock at any time prior to December 31, 2006 at a
price of $1.8125 per share. Additionally, the Company issued to the investors
supplemental warrants to purchase an aggregate of 1,038,000 shares of common
stock at any time prior to December 31, 2006 at a price of $2.20 per share.
In connection with these warrants, the Company will record financial expenses of
$ 1,545,000 and $1,297,500 for the additional and the supplemental warrants
referred to above, respectively, which will be amortized ratably over the life
of the convertible debentures (3 years). This transaction was accounted
according to APB No. 14 "Accounting for Convertible debt and Debt Issued with
Stock Purchase Warrants" and Emerging Issue Task Force No. 00-27 "Application of
Issue No. 98-5 to Certain Convertible Instruments" ("EITF 00-27"). The fair
value of these warrants was determined using Black-Scholes pricing model,
assuming a risk-free interest rate of 2.45%, a volatility factor 98%, dividend
yields of 0% and a contractual life of 3 years.
During 2003 the Company recorded an expense of $53,440 for amortization of these
debt discounts over their term, which is included in financial expenses.
g. Stock option plans:
1. Options to employees and others (except consultants)
a. The Company has adopted the following stock option plans, whereby options may
be granted for purchase of shares of the Company's common stock. Under the terms
of the employee plans, the Board of Directors or the designated committee grants
options and determines the vesting period and the exercise terms.
1) 1991 Employee Option Plan - 2,115,600 shares reserved for issuance, of which
53,592 were available for future grants to employees as of December 31, 2003.
2) 1993 Employee Option Plan - as amended, 6,200,000 shares reserved for
issuance, of which no shares were available for future grants to employees as of
December 31, 2003.
F-34
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
In U.S. dollars
NOTE 11: - SHAREHOLDERS' EQUITY (Cont.)
3) 1998 Employee Option Plan - as amended, 4,750,000 shares reserved for
issuance, of which no shares were available for future grants to employees and
consultants as of December 31, 2003.
4) 1995 Non-Employee Director Plan - 1,000,000 shares reserved for issuance, of
which 600,000 were available for future grants to directors as of December 31,
2003.
b. Under these plans, options generally expire no later than 10 years from the
date of grant. Each option can be exercised to purchase one share, conferring
the same rights as the other common shares. Options that are cancelled or
forfeited before expiration become available for future grants. The options
generally vest over a three-year period (33.3% per annum).
c. A summary of the status of the Company's plans and other share options
(except for options granted to consultants) granted as of December 31, 2003,
2002 and 2001, and changes during the years ended on those dates, is presented
below:
2003 2002 2001
-------------------------- -------------------------- -------------------------
Amount Weighted Amount Weighted Amount Weighted
average average average
exercise exercise exercise
price price price
-------------------------- -------------------------- -------------------------
$ $ $
------------ ------------ ----------
Options outstanding at beginning
of year 5,260,366 $ 2.26 4,240,228 $ 2.74 2,624,225 $ 3.82
Changes during year:
Granted (1) (2) 5,264,260 $ 0.71 1,634,567 $ 0.87 2,172,314 $ 1.55
Exercised (3) 689,640 $ 0.64 (191,542) $ 1.29 (159,965) $ 1.31
Forfeited or cancelled (816,675) $ 3.51 (422,887) $ 1.92 (396,346) $ 4.11
------------ ------------ ------------ ------------ ------------- ----------
Options outstanding at end of year 9,018,311 $ 1.37 5,260,366 $ 2.26 4,240,228 $ 2.74
============ ============ ============ ============ ============= ==========
Options exercisable at end of year 5,826,539 $ 1.70 4,675,443 $ 2.26 2,643,987 $ 2.75
============ ============ ============ ============ ============= ==========
(1) Includes 2,035,000, 481,435 and 1,189,749 options granted to
related parties in 2003, 2002 and 2001, respectively.
(3) The Company recorded deferred stock compensation for options issued
with an exercise price below the fair value of the common stock in the
amount of $4,750, $0 and $18,000 as of December 31, 2003, 2002 and
2001, respectively. Deferred stock compensation is amortized and
recorded as compensation expenses ratably over the vesting period of
the option. The stock compensation expense that has been charged in the
consolidated statements of operations in respect of options to
employees and directors in 2003, 2002 and 2001, was $8,286, $6,000 and
$17,240, respectively.
(3) In June 2002 and December 2001, the employees exercised 100,000 and
33,314, respectively, options for which the exercise price was not paid
at the exercise date. The Company recorded the owed amount of $73,000
and $43,308, respectively, as "Note receivable from shareholders" in
the statement of shareholders' equity. In accordance with EITF 95-16,
since the original option grant did not permit the exercise of the
options through loans, and due to the Company's history of granting
non-recourse loans, this postponement in payments of the exercise price
resulted in a variable plan accounting. However, the Company did not
record any compensation due to the decrease in the market value of the
Company's shares during 2001 and 2002. During the year 2002 the notes
in the amount of $43,308 were entirely repaid and note at the amount of
$36,500 was forgiven and appropriate compensation was recorded. During
the year 2003, the company recorded compensation in amount of $38,500
due to increase in the market value of the company's shares.
F-35
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
In U.S. dollars
NOTE 11: - SHAREHOLDERS' EQUITY (Cont.)
d. The options outstanding as of December 31, 2003 have been separated into
ranges of exercise price, as follows:
Total options outstanding Exercisable options outstanding
--------------------------------------------------- ----------------------------------
Range of Amount Weighted Weighted Amount Weighted
average
outstanding at remaining exercisable at
exercise December 31, contractual average December 31, average
prices 2003 life exercise price 2003 exercise price
- ------------ ---------------- ---------------- ----------------
$ Years $ $
- ------------ ---------------- ---------------- ----------------
0.01-2.00 7,773,767 7.48 0.90 4,584,740 0.98
2.01-4.00 314,544 3.56 3.07 314,544 3.07
4.01-6.00 885,000 6.28 4.60 882,255 4.60
6.01-8.00 35,000 2.05 7.73 35,000 7.73
8.01 10,000 3.75 9.06 10,000 9.06
---------------- ---------------- ---------------- ---------------- ----------------
9,018,311 7.20 1.37 5,826,539 1.70
================ ================ ================ ================ ================
Weighted-average fair values and exercise prices of options on dates of grant
are as follows:
Equals market price Exceeds market price Less than market price
----------------------------- ------------------------------ ------------------------------
Year ended December 31, Year ended December 31, Year ended December 31,
----------------------------- ------------------------------ ------------------------------
2003 2002 2001 2003 2002 2001 2003 2002 2001
-------- -------- -------- -------- ---------- -------- -------- -------- ---------
Weighted average $ 0.950 $ 1.265 $ 1.579 $ - $ - $ 1.466 $ - $ 0.755 $ 1.300
exercise prices
Weighted average fair 0 0 0 0 0
value on grant date $ 0.73 $ 0.56 $ 0.50 $ - $ - $ 0.56 $ - $ 0.25 $ 0.790
2. Options issued to consultants:
a. The Company's outstanding options to consultants as of December 31, 2003, are
as follows:
2003 2002 2001
--------------------------- --------------------------- ---------------------------
Amount Weighted Amount Weighted Amount Weighted
average average average
exercise exercise exercise
price price price
--------------------------- --------------------------- ---------------------------
$ $ $
------------- ------------- -------------
Options outstanding at 245,786 $ 5.55 245,786 $ 5.55 175,786 $ 6.57
beginning of year
Changes during year:
Granted (1) 83,115 $ 0.99 - - 130,000 $ 6.02
Exercised (15,000) $ 0.49 - - (60,000) $ 5.13
Repriced (2):
Old exercise price - - - - (56,821) $ 9.44
New exercise price - - - - 56,821 $ 4.78
------------ ------------ -------------
Options outstanding at
end of year 313,901 $ 4.59 245,786 $ 5.55 245,786 $ 5.55
============ ============= ============ ============= ============= =============
Options exercisable at
end of year 193,901 $ 3.46 125,786 $ 6.42 125,786 $ 6.42
============ ============= ============ ============= ============= =============
(1) 120,000 options out of 130,000 options granted in 2001 to the Company's
selling and marketing consultants are subject to the achievement of the
targets specified in the agreements with these consultants. The measurement
date for these options has not yet occurred, as these targets have not been
met, in accordance with EITF 96-18. When the targets is achieved the
Company will record appropriate compensation upon the fair value at the
same date at which the targets is achieved
F-36
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
In U.S. dollars
NOTE 11: - SHAREHOLDERS' EQUITY (Cont.)
(2) During the year 2001 the Company repriced 56,821 options to its service
providers. The fair value of repriced warrants was calculated as a
difference measured between (1) the fair value of the modified warrants
determined in accordance with the provisions of SFAS 123, and (2) the value
of the old warrant immediately before its terms were modified, determined
based on the shorter of (a) its remaining expected life or (b) the expected
life of the modified option. As a result of the repricing, the Company has
recorded an additional compensation at the amount of $21,704, and included
this amount in marketing expenses.
b. The Company accounted for its options to consultants under the fair value
method of SFAS No. 123 and EITF 96-18. The fair value for these options was
estimated using a Black-Scholes option-pricing model with the following
weighted-average assumptions:
2003 2002 2001
---------------- --------------- ---------------
Dividend yield 0% - 0%
Expected volatility 78% - 82%
Risk-free interest 2.3% - 3.5-4.5%
Contractual life of up to 10 years - 10 years
c. In connection with the grant of stock options to consultants, the Company
recorded stock compensation expenses totaling $29,759, $0 and $139,291 for the
years ended December 31, 2003, 2002 and 2001, respectively, and included these
amounts in marketing and general and administrative expenses.
3. Dividends:
In the event that cash dividends are declared in the future, such dividends will
be paid in U.S. dollars. The Company does not intend to pay cash dividends in
the foreseeable future.
4. Treasury Stock:
Treasury stock is the Company's common stock that has been issued and
subsequently reacquired. The acquisition of common stock is accounted for under
the cost method, and presented as reduction of stockholders' equity.
h. Issuances in connection with acquisitions:
In September 2003, the Company acquired an additional 12% interest in MDT Armor
Corporation and an additional 24.5% interest in MDT Protective Industries Ltd.
in exchange for the issuance to AGA Means of Protection and Commerce Ltd. of
126,000 shares of its common stock.
F-37
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
In U.S. dollars
NOTE 12: - INCOME TAXES
a. Taxation of U.S. parent company (Arotech):
As of December 31, 2003, Arotech has operating loss carryforwards for U.S.
federal income tax purposes of approximately $17.0 million, which are available
to offset future taxable income, if any, expiring in 2010 through 2022.
Utilization of U.S net operating losses may be subject to substantial annual
limitations due to the "change in ownership" provisions of the Internal Revenue
Code of 1986 and similar state provisions. The annual limitation may result in
the expiration of net operating loses before utilization.
b. Israeli subsidiary (EFL):
1. Tax benefits under the Law for the Encouragement of Capital Investments, 1959
(the "Investments Law"):
A small part of EFL's manufacturing facility has been granted "Approved
Enterprise" status under the Investments Law, and is entitled to investment
grants from the State of Israel of 38% on property and equipment located in
Jerusalem, and 10% on property and equipment located in its plant in Beit
Shemesh, and to reduced tax rates on income arising from the "Approved
Enterprise," as detailed below.
The approved investment program is in the amount of approximately $500,000. EFL
effectively operated the program during 1993, and is entitled to the tax
benefits available under the Investments Law. EFL is entitled to additional tax
benefits as a "foreign investment company," as defined by the Investments Law.
The tax-exempt income attributable to the "Approved Enterprise" can be
distributed to shareholders without subjecting the Company to taxes only upon
the complete liquidation of the Company. If these retained tax-exempt profits
are distributed in a manner other than in the complete liquidation of the
Company they would be taxed at the corporate tax rate applicable to such profits
as if the Company had not elected the alternative system of benefits, currently
between 25% for an "Approved Enterprise." As of December 31, 2003, the
accumulated deficit of the Company does not include tax-exempt profits earned by
the Company's "Approved Enterprise."
The entitlement to the above benefits is conditional upon the Company's
fulfilling the conditions stipulated by the Investments Law, regulations
published thereunder and the instruments of approval for the specific
investments in "approved enterprises." In the event of failure to comply with
these conditions, the benefits may be canceled and the Company may be required
to refund the amount of the benefits, in whole or in part, including interest.
As of December 31, 2003, according to the Company's management, the Company has
fulfilled all conditions.
The main tax benefits available to EFL are:
a) Reduced tax rates:
During the period of benefits (seven to ten years), commencing in the first year
in which EFL earns taxable income from the "Approved Enterprise," a reduced
corporate tax rate of between 10% and 25% (depending on the percentage of
foreign ownership, based on present ownership percentages of 15%) will apply,
instead of the regular tax rates.
F-38
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
In U.S. dollars
NOTE 12: - INCOME TAXES(Cont.)
The period of tax benefits, detailed above, is subject to limits of 12 years
from the commencement of production, or 14 years from the approval date,
whichever is earlier. Hence, the first program will expire in the year 2004. The
benefits have not yet been utilized since the Company has no taxable income,
since its incorporation.
b) Accelerated depreciation:
EFL is entitled to claim accelerated depreciation in respect of machinery and
equipment used by the "Approved Enterprise" for the first five years of
operation of these assets.
Income from sources other than the "Approved Enterprise" during the benefit
period will be subject to tax at the regular corporate tax rate of 36%.
2. Measurement of results for tax purposes under the Income Tax Law
(Inflationary Adjustments), 1985
Results for tax purposes are measured in real terms of earnings in NIS after
certain adjustments for increases in the Consumer Price Index. As explained in
Note 2b, the financial statements are presented in U.S. dollars. The difference
between the annual change in the Israeli consumer price index and in the
NIS/dollar exchange rate causes a difference between taxable income and the
income before taxes shown in the financial statements. In accordance with
paragraph 9(f) of SFAS No. 109, EFL has not provided deferred income taxes on
this difference between the reporting currency and the tax bases of assets and
liabilities.
3. Tax benefits under the Law for the Encouragement of Industry (Taxation),
1969:
EFL is an "industrial company," as defined by this law and, as such, is entitled
to certain tax benefits, mainly accelerated depreciation, as prescribed by
regulations published under the inflationary adjustments law, the right to claim
public issuance expenses and amortization of know-how, patents and certain other
intangible property rights as deductions for tax purposes.
4. Tax rates applicable to income from other sources:
Income from sources other than the "Approved Enterprise," is taxed at the
regular rate of 36%.
5. Tax loss carryforwards:
As of December 31, 2003, EFL has operating and capital loss carryforwards for
Israeli tax purposes of approximately $84.0 million, which are available,
indefinitely, to offset future taxable income.
F-39
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
In U.S. dollars
NOTE 12: - INCOME TAXES(Cont.)
c. Deferred income taxes:
Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and amounts used for income tax purposes. Significant components of the
Company's deferred tax assets resulting from tax loss carryforward are as
follows:
December 31,
-----------------------------------
2003 2002
--------------- ----------------
Operating loss carryforward $33,958,434 $ 29,257,118
Reserve and allowance 843,453 303,204
--------------- ----------------
Net deferred tax asset before valuation allowance 34,801,887 29,560,322
Valuation allowance (34,801,887) (29,560,322)
--------------- ----------------
$ - $ -
=============== ================
The Company and its subsidiaries provided valuation allowances in respect of
deferred tax assets resulting from tax loss carryforwards and other temporary
differences. Management currently believes that it is more likely than not that
the deferred tax regarding the loss carryforwards and other temporary
differences will not be realized. The change in the valuation allowance as of
December 31, 2003 was $5,241,565.
d. Loss from continuing operations before taxes on income and minority interest
in loss (earnings) of a subsidiary:
Year ended December 31
---------------------------------------------------------------
2003 2002 2001
------------------- ------------------- -------------------
Domestic $ (7,181,774) $ (5,250,633) $ (5,828,828)
Foreign (1,697,617) (13,254,195) (11,457,960)
------------------- ------------------- -------------------
$ (8,879,391) $ (18,504,358) $ (17,286,788)
=================== =================== ===================
e. Taxes on income were comprised of the following:
Year ended December 31
---------------------------------------------------------------
2003 2002 2001
------------------- ------------------- -------------------
Current taxes $ 44,102 $ - $ -
Taxes in respect of prior
years 352,091 - -
------------------- ------------------- -------------------
$ 396,193 $ - $ -
=================== =================== ===================
Domestic $ 33,020 $ - $ -
Foreign 363,173 - -
------------------- ------------------- -------------------
$ 396,193 $ - $ -
=================== =================== ===================
F-40
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
In U.S. dollars
NOTE 12: - INCOME TAXES(Cont.)
f. A reconciliation between the theoretical tax expense, assuming all income is
taxed at the statutory tax rate applicable to income of the Company and the
actual tax expense as reported in the Statement of Operations, is as follows:
Year ended December 31,
-------------------------------------------------------
2003 2002 2001
---------------- --------------- ---------------
Loss from continuing operations before taxes, as
reported in the consolidated statements of income $ (8,879,391) $ (4,582,792) $ (4,025,789)
================ =============== ===============
Statutory tax rate 35% 35% 35%
================ =============== ===============
Theoretical tax income on the above amount at the $ (3,107,787) $ (1,603,977) $ (1,409,026)
U.S. statutory tax rate
Deferred taxes on losses for which valuation
allowance was not provided 1,178,215 1,603,977 1,409,026
Non-deductible expenses 1,940,019 - -
State taxes 33,020 - -
Other 635 - -
Taxes in respect of prior years due to change in
estimates 352,091 - -
---------------- --------------- ---------------
Actual tax expense $ 396,193 $ - $ -
================ =============== ===============
NOTE 13: - SELECTED STATEMENTS OF OPERATIONS DATA
Financial income (expenses), net:
Year ended December 31,
------------------------------------------------
2003 2002 2001
-------------- ------------- -------------
Financial expenses:
Interest, bank charges and fees $ (355,111) $ (89,271) $ (49,246)
Amortization of compensation related to beneficial
convertible feature of convertible debenture and
warrants issued to the holders of convertible
debenture (3,359,987) - -
Foreign currency translation differences 115,538 15,202 (16,003)
-------------- ------------- -------------
(3,599,560) (74,069) (65,249)
-------------- ------------- -------------
Financial income:
Interest 129,101 174,520 327,830
-------------- ------------- -------------
Total $ (3,470,459) $ 100,451 $ 262,581
============== ============= =============
F-41
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
In U.S. dollars
NOTE 14: - RELATED PARTY DISCLOSURES
Year ended December 31,
----------------------------------------------------------
2003 2002 2001
----------------- ----------------- -----------------
Transactions:
Reimbursement of general and administrative expenses - $ 36,000 $ 23,850
================= ================= =================
Financial income (expenses), net from notes receivable
and loan holders - $ (7,309) $ (36,940)
================= ================= =================
NOTE 15: - SEGMENT INFORMATION
a. General:
The Company and its subsidiaries operate primarily in two business segments (see
Note 1a for a brief description of the Company's business) and follow the
requirements of SFAS No. 131.
The Company previously managed its business in three reportable segments
organized on the basis of differences in its related products and services. With
the discontinuance of Consumer Batteries segment (see Note 1.e-Discontinued
Operation) and acquiring two subsidiaries (see Notes 1.b.and c.), two reportable
segments remain: Electric Fuel Batteries, and Defense and Security Products. As
a result the Company reclassified information previously reported in order to
comply with new segment reporting.
The Company's reportable operating segments have been determined in accordance
with the Company's internal management structure, which is organized based on
operating activities. The accounting policies of the operating segments are the
same as those described in the summary of significant accounting policies. The
Company evaluates performance based upon two primary factors, one is the
segment's operating income and the other is based on the segment's contribution
to the Company's future strategic growth.
b. The following is information about reported segment gains, losses and assets:
Defense and
Security
Batteries Products All Other Total
----------------- ---------------- ----------------- -----------------
2003
Revenues from outside customers $ 5,868,899 $ 11,457,742 $ - $ 17,326,641
Depreciation expense and amortization (527,775) (927,665) (139,630) (1,595,070)
Direct expenses (1) (5,945,948) (10,892,933) (4,539,674) (21,378,555)
----------------- ---------------- ----------------- -----------------
Segment gross loss (604,824) (362,856) (4,679,304) (5,646,984)
================= ================ =================
Financial income (in deduction of - - - (3,471,700)
minority rights)
-----------------
Net loss from continuing operation (9,118,684)
=================
Segment assets (2) 2,128,062 1,628,562 450,864 4,207,488
================= ================ ================= =================
Expenditures for segment assets 247,989 208,497 124,463 580,949
================= ================ ================= =================
2002
Revenues from outside customers $ 1,682,296 $ 4,724,443 $ - $ 6,406,739
Depreciation expense and amortization (252,514) (676,753) (194,014) (1,123,281)
Direct expenses (1) (3,062,548) (4,353,770) (2,905,743) (10,322,061)
----------------- ---------------- ----------------- -----------------
Segment gross loss $ (1,632,766) $ (306,080) $ (3,099,757) (5,038,603)
================= ================ ================= =================
Financial income 100,451
-----------------
Net loss from continuing operation $ 4,938,152
=================
Segment assets (2) $ 2,007,291 $ 1,683,825 $ 575,612 $ 4,266,728
================= ================ ================= =================
Expenditures for segment assets $ 246,664 $ 58,954 $ 70,486 $ 376,104
================= ================ ================= =================
F-42
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
In U.S. dollars
NOTE 15: - SEGMENT INFORMATION(Cont.)
Defense and
Security
Batteries Products All Other Total
----------------- ---------------- ----------------- -----------------
2001
Revenues from outside customers $ 2,093,632 $ - $ - $2,093,632
Depreciation expense (304,438) - (225,577) (530,015)
Direct expenses (1) (2,295,501) - (3,556,486) (5,851,987)
----------------- ---------------- ----------------- -----------------
Segment gross loss $ (506,307) $ - $ (3,782,063) (4,288,370)
================= ================ =================
Financial income net 262,581
-----------------
Net loss from continuing operations $ (4,025,789)
=================
Segment assets (2) $ 2,044,257 $ 1,175,521 $ 702,915 $ 2,744,172
================= ================ ================= =================
Expenditures for segment assets $ 229,099 $ 229,099 $ 323,985 $ 553,084
================= ================ ================= =================
(1) Including sales and marketing, general and administrative expenses.
(2) Including property and equipment and inventory.
c. Summary information about geographic areas:
The following presents total revenues according to end customers location for
the years ended December 31, 2003, 2002 and 2001, and long-lived assets as of
December 31, 2003, 2002 and 2001:
2003 2002 2001
------------------------------ ------------------------------ ------------------------------
Total Long-lived Total Long-lived Total Long-lived
revenues assets revenues assets revenues assets
-------------- -------------- -------------- -------------- -------------- ---------------
U.S. dollars
----------------------------------------------------------------------------------------------
U.S.A. $10,099,652 $6,778,050 $ 2,787,250 $ 6,710,367 $ 1,057,939 $ 60,531
Germany 2,836,725 - 38,160 - 526,766 -
England 29,095 - 47,696 - 36,648 -
Thailand 95,434 - 291,200 - - -
Israel 3,576,139 2,954,441 2,799,365 3,367,320 13,773 2,160,275
Other 689,596 - 443,068 - 458,506 -
-------------- -------------- -------------- -------------- -------------- ---------------
$17,326,641 $ 9,732,491 $ 6,406,739 $ 10,077,687 $ 2,093,632 $ 2,220,806
============== ============== ============== ============== ============== ===============
F-43
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
In U.S. dollars
NOTE 15: - SEGMENT INFORMATION(Cont.)
d. Revenues from major customers:
Year ended December 31,
----------------------------------------------------
2003 2002 2001
%
----------------------------------------------------
Electric Fuel Batteries:
Customer A - - 22%
Customer B 2% 7% 20%
Customer C 1% 2% 13%
Customer D 27% 8% 12%
Defense and Security Products:
Customer A 17% 43% -
Customer B 16% - -
e. Revenues from major products:
Year ended December 31,
----------------------------------------------------
2003 2002 2001
-------------- -------------- --------------
EV $ 408,161 $ 460,562 $ 894,045
WAB 703,084 647,896 951,598
Military batteries 4,757,116 573,839 247,989
Car armoring 3,435,715 2,744,382 -
Interactive use-of-force training 7,961,302 1,980,060 -
Other 61,263 - -
-------------- -------------- --------------
Total $17,326,641 $6,406,749 $2,093,632
============== ============== ==============
NOTE 16: - CONVERTIBLE DEBENTURES
a. 9% Secured Convertible Debentures due June 30, 2005
Pursuant to the terms of a Securities Purchase Agreement dated December 31,
2002, the Company issued and sold to a group of institutional investors an
aggregate principal amount of 9% secured convertible debentures in the amount of
$3.5 million due June 30, 2005. These debentures are convertible at any time
prior to June 30, 2005 at a conversion price of $0.75 per share, or a maximum
aggregate of 4,666,667 shares of common stock (see also Note 11.f.4). The
conversion price of these debentures was adjusted to $0.64 per share in April
2003. In accordance with EITF 96-19, "Debtor's Accounting for a Modification or
Exchange of Debt Instruments," the terms of convertible debentures are not
treated as changed or modified when the cash flow effect on a present value
basis is less than 10%, and therefore the Company did not record any
compensation related to the change in the conversion price of the convertible
debentures.
During 2003, an aggregate of $2,350,000 in 9% secured convertible debentures was
converted into an aggregate of 3,671,875 shares of common stock.
In determining whether the convertible debentures include a beneficial
conversion feature in accordance with EITF 98-5 "Accounting for Convertible
Securities with Beneficial Conversion Features or Continently Adjustable
Conversion Ratios" and EITF 00-27, the total proceeds were allocated to the
convertible debentures and the detachable warrants based on their relative fair
values. In connection with these convertible debentures, the Company will record
financial expenses of $600,000 with respect to the beneficial conversion
feature. The $600,000 is amortized from the date of issuance to the stated
redemption date - June 30, 2005 - as financial expenses.
F-44
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
In U.S. dollars
NOTE 16: - CONVERTIBLE DEBENTURES(Cont.)
During 2003 the Company recorded an expense of $481,714, of which $174,000 was
attributable to amortization of the beneficial conversion feature of the
convertible debenture over its term and $307,714 was attributable to
amortization due to conversion of the convertible debenture into shares.
b. 8% Secured Convertible Debentures due September 30, 2006
Pursuant to the terms of a Securities Purchase Agreement dated September 30,
2003, the Company issued and sold to a group of institutional investors an
aggregate principal amount of 8% secured convertible debentures in the amount of
$5.0 million due September 30, 2006. These debentures are convertible at any
time prior to September 30, 2006 at a conversion price of $1.15 per share, or a
maximum aggregate of 4,347,826 shares of common stock (see also Note 11.f.5).
During 2003, an aggregate of $3,775,000 in 8% secured convertible debentures was
converted into an aggregate of 3,282,608 shares of common stock.
In determining whether the convertible debentures include a beneficial
conversion option in accordance with EITF 98-5 "Accounting for Convertible
Securities with Beneficial Conversion Features or Continently Adjustable
Conversion Ratios" and EITF 00-27, the total proceeds were allocated to the
convertible debentures and the detachable warrants based on their relative fair
values. In connection with these convertible debentures, the Company will record
financial expenses of $1,938,043 with respect to the beneficial conversion
feature. The $1,938,043 is amortized from the date of issuance to the stated
redemption date - September 30, 2006 - as financial expenses.
During 2003 the Company recorded an expense of $1,503,080, of which $134,646 was
attributable to amortization of the beneficial conversion feature of the
convertible debenture over its term and $1,368,434 was attributable to
amortization due to conversion of the convertible debenture into shares.
c. 8% Secured Convertible Debentures due December 31, 2006
Pursuant to the terms of a Securities Purchase Agreement dated September 30,
2003, the Company issued and sold to a group of institutional investors an
aggregate principal amount of 8% secured convertible debentures in the amount of
$6.0 million due December 31, 2006. These debentures are convertible at any time
prior to December 31, 2006 at a conversion price of $1.45 per share, or a
maximum aggregate of 4,137,931 shares of common stock (see also Note 11.f.6).
F-45
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
In U.S. dollars
NOTE 16: - CONVERTIBLE DEBENTURES(Cont.)
In determining whether the convertible debentures include a beneficial
conversion option in accordance with EITF 98-5 "Accounting for Convertible
Securities with Beneficial Conversion Features or Continently Adjustable
Conversion Ratios" and EITF 00-27, the total proceeds were allocated to the
convertible debentures and the detachable warrants based on their relative fair
values. In connection with these convertible debentures, the Company will record
financial expenses of $3,157,500 with respect to the beneficial conversion
feature. The $3,157,500 is amortized from the date of issuance to the stated
redemption date - December 31, 2006 - as financial expenses.
During 2003 the Company recorded an expense of $59,362, which represents the
amortization of the beneficial conversion feature of the convertible debenture
over its term.
NOTE 17: - SUBSEQUENT EVENTS (UNAUDITED)
a. Debenture conversion:
In January 2004, a total of $1,150,000 principal amount of 9% debentures was
converted into an aggregate of 1,796,875 shares of common stock at a conversion
price of $0.64 per share.
b. Issuance of common stock to investors:
In January 2004, the Company issued to a group of investors an aggregate of
9,840,426 shares of common stock at a price of $1.88 per share, or a total
purchase price of $18,500,000. (See also Note 17.c.)
c. Issuance of warrants to investors:
As part of the investment agreement in January 2004 (see Note 17.b.), the
Company issued to a group of investors warrants to purchase an aggregate of
9,840,426 shares of common stock at a price of $1.88 per share. These warrants
are exercisable by the holder at any time after August 12, 2004 and will expire
on January 12, 2007.
d. Acquisition of FAAC Incorporated:
In January 2004, the Company purchased all of the outstanding stock of FAAC
Incorporated, a Michigan corporation ("FAAC"), from FAAC's existing
shareholders. The assets acquired through the purchase of all of FAAC's
outstanding stock consisted of all of FAAC's assets, including FAAC's current
assets, property and equipment, and other assets (including intangible assets
such as goodwill, intellectual property and contractual rights). The
consideration for the assets purchased consisted of (i) cash in the amount of
$12,000,000, and (ii) the issuance of $2,000,000 in Arotech stock, plus an
earn-out based on 2004 net pretax profit, with an additional earn-out on the
2005 net profit from certain specific and limited programs.
e. Acquisition of Epsilor Electronic Industries, Ltd.:
In January 2004, the Company purchased all of the outstanding stock of Epsilor
Electronic Industries, Ltd., an Israeli corporation ("Epsilor"), from Epsilor's
existing shareholders. The assets acquired through the purchase of all of
F-46
F-45
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
In U.S. dollars
NOTE 17: - SUBSEQUENT EVENTS (UNAUDITED)(Cont.)
Epsilor's outstanding stock consisted of all of Epsilor's assets, including
Epsilor's current assets, property and equipment, and other assets (including
intangible assets such as goodwill, intellectual property and contractual
rights). The consideration for the assets purchased will consist of (i) cash in
the amount of $7,000,000, and (ii) a series of three $1,000,000 promissory
notes, due on the first, second and third anniversaries of the Agreement under
the circumstances set forth in the acquisition agreement.
f. Settlement of litigation:
On February 4, 2004, the Company entered into an agreement settling the
litigation brought against it in the Tel-Aviv, Israel district court by I.E.S.
Electronics Industries, Ltd. ("IES Electronics") and certain of its affiliates
in connection with the Company's purchase of the assets of its IES Interactive
Training, Inc. subsidiary from IES Electronics in August 2002. The litigation
had sought monetary damages in the amount of approximately $3 million. Pursuant
to the terms of the settlement agreement, in addition to agreeing to dismiss
their lawsuit with prejudice, IES Electronics agreed (i) to cancel the Company's
$450,000 debt to them that had been due on December 31, 2003, and (ii) to
transfer to the Company title to certain certificates of deposit in the
approximate principal amount of $112,000. The parties also agreed to exchange
mutual releases. In consideration of the foregoing, the Company issued to IES
Electronics (i) 450,000 shares of common stock, and (ii) five-year warrants to
purchase up to an additional 450,000 shares of common stock at a purchase price
of $1.91 per share.
In respect of the above settlement, the Company recorded in 2003 an expense of
$838,714, representing the fair value of the warrants and shares over the
remaining balance of the Company's debt to IES Electronics as carried in the
Company books at December 31, 2003, less the $112,000 certificate of deposit
that was transferred to the Company's name as noted above.
- - - - - - - -
F-47
SUPPLEMENTARY FINANCIAL DATA
Quarterly Financial Data (unaudited) for the two years ended December 31, 2003
Quarter Ended
--------------------------------------------------------------------
2003 March 31 June 30 September 30 December 31
------------------------------ --------------------------------------------------------------------
Net revenue................................. $ 4,033,453 $ 3,493,135 $ 5,705,898 $ 4,094,155
Gross profit................................ $ 1,399,734 $ 1,013,965 $ 2,453,575 $ 1,371,527
Net loss from continuing operations......... $ (1,291,122) $ (2,640,920) $ 77,093 $ (5,263,735)
Net loss from discontinued operations....... $ (95,961) $ 179,127 $ (2,285) $ 29,529
Net loss for the period..................... $ (1,387,083) $ (2,461,793) $ 74,808 $ (5,234,206)
Net loss per share - basic and diluted...... $ (0.04) $ (0.07) $ 0.00 $ (0.12)
Shares used in per share calculation........ 34,758,960 36,209,872 40,371,940 43,604,830
Quarter Ended
--------------------------------------------------------------------
2002 March 31 June 30 September 30 December 31
------------------------------ --------------------------------------------------------------------
Net revenue................................. $ 570,545 $ 425,053 $ 3,262,711 $ 2,148,430
Gross profit................................ $ 186,917 $ 48,807 $ 1,593,770 $ 155,497
Net loss from continuing operations......... $ (990,097) $ (1,005,877) $ (923,122) $ (2,019,054)
Net loss from discontinued operations....... $ (2,324,109) $ (1,654,108) $ (8,716,422) $ (871,567)
Net loss for the period..................... $ (3,314,208) $ (2,659,985) $ (9,369,544) $ (2,890,621)
Net loss per share - basic and diluted...... $ (0.11) $ (0.09) $ (0.29) $ (0.08)
Shares used in per share calculation........ 30,149,210 30,963,919 33,441,137 34,758,048
F-48
FINANCIAL STATEMENT SCHEDULE
Arotech Corporation and Subsidiaries
Schedule II - Valuation and Qualifying Accounts
For the Years Ended December 31, 2003, 2002 and 2001
Additions
-------------------------------------------------
Balance at charged to Balance at
beginning costs and end of
Description of period expenses period
- --------------------------------------------- --------------- --------------- ----------------
Year ended December 31, 2003
Allowance for doubtful accounts........... $ 40,636 $ 20,646 $ 61,282
Valuation allowance for deferred taxes.... 29,560,322 5,241,565 34,801,887
--------------- --------------- ----------------
Totals.................................... $ 29,600,958 $ 5,262,211 $ 34,863,169
=============== =============== ================
Year ended December 31, 2002
Allowance for doubtful accounts........... $ 39,153 $ 1,483 $ 40,636
Valuation allowance for deferred taxes.... 12,640,103 16,920,219 29,560,322
--------------- --------------- ----------------
Totals.................................... $ 12,679,256 $ 16,921,702 $ 29,600,958
=============== =============== ================
Year ended December 31, 2001
Allowance for doubtful accounts........... $ 13,600 $ 25,553 $ 39,153
Valuation allowance for deferred taxes.... 8,987,750 3,652,353 12,640,103
--------------- --------------- ----------------
Totals.................................... $ 9,001,350 $ 3,677,906 $ 12,679,256
=============== =============== ================
F-49
EXHIBIT INDEX
Exhibit
Number Description
- ------ -----------
3.1.3....Amendment to our Amended and Restated Certificate of Incorporation
10.72....Promissory Note dated July 1, 2002 from Robert S. Ehrlich to us
10.86....Consulting agreement dated January 1, 2004 between us and Edward J. Borey
10.87....Lease dated April 8, 1997, between AMR Holdings, L.L.C. and FAAC Incorporated
10.88....Lease dated as of March 22, 2004 between us and Fisk Building Associates L.L.C.
14.......Code of Ethics
21.......List of Subsidiaries of the Registrant
23.......Consent of Kost, Forer, Gabbay & Kassierer
31.1.....Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of
2002
31.2.....Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of
2002
32.1.....Written Statement of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002
32.2.....Written Statement of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002