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CAUTIONARY STATEMENT CONCERNING FORWARD-LOOKING STATEMENTS  

This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, adopted pursuant to the Private Securities Litigation Reform Act of 1995. Forward-looking statements involve risks and uncertainties, as well as assumptions that could cause our results to differ materially from those expressed or implied by such forward-looking statements. Forward-looking statements generally are identified by the words “may,” “will,” “project,” “might,” “expects,” “anticipates,” “believes,” “intends,” “estimates,” “should,” “could,” “would,” “strategy,” “plan,” “continue,” “pursue,” or the negative of these words or other words or expressions of similar meaning. All statements, other than statements of historical fact, are statements that could be deemed forward-looking statements. These forward-looking statements are based on information available to us, are current only as of the date on which the statements are made, and are subject to numerous risks and uncertainties that could cause our actual results, performance, prospects or opportunities to differ materially from those expressed in, or implied by, the forward-looking statements. For a discussion of such risks and uncertainties, please see the discussion under the caption “Risk Factors” contained in this Annual Report on Form 10-K and in other information contained in this annual report and our publicly available filings with the SEC. You should not place undue reliance on any forward-looking statements. Except as otherwise required by federal securities laws, we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events, changed circumstances or any other reason.

EXPLANATORY NOTE

        The terms “CDTi” or the “Company” or “we,” “our” and “us” means Clean Diesel Technologies, Inc. and its consolidated subsidiaries as of the date of this Annual Report on Form 10-K. References to “Notes” are notes included in the consolidated financial statements included in this Annual Report on Form 10-K.  

TRADEMARKS

        The Clean Diesel Technologies name with logo, CDT logo, CDTi name with logo, CSI^®, CATALYTIC SOLUTIONS^®, CSI logo, ARIS^®, BARETRAP^®, BMARS^™, CATTRAP^®, CDTI SPINEL^™, COMBICLEAN^®, COMBIFILTER^®, DESIGNED TO FIT. BUILT TO LAST.^™, DURAFIT^™, DURAFIT OEM REPLACEMENT EMISSION TECHNOLOGIES^™, MPC^®, OPTIMAL SPINEL^™, P2C^™, PATFLUID^®, PLATINUM PLUS^®, PURIFIER and design, PURIFILTER^®, PURIMUFFLER^®, SPGM^™, SPINEL^™, SPINEL PHASE^™,  THREE-WAY ZPGM^™, TWO-WAY ZPGM^™, ZPGM^™, ZPGM TWC^™, TERMINOX^® and UNIKAT^®, among others, are registered or unregistered trademarks of Clean Diesel (including its subsidiaries).

PART I

ITEM 1.      BUSINESS

We plan to continue to maintain our current world-class manufacturing capability, and deploy it selectively where it adds value for our customers; to explore new joint ventures and partnerships; and to pursue new verticals. We intend to continue to evaluate and refine our strategic plan in order to seize opportunities as they arise. 

Since 2013, we have filed nearly 100 patents pertaining to our advanced low-PGM and ZPGM^™ catalysts. The development of our advanced low-PGM and ZPGM^™ catalysts utilizing our Spinel^™ technology and their commercialization is a strategic priority and will require investment in research, development, marketing and sales.

Emissions Control Industry Overview

        Regulatory standards have been adopted worldwide to control the exhaust emissions from on- and off-road engines. These emissions typically include nitrogen oxides, hydrocarbons, particulate matter, carbon monoxide and more recently greenhouse gases such as carbon dioxide. Emission regulations for mobile sources have tightened and expanded over the years due to an increased understanding of the impacts of these emissions on human health and the environment, which is highlighted by the following:

·       According to a March 2014 EPA report, over 149 million Americans today still experience unhealthy levels of air pollution which are linked to adverse health impacts such as hospital admissions, emergency room visits and premature mortality.

·       In a 2014 State of the Air report prepared by the American Lung Association, it was documented that air pollution hovers at unhealthy levels in almost every major city, placing lives at risk. The same report indicated that cleaner diesel engines helped cut year-round particle pollution in many areas.

·       According to a 2013 report published by the World Health Organization, exposure to particulate matter less than 2.5 micrometers in diameter (PM _2.5) reduces the life expectancy of each person in Europe by an average of 8.6 months.   

Because standards put in place by the EPA, CARB, the European Union and other international regulators continue to become more restrictive, we view the market opportunities for our products as continually expanding, as our light duty vehicle catalyst products and heavy duty diesel emission control systems are designed specifically to deal with emissions from gasoline, diesel and a variety of alternative fuel powered engines.

Light Duty Vehicles 

Key milestones in the evolution of light duty vehicle emissions control in the U.S. are summarized in the table below:

Europe implemented similar regulations as those noted above under Euro III (effective 2000), Euro IV (effective 2005), Euro V (effective 2009) and Euro VI (effective 2014). Further, in various Asian countries, similar regulations have been implemented or will be implemented over the coming years.

We currently supply our catalyst products featuring our proprietary MPC^® technology to OEMs such as Honda, whose 2014 Plug-in Hybrid Accord was approved by CARB as the first gasoline-powered car to meet what is known as the Super Ultra Low Emission Vehicle 20 (SULEV20) standard, the most stringent standard in the nation.

Heavy Duty Diesel Engines

Key milestones in the evolution of heavy duty diesel engine emissions control in the U.S. are summarized in the table below:

Off-road compression ignition emissions standards (non-road Tier 1) were first set in 1996 and consistently phased in and further tightened by off-road Tier 2 and Tier 3 emissions limits. Tier 4 emissions limits which have been phased in between 2011 and 2014 saw the first introduction of various exhaust emissions controls including diesel oxidation catalysts, diesel particulate filters and selective catalytic reduction catalysts. Given the global nature of the off-road diesel powered equipment market, common EPA and European Union standards have typically been enacted at comparable times. 

Government Programs

Governments continue to issue increasingly stringent diesel emission control regulations and mandates. Increased compliance with these regulatory initiatives drives demand for our products and the timing of implementation for emission reduction projects. Funding mechanisms are evolving which involve government and private sector funding of emission control projects, including the following key programs:

·        National Clean Diesel Campaign. Established by the EPA, this program promotes diesel emission reduction strategies and oversees regulatory programs that address new diesel engines as well as other innovative programs to address the millions of diesel engines already in use. In the U.S., heavy duty diesel retrofits have been driven primarily by subsidy programs supported under the Diesel Emissions Reduction Act, or DERA, the American Recovery and Reconstruction Act, or ARRA, Proposition 1B in California, the U.S. Department of Transportation’s Congestion Mitigation and Air Quality Improvement program, or CMAQ, as well as various other state and local programs. 

·        CMAQ Program. This program provides a flexible funding source to state and local governments for transportation projects and programs to help meet the requirements of the Clean Air Act. Over $2.2 billion in funding was authorized for 2013 and 2014 to reduce congestion and improve air quality for areas that do not meet the National Ambient Air Quality Standards (NAAQS) for ozone, carbon monoxide or particulate matter (nonattainment areas) and for former nonattainment areas that are now in compliance (maintenance areas).

·        International Programs. London implemented a stricter low emission zones, or LEZs, regulations, which went into effect in early 2012, resulted in the successful retrofit of an estimated 17,000 heavy duty diesel vehicles during 2011 and early 2012. We believe that our emission reduction systems were used to retrofit approximately 20% of those vehicles. Further, we believe that countries will likely follow Europe and the United States in passing more stringent regulations, funding retrofit programs, and establishing LEZs. For example, countries such as Chile, Columbia, Brazil, China and Israel are leading the way with urban bus retrofit programs. We estimate over 50,000 urban buses and trucks could be retrofitted by 2016 in major metropolitan areas within these countries with the potential for major follow-on LEZ programs and on-road mandates.  

Emerging Replacement Market in North America

According to market analysis firm Power System Research, manufacturers in North America have produced an average 250,000 heavy duty on-road diesel vehicles equipped with a diesel particulate filter each year since 2007 to comply with EPA requirements. The typical OEM warranty on diesel particulate filters is five years and has expired for many of these vehicles with more continuing to expire in the coming years. As 2007 and newer diesel particulate filters from OEMs fail and require replacement, non-OEM diesel particulate filters will be needed as replacements. According to a 2012 industry report, the market for medium and heavy duty vehicle after-treatment maintenance and repair is projected to grow from $0.5 billion in 2010 to $3.0 billion by 2017. In the second quarter of 2014, we introduced the CDTi manufactured DuraFit^™ OEM replacement diesel particulate filters through our channel of distributors to provide an alternative to OEM manufactured parts.  We expect to leverage our existing technology and know-how to cost effectively serve this emerging market.

Technology 

        We have succeeded in developing a world-class technology portfolio to meet and exceed regulatory emission standards around the globe. In particular, our Spinel^™, MPC^® and Platinum Plus^® fuel-borne catalyst technologies, as well as our diesel particulate filter and selective catalytic reduction system design and packaging know-how, are at the core of our business.

·       Spinel™.  Our Spinel^™ technology is a unique clean emissions exhaust technology which we believe will dramatically reduce the cost of attaining more stringent clean air standards. Spinel was the name initially given to naturally-occurring magnesium aluminate (MgAI2O4) and is now used to describe any composition with the same structure. Our Spinel^™ technology may employ numerous low-cost metals in the spinel structure enabling use in a wide range of engine and vehicle applications, both gasoline and diesel, as well as other potential vertical markets. Our unique Spinel^™ technology utilizes various base metals, which when combined together in a common structure, achieve unusual and very effective catalytic conversion activity. Spinel^™ technology is ideal for the coating of catalytic converters – an alternative to those utilizing costly PGMs and rare earth materials. The base metals we use are common and inexpensive compared to PGMs, such as platinum, palladium and rhodium, and rare earth metals, like cerium, lanthanum and neodymium. We believe Spinel^™ technology will provide significant cost savings over conventional coating formulations. In addition, the Spinel^™ technology structure is extremely versatile and stable. The versatility is critical for optimizing future generations of products to meet changing catalytic conversion needs for rapidly evolving engine technologies and increasingly stringent clean air standards. The stability is critical to provide superior catalytic performance over time and at extreme temperatures for lifetime durability. In addition to SPGM^™ and ZPGM^™ catalysts, we currently have oxygen storage material, or OSM, under development which synergizes PGM function and drives the critical vehicle on-board diagnostic system. Our newest family of advanced low-PGM and ZPGM^™ oxide compounds based upon our Spinel^™ technology is summarized below:

To date, we have filed numerous patents on our Spinel^™ technology and two were recently issued. While not yet available, we are well underway with testing Spinel^™ technology on production models of popular passenger cars and heavy duty diesel vehicles at independent vehicle test facilities.

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·       MPC^®. We have developed and patented intellectual property rights to a novel technology for creating and manufacturing catalysts known as mixed phase catalysts (MPC^®). This technology involves the self-assembly of a ceramic oxide matrix with catalytic metals precisely positioned within three-dimensional structures. The MPC^® design gives our catalyst products two critical attributes that we believe differentiate them from competing offerings: superior stability that allows heat resistance and high performance with very low levels of precious metals; and base metal activation that allows base metals to be used instead of costly PGMs without compromising catalytic performance. The stability platform will continue to be important in the context of the new ZPGM^™ materials. The design methodology of sintering resistance will continue to be a key focus as we integrate the new materials with full catalyst design strategies.

·       Platinum Plus^®.  We have developed and patented our Platinum Plus^® fuel-borne catalyst as a diesel fuel soluble additive, which contains minute amounts of organo-metallic platinum and cerium catalysts. Platinum Plus^® enables rapid conversion of particulate matter from diesel engines when coupled with a diesel particulate filter. It also improves combustion, which acts to reduce engine-out emissions. Platinum Plus^® fuel-borne catalyst lends itself to a wide range of enabling solutions including diesel particulate filtration, low emission biodiesel, carbon reduction and exhaust emission reduction. Environmentally conscious corporations and fleets can utilize this solution to voluntarily reduce emissions.

·       ARIS^®. We have developed technology for selective catalytic reduction using urea, which is a highly effective method of reducing oxides of nitrogen. ARIS^® technology forms a key part of the selective catalytic reduction system and is an advanced, computer-controlled, reagent injection system. Our ARIS^® technology applies to single-fluid systems, methods of control and the combination of selective catalytic reduction with exhaust gas recirculation technology. It covers a concept for injecting urea into the engine exhaust where it reacts across a catalyst to reduce oxides of nitrogen and water vapor. ARIS^® technology also provides reliable hydrocarbon (HC) injection into the exhaust stream for applications including lean NOx traps, reformer systems and diesel particulate filter active regeneration. Effective heat removal and reliable, trouble-free fuel injection for durable exhaust emissions systems performance is a paramount consideration for designing OEM and retrofit solutions. Our patented ARIS^® for selective catalytic reduction reduces nitrogen oxide by up to 90%. We have numerous U.S. and corresponding international patents on the use of ARIS^® technology.

·       Exhaust Gas Recirculation and Selective Catalytic Reduction. Exhaust Gas Recirculation, or EGR, and Selective Catalytic Reduction, or SCR, are technologies developed in the global transportation industry by manufacturers of diesel powered equipment in order to meet the standards of oxides of nitrogen emissions defined by the EPA and other global environmental regulation agencies. In 1997, we developed and patented the concept of combined use of EGR and SCR to minimize emissions and take advantage of the benefits each can bring in terms of oxides of nitrogen reduction. As legislation tightens across the globe, we believe EGR in combination with SCR is a key solution to meet strict oxides of nitrogen regulations. Previously seen as competing approaches, combined EGR/SCR allows users to meet strict oxides of nitrogen levels outlined by the U.S. 2010 and Euro 6/VI emission standards. The EGR system can be activated to reduce oxides of nitrogen when starting a cold engine. The SCR operates at a higher temperature when the catalyst is fully active and at low EGR rates. With both EGR and SCR in place, engines can be fine-tuned to optimize fuel efficiency and deliver greater emissions reduction. We have intellectual property holdings for the design and implementation of these combination systems and have licensed these patents to several industry providers.

        We protect our proprietary technologies, along with our other intellectual property, through the use of patents, trade secrets and registered and common law trademarks. For additional information, refer to the “Intellectual Property” discussion below. 

Competitive Advantages

Through persistent technology development, we maintain a broad portfolio of emission control products ranging from catalysts to complete retrofit or OEM systems. We believe that our technologies and products represent a fundamentally different solution, and the following competitive strengths position us as a leading provider of emission control products and systems.

·       Superior Catalyst Performance. Our proprietary technology enables us to produce catalytic coatings capable of significantly better catalytic performance than those previously available. We have achieved this demonstrated performance advantage by creating catalysts using unique nanostructures with superior stability under prolonged exposure to high temperatures. As a result, in heavy duty diesel and automotive applications, our catalyst formulations are able to maintain high levels of performance over time using substantially lower– or zero–PGMs than products previously available.

·       Catalyst Cost Advantage – Addressing Global PGM Supply and Demand. Expensive PGMs, which include palladium, platinum and rhodium, and rare earth metals such as cerium, neodymium and lanthanum, are used in the manufacture of emission control catalysts, with palladium being the primary component used in catalysts serving the global light duty vehicle market. According to Johnson Matthey PLC’s “Platinum 2013 Interim Review”, in 2013, over 70% of all primary platinum and 80% of all primary rhodium produced originated in South Africa. Russia and South Africa combined supplied over 75% of palladium. We believe that the continued growth of these metals from the mines in South Africa and Russia will be critical in order to meet the increasingly stringent global emission control standards. According to the same report, it is estimated that more than $6 billion is spent annually by OEMs on PGM purchases for catalysts. The global auto industry is expected to produce over 100 million vehicles by 2018, according to IHS Automotive. These production levels are expected to result in a continued increase in PGM demand for the foreseeable future. In addition, continued tightening of emission standards by regulators globally will require increased loading of PGM in emission catalysts. For example, the landmark Tier 3 emission standards announced by the EPA in 2014 are expected to increase per-vehicle PGM requirements and volumes, which will contribute to higher demand for North America. The EPA expects the new standards will increase PGM loadings by 50% for palladium and 20% for rhodium. The need to reduce the dependence on the use of PGMs in vehicle emission control systems is one of our primary drivers for developing catalysts that use much less or zero PGM to achieve air quality standards, as the cost of PGMs has trended up over the past 15 years and has been subject to extreme volatility due to growing demand and limited supply.

In the automotive market in particular, where PGM costs represent a large portion of manufacturers’ costs, a significant benefit of our catalyst technology is that it offers performance equal to or exceeding that of other catalyst technologies with up to a 50% reduction in PGM loadings. Once verified, we expect that catalysts featuring our Spinel^™ technology will further reduce or completely eliminate the need for PGM loadings.

·       Highly Customizable Catalyst Formulations. Our proprietary MPC^® technology is a design approach, as opposed to a single chemical formulation. We have developed this technology since inception as a platform that can be tailored for a range of different industrial catalyst applications. Specifically, our formulations can be tailored in two distinct ways. First, the oxide compounds used in our formulations can be adapted for specific applications by adding to them, or doping them with, a wide range of chemical elements, a process known as tuning. This technical approach is accelerating with major new resource investments to establish a new family of advanced low-PGM and ZPGM^™ oxide compounds based upon our Spinel^™ technology. By contrast, our competitors typically tune their catalyst offerings by adjusting the PGM type and content. Second, we are able to vary the mixtures of our compounds to create customized solutions for specific applications. In the emissions control market, these two independent design mechanisms allow for customization and optimization for different vehicle platforms within the auto industry, complex heavy duty diesel equipment for OEMs, aftermarket and retrofit markets, and for different applications in the energy sector, such as selective catalytic reduction nitrogen oxide control for industrial and utility boilers, process heaters, gas turbines and generator sets. In addition, the material science underlying our MPC^® and Spinel^™ technologies could have applications where reduction in PGMs would provide cost advantages. These could include applications in the fuel cell, petrochemical and refinery, and thermoelectric industries.

·       Proven Durability.  Our products and systems have undergone substantial laboratory and field testing by our existing and prospective customers and have demonstrated their durability and reliability in a wide range of applications in actual use for many years. In addition, our products and systems have achieved numerous certifications and meet or exceed industry standards. Of particular note, our Catalyst division has supplied over eleven million catalyst parts to light duty vehicle customers since 2001.

·       Broad Portfolio of Verified Heavy Duty Diesel Systems.  We believe we offer one of the industry’s most comprehensive portfolios of system products that have been evaluated and verified (approved) by the EPA and CARB, as well as regulators in several European countries, for use in engine retrofit programs and in the aftermarket segment. Additionally, we have a thorough understanding of the verification process and the demonstrated ability to obtain broad verifications of products for use in the retrofit market.

·       Compatibility with Existing Manufacturing Infrastructure and Operating Specifications. Catalytic converters using our catalyst products are compatible with existing automotive manufacturing processes as well as specific vehicle operating specifications. Our customers generally do not need to change their manufacturing operations, processes, or how their products operate in order to utilize our proprietary technology. Our heavy duty diesel emission control products and solutions are engineered to each customer’s specific application and designed to deliver custom and industry-leading solutions that meet or exceed environmental mandates. 

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Products

        Catalyst Division

        Our Catalyst division currently produces catalyst formulations for gasoline, diesel and natural gas induced emissions that offer superior performance, proven durability and cost effectiveness for multiple markets and a wide range of applications. The Catalyst division products include catalysts for gasoline (light duty vehicle) engines, diesel engines and for energy applications, as further discussed below:

       Our unique advanced materials technology provides a number of potential vertical market opportunities for us that we are focused on pursuing. These opportunities arise from our ability to reduce the use of PGMs and even eliminate the PGM content. Other than the emission reduction market, we believe that the fuel cells market, petrochemicals catalyst market and the thermoelectric market may provide us the opportunity to use our advanced materials technology to develop and sell or license products.

In addition to the portfolio of products already developed from our proprietary MPC^® technology platform, we have a pipeline of new products under development based upon our new Spinel^™ technology platform. We are working on the next generation of our current product offerings and in growing the portfolio of advanced low-PGM and ZPGM^™ products and verified technologies.      

Heavy Duty Diesel Systems Division

        Our Heavy Duty Diesel Systems division offers a full range of products globally for OEM and verified retrofit markets for the reduction of exhaust emissions of on-road, off-road and stationary diesel and alternative fuel engines including propane and natural gas. These division products include:

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Sales and Marketing

        The catalyst industry is mainly comprised of a few suppliers serving large, sophisticated customers such as automobile manufacturers. Purchase cycles for catalysts tend to be long, resulting in generally predictable and stable revenue streams. Catalysts are technology intensive products that have a profound effect on the performance of the large, expensive systems in which they are embedded. Extensive interaction is required between catalyst manufacturers and their customers in the course of developing an effective, reliable catalyst for a particular application. For this reason it would appear that even the largest customers prefer to work with only two or three preferred catalyst suppliers on a specific application. The collaboration required for catalyst development and the technical hurdles involved in making effective and reliable catalysts create barriers to entry and provide an opportunity for catalyst manufacturers to earn attractive margins. We are an approved supplier of catalysts for major automotive manufacturers, such as Honda. In addition, the Catalyst division targets large heavy duty diesel engine manufacturers as potential buyers of our catalyst products and explores potential vertical markets for utilization of our technologies. Our Heavy Duty Diesel Systems division is also a customer of our catalyst products.

        A significant portion of Catalyst division sales to external customers in 2014 and 2013 were made to Honda. Sales to Honda represented 98% and 95% of Catalyst division revenues and 52% and 41% of consolidated revenues for the years ended December 31, 2014 and 2013, respectively. A significant loss in sales to Honda could have a material adverse effect on our business.

       We sell our heavy duty diesel system products to customers worldwide through a large network of dealers and distributors, as well as directly to OEM customers. The dealers and distributors receive a discount from list price or a commission, which varies depending on the product sold. Customers purchase heavy duty diesel system products to reduce emissions for either retrofit or OEM applications. Retrofit applications generally involve funded projects that use “approved systems” that are one-off in nature. Typical retrofit end-user customers include school districts, municipalities and other fleet operators, and the market for our heavy duty diesel systems products is heavily influenced by government funding of emissions control projects. OEM customers include manufacturers of heavy duty diesel equipment, such as mining equipment, vehicles, generator sets and construction equipment. Recently, we launched our DuraFit^™ OEM replacement diesel particulate filters, which leverage our proprietary catalyst technology within the medium and heavy duty vehicle parts replacement market, a new market segment for us. We expect that showcasing DuraFit^™ at industry tradeshows, advertising in industry publications and creating a website dedicated to DuraFit^™ will allow us to quickly grow the distribution reach and market acceptance of this new product. Adoption and implementation of diesel emission control regulations drives demand for our products.

     Our total backlog of confirmed orders was approximately $6.6 million at December 31, 2014 and $6.3 million at December 31, 2013. We expect to fulfill the confirmed orders as of December 31, 2014 during 2015.         

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Competition

        Our company operates in two market segments, with two different competitive landscapes.       

        Catalyst. The catalyst industry is highly concentrated with a few major competitors as a result of continuing consolidation through acquisitions. The major competitors are diversified enterprises with catalysts representing one of several lines of business. Our Catalyst division competes directly against BASF GmbH, Johnson Matthey plc and Umicore Limited Liability Company. In the worldwide market the key competitive factors are:

·      Ability to provide a solution that satisfies emission reduction regulations;

·      Total cost of product (inclusive of PGM);

·      Ability to transition new products from development to production;

·      Quality control that guarantees 100% compliance with specifications;

·      On-time delivery to support customer production requirements; and

·      Financial stability and global reach.

        We believe that our advanced low-PGM catalyst technology and our history of quality and service enable us to compete in some cases despite our lack of financial stability and size. Our strategy of transitioning to an advanced materials company is intended to enable broad commercialization of our technology without the need for a global manufacturing footprint.

       Heavy Duty Diesel Systems. Our Heavy Duty Diesel Systems division competes directly against other companies that market verified products. In North America, our key competitors with verified products include: Donaldson Company, Inc., ESW, Inc., Hug Filtersystems, Johnson Matthey plc and DCL International Inc. In Europe, we compete with a number of companies, including Dinex Exhausts Ltd, Eminox Ltd, Huss Group and HJS Emission Technology. Key competitive factors are:

·      Having a broad portfolio of verified products;

·      Performance track record with dealers, distributors and end-use customers; and

·      Ability to provide cost effective innovative solutions.

We believe that we are very competitive on all key criteria with other companies in this marketplace.

Research and Development.

          Our research and development in catalyst technology is our core strength and has resulted in a broad array of products for the light duty vehicle and heavy duty diesel markets. Our greatest strength in the catalyst business lies in the technical sophistication and cost-to-performance ratio of our products. Product development in our Heavy Duty Diesel Systems division has resulted in a broad family of verified products and systems. We credit our accomplishments to strong engineering capabilities, an experienced team, streamlined product development processes and solid experience in the verification and approval process. We seek to acquire competitive advantage through the use of customized catalysts for our emission control systems. We spent approximately $6.5 million and $4.7 million on research and development activities in the years ended December 31, 2014 and 2013, respectively.

Intellectual Property

        Our intellectual property includes patent rights, trade secrets and registered and common law trademarks. Historically, we have primarily protected our intellectual property, particularly in the area of three-way catalysts (and particularly in the automotive area) by maintaining our innovative technology as trade secrets. We believe that the protection provided by trade secrets for our intellectual property was the most suitable protection available for the automotive industry where our business initially started and in which we currently sell our commercial products. Our automotive competitors largely rely on trade secret protection for their innovative technology. 

In order to more broadly commercialize our technology in new business models, we have sought patent protection in relation to any new industries and new countries in which we expect to do business. We currently have approximately 170 issued patents and approximately 150 pending applications covering the following main technologies: fundamental catalyst formulations based on perovskite mixed metal oxides applicable to all catalyst markets, Spinel^™ technology, Mixed Phase Catalyst (MPC^®) technology, PGM-free catalyzed diesel particulate filter, selective catalytic reduction, diesel oxidation catalyst, ZPGM^™ three-way catalyst formulations, ZPGM^™ diesel oxidation catalyst, palladium three-way catalyst formulations, fuel-borne catalysts, optimization and stabilization of oxygen storage materials without rare earth materials, exhaust gas recirculation with selective catalytic reduction and exhaust systems for diesel engines incorporating particulate filters.  Currently, our patents have expiration dates ranging from 2015 through 2032.

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        We have conducted an analysis of our technologies and intellectual property and have decided to aggressively patent our important technologies going forward. While we continue to rely on a combination of trade secrets, know-how, trademark registrations, confidentiality and other agreements with employees, customers, partners and others, we intend to strengthen our position through the prosecution of patents to protect our intellectual property rights pertaining to our products and technology.

        We currently have registered and unregistered trademarks for the Clean Diesel Technologies name with logo, CDT logo, CDTi name with logo, CSI^®, CATALYTIC SOLUTIONS^®, CSI logo, ARIS^®, BARETRAP^®, BMARS^™, CATTRAP^®, CDTI SPINEL^™, COMBICLEAN^®, COMBIFILTER^®, DESIGNED TO FIT. BUILT TO LAST.^™, DURAFIT^™, DURAFIT OEM REPLACEMENT EMISSION TECHNOLOGIES^™, MPC^®, OPTIMAL SPINEL^™, P2C^™, PATFLUID^®, PLATINUM PLUS^®, PURIFIER and design, PURIFILTER^®, PURIMUFFLER^®, SPGM^™, SPINEL^™, SPINEL PHASE^™,  THREE-WAY ZPGM^™, TWO-WAY ZPGM^™, ZPGM^™, ZPGM TWC^™, TERMINOX^® and UNIKAT^®.       

Manufacturing Operations

        Our Catalyst division has developed an innovative and sophisticated manufacturing process for coating substrates using our MPC^® catalytic coatings. The manufacturing process consists of mixing specially formulated catalytic coatings, applying the coatings to ceramic substrates, firing the coated substrates in a furnace, then repeating this process one or two more times. The process of mixing and applying the various types of coatings onto high cell density substrates is complex and requires sophisticated manufacturing technology. We have been manufacturing automotive catalysts since 1999. Our manufacturing lines are designed to provide a high level of quality control at every step of the unique manufacturing process. We manufacture our proprietary catalyst products in our manufacturing facility in Oxnard, California.

        Our Heavy Duty Diesel Systems division engineers our emissions control products to customer-specific applications. We believe that this approach reduces installation or assembly time and optimizes operating uptime. Our Heavy Duty Diesel Systems division works as the customer’s partner to deliver custom, industry-leading solutions that address each customer’s particular environmental mandates. Our heavy duty diesel systems are designed and manufactured in facilities located in Thornhill, Ontario and Malmö, Sweden.

        We maintain ISO 9001:2008, ISO/TS 16949:2009 and ISO 14001:2004 certifications.

       Our raw material requirements vary by division. Our Catalyst division purchases ceramic substrates that we coat with specialty formulated catalysts comprised of PGMs and various chemicals. PGMs are either provided on a consignment basis by the customers of the division or are purchased by us on behalf of the customer. Our Heavy Duty Diesel Systems division purchases filters, filters coated with catalysts and other materials to manufacture our emission systems. These raw materials are purchased from third party suppliers as well as internally from our Catalyst division. For the Catalyst division, the availability of raw materials is generally dictated by global market supply of key materials. Key materials such as rare earth metals and platinum group metals have at times had delivery constricted due to global supply constraints. The ceramic substrates that we buy are generally sourced by our automotive OEM customers and adequate supply is generally available. The filters for our Heavy Duty Diesel division can generally be purchased from more than one source, limiting our risk of supply, and coated filters, can be sourced from either our Catalyst division or outside suppliers, though changing suppliers for some catalysts may require regulatory approval. For further discussion of risk of supply, refer to “Item 1.A. Risk Factors— Failure of one or more key suppliers to timely deliver could prevent, delay or limit us from supplying products. Delays in delivery times for PGM purchases could also result in losses due to fluctuations in prices. Delays in the delivery times and the cost impact of the world-wide shortage of rare earth metals could delay us from supplying products and could result in lower profits.”  

Regulations

       We are committed to complying with all federal, state and international environmental laws governing production, use, transport and disposal of substances and control of emissions. In addition to governing our manufacturing and other operations, these laws often impact the development of our emissions control products, including, but not limited to, required compliance with emissions standards applicable to new product diesel, gasoline and alternative fuel engines. These regulations include those developed in Japan, in the United States by the EPA and CARB and in the E.U. by the European Environment Agency, including standards from the Verification of Emission Reduction Technologies, or VERT, Association.

       Many of our products must receive regulatory approval prior to sale. In the United States, regulatory approval is obtained from the EPA or CARB through a verification process. The verification process includes a thorough review of the technology as well as tightly controlled testing to quantify statistically significant levels of emission reductions. For example, the EPA verification process begins with a verification application and a test plan. Once this is completed, the testing phase begins and is then followed by a data analysis to determine if the technology qualifies for verification. Once a technology is placed on the verified technologies list and 500 units are sold, the manufacturer is responsible for conducting in-use testing and reporting of results to the EPA. Similar product approval schemes exist in other countries around the world.

Company History

We are a Delaware corporation formed in 1994 as a wholly-owned subsidiary of Fuel Tech, Inc., a Delaware corporation (formerly known as Fuel-Tech N.V., a Netherlands Antilles limited liability company) (“Fuel Tech”), and were spun off by Fuel Tech in a rights offering in December 1995 on the NASDAQ Stock Market (Symbol CDTI). On October 15, 2010, we completed a business combination with Catalytic Solutions, Inc. (“CSI”), a California corporation formed in 1996, when our wholly-owned subsidiary, CDTI Merger Sub, Inc., merged with and into CSI. We refer to this transaction as the “Merger.” The Merger was accounted for as a reverse acquisition and, as a result, our Company’s (the legal acquirer) consolidated financial statements are now those of CSI (the accounting acquirer), with the assets, liabilities, revenues and expenses of CDTI being included effective from October 15, 2010, the closing date of the Merger. From November 22, 2006 through the closing date of the Merger, CSI’s common stock was listed on the AIM of the London Stock Exchange (AIM: CTS and CTSU).

Employees

        As of December 31, 2014, we had 113 full time employees and 4 part time employees. None of our employees is a party to a collective bargaining agreement. We also retain outside consultants and sales and marketing consultants and agents.

ITEM 1A.  RISK FACTORS

        We are subject to risks and uncertainties that may affect our future financial performance and our stock price. Some of the risks and uncertainties that may cause our financial performance to vary or that may materially or adversely affect our financial performance or stock price are discussed below. Any of these risks, as well as other risks and uncertainties not known to us or that we believe to be immaterial, could harm our financial condition, results of operations or cash flows. You should carefully consider the risks described below in addition to the cautionary statements and risk factors described elsewhere and the other information contained in this Annual report on Form 10-K and in our other filings with the SEC, including subsequent reports on Forms 10-K, 10-Q and 8-K, before deciding to purchase, hold, or sell our stock.

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Future growth of our business depends, in part, on the general availability of funding for emissions control programs, as well as enforcement of existing emissions-related environmental regulations and further tightening of emission standards worldwide.

The pursuit of opportunities relating to special government mandated retrofit programs requires cash investment in operating expenses and working capital such as inventory and receivables prior to the realization of profits and cash from sales and, if we are not successful in accessing cash resources to make these investments, we may miss out on these opportunities; further, if we are not successful in generating sufficient sales from these opportunities, we will not realize the benefits of the investments in inventory, which could have an adverse effect on our business, financial condition and results of operations.

We are pursuing revenue generating opportunities relating to special government mandated retrofit programs such as those in California and potentially others in various jurisdictions in North America, Europe and Asia. Opportunities such as these require cash investment in operating expenses and working capital such as inventory and receivables prior to realizing profits and cash from sales. If we are not successful in accessing cash resources to make these investments, we may miss out on these opportunities. Further, if we are not successful in generating sufficient sales from these opportunities, we will not realize the benefits of the investments in inventory, which would have an adverse effect on our business, financial condition and results of operations.

If we fail to maintain an effective system of internal control over financial reporting, we may not be able to accurately report our financial results, which will likely result in significant legal and accounting expense and diversion of management resources, and current and potential stockholders may lose confidence in our financial reporting and the market price of our stock will likely decline.

We are required by the SEC to establish and maintain adequate internal control over financial reporting that provides reasonable assurance regarding the reliability of our financial reporting and the preparation of financial statements in accordance with generally accepted accounting principles. We are likewise required, on a quarterly basis, to evaluate the effectiveness of our internal controls and to disclose any changes and material weaknesses in those internal controls.

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The Merger adversely affects our ability to take advantage of the significant U.S. federal tax loss carryforwards and tax credits accumulated.

In connection with the Merger, we performed a study to evaluate the status of net operating loss carryforwards. Because the Merger caused an “ownership change” (as defined for U.S. federal income tax purposes), our ability to use our net operating losses and credits in future tax years has been significantly limited. In addition, due to the “ownership change,” our federal research and development credits have also been limited and, consequently, we do not anticipate being able to use any of these credits that existed as of the date of the Merger in future tax years. Our limited ability to use these net operating losses and tax credits as a result of the Merger or otherwise, including as a result of equity offerings subsequent to the Merger, could have an adverse effect on our results of operations. 

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PGMs and rare earth metals price fluctuations could impact financial performance.

Because our catalysts contain platinum, palladium and rhodium, or platinum group metals (PGMs), and rare earth metals, fluctuations in prices could have an adverse impact on our profits as it may not be possible to recover price increases from customers. Additionally, increased prices could result in increased working capital requirements which we may not be able to finance.

We depend on intellectual property and the failure to protect our intellectual property could adversely affect our future growth and success.  

We rely on patent, trademark and copyright law, trade secret protection, and confidentiality and other agreements with employees, customers, partners and others to protect our intellectual property. In addition, some of our intellectual property is not protected by any patent or patent application. The lack of patent and trademark protection may be intentional as we may lack sufficient resources to protect our intellectual property in every applicable jurisdiction. As a result, it may be possible for third parties to obtain and use our intellectual property without the need to obtain our authorization.

We do not know whether any patents will be issued from our pending or future patent applications or whether the scope of any issued patents is or will be sufficiently broad to protect our technologies. Moreover, patent applications and issued patents may be challenged or invalidated. We could incur substantial costs in prosecuting or defending patent infringement suits. In addition, the laws of some foreign countries may not protect or enforce intellectual property rights to the same extent as do the laws of the United States. 

The patents protecting our proprietary technologies expire after a period of time. Currently, our patents have expiration dates ranging from 2015 through 2032. Although we have attempted to incorporate technology from our core patents into specific patented product applications, product designs and packaging, there can be no assurance that this building block approach will be successful in protecting our proprietary technology and products. If we are not successful in protecting our proprietary technology, it could have a material adverse effect on our business, financial condition and results of operations. Questions have arisen regarding our exclusive ownership and control of certain technologies, including by our principal customer, Honda, and a former employee, who claims ownership in a patent relating to ZPGM^™. In addition, we have sold technology for exclusive use in Asia to another party. For additional information, refer to “—Historically, we have been dependent on a few major customers, particularly Honda…" above and "—We are subject to restrictions and must pay a royalty a royalty on certain sales of our products and technology in specified countries in Asia.” below. Past or future weaknesses in control of our intellectual property could render our current strategies unachievable, require that we change our strategies which could prove unsuccessful, result in litigation over ownership issues including the costs thereof and potential adverse findings, require that we pay to license back technology that we developed or co-developed, or otherwise material adversely affect us, our business and our financial performance.

As part of our confidentiality procedures, we generally have entered into nondisclosure agreements with employees, consultants and corporate partners. We also have attempted to control access to and distribution of our technologies, documentation and other proprietary information. We plan to continue these procedures. Despite these procedures, third parties could copy or otherwise obtain and make unauthorized use of our technologies or independently develop similar technologies. The steps that we have taken and that may occur in the future might not prevent misappropriation of our solutions or technologies, particularly in foreign countries where laws or law enforcement practices may not protect the proprietary rights as fully as in the United States.

There can be no assurance that we will be successful in enforcing our proprietary rights. For example, from time to time we have become aware of competing technologies employed by third parties who might be covered by one or more of our patents. In such situations, we may seek to grant licenses to such third parties or seek to stop the infringement, including through the threat of legal action. There is no assurance that we would be successful in negotiating a license agreement on favorable terms, if at all, or able to stop the infringement. Any infringement upon our intellectual property rights could have an adverse effect on our ability to develop and sell commercially competitive systems and components. 

If we fail to obtain the right to use the intellectual property rights of others which are necessary to operate our business, our ability to succeed will be adversely affected.

From time to time, we may choose to or be required to license technology or intellectual property from third parties in connection with the development of our products. We cannot assure you that third-party licenses will be available to us on commercially reasonable terms, if at all. Generally, a license, if granted, would include payments of up-front fees, ongoing royalties or both. These payments or other terms could have an adverse impact on our results of operations. The inability to obtain a necessary third-party license required for our product offerings or to develop new products and product enhancements could require us to substitute technology of lower quality or performance standards, or of greater cost, either of which could adversely affect our business. If we are not able to obtain licenses from third parties, if necessary, then we may also be subject to litigation to defend against infringement claims from these third parties. Our competitors may be able to obtain licenses or cross-license their technology on better terms than we can, which could put us at a competitive disadvantage. If we are unable to obtain or maintain any third-party license required to develop new products and product enhancements, on favorable terms, our results of operations may be harmed.

If third parties claim that our products infringe upon their intellectual property rights, we may be forced to expend significant financial resources and management time litigating such claims and our operating results could suffer.

       Third parties may claim that our products and systems infringe upon their patents and other intellectual property rights. Identifying third-party patent rights can be particularly difficult, notably because patent applications are generally not published until up to 18 months after their filing dates. If a competitor were to challenge our patents, or assert that our products or processes infringe their patent or other intellectual property rights, we could incur substantial litigation costs, be forced to make expensive product modifications, pay substantial damages or even be forced to cease some operations. Third-party infringement claims, regardless of their outcome, would not only drain financial resources but also divert the time and effort of management and could result in customers or potential customers limiting or deferring their purchase or use of the affected products or services until resolution of the litigation.

We are subject to restrictions and must pay a royalty on certain sales of our products and technology in specified countries in Asia.

In February 2008, we established a joint venture in Japan called TC Catalyst, Inc., or TCC, with Tanaka Holdings Co., Ltd. (formerly Tanaka Holdings K.K.), a Japanese company, which, together with its subsidiary Tanaka Kikinzoku Kogyo K.K., is referred to herein as TKK. Initially, we and TKK each owned 50% of TCC, but since formation we have sold most of our stake in the venture to TKK and now own 5%. In connection with these transactions, we also sold to TKK certain proprietary technology for sale, licensing or use in various countries in Asia, which we refer to as the Territory. In general, the technology covers our catalyst formulations (including platinum and zero platinum) developed for heavy duty commercial vehicles and other applications through 2013, and for non-commercial light vehicles through 2012. In addition, TKK has a right to cause us to license heavy duty commercial technology to TKK or TCC in exchange for a royalty if TKK or TCC desire to sell related products or services outside the Territory to subsidiaries of OEM customers located within the Territory. We have also agreed not to compete in the Territory with TKK or TCC in connection with heavy duty commercial vehicles and applications and light duty vehicles.

 Subsequent to these arrangements, we discovered that an exception allowing us to continue to supply catalysts in Japan to our largest customer, Honda, had been omitted in an amendment to the original transaction documents with TKK. We have shipped approximately $5.6 million of catalysts covered by the agreements since such amendment through December 31, 2014. In this regard, we have made a good faith payment of $0.3 million to TKK with respect to such prior shipments.

In addition, on March 13, 2015, we further amended our agreements with TKK and TCC to, among other things, enable us to sell in the Territory (i) coated substrates or certain catalytic materials utilizing the technology we sold to TKK for a 4% royalty to TKK; (ii) coated substrates and certain catalytic materials utilizing solely new technology developed by us after we sold TKK the prior technology, as well as licenses of such technology related to catalysts for heavy-duty commercial vehicles and applications and light duty vehicles, for a 3% royalty to TKK; (iii) products used in vehicles without a royalty, provided that the ultimate user of the vehicle which contains the product purchases the vehicle outside the Territory; (iv) limited quantities of coated substrates or certain catalytic materials sold for the purpose of customer testing, evaluation and approval without a royalty; and (v) limited quantities of coated substrates sold during an extended period of time after mass production ends for a specified vehicle model year program without a royalty.

Pursuant to the terms of the amendment, once an aggregate amount of approximately $16.6 million in royalties has been paid by us to TKK, we may commercialize any technology without a royalty, including inside the Territory.

Consequently, if we or third parties desire to sell our products or otherwise commercialize certain of our technology in the Territory, we currently would have to pay a royalty to TKK in order to do so, which could adversely affect our ability to expand. In addition, although we believe that the amendment to the parties’ agreements will generally enable us to pursue our business strategies in the Territory and that, based on discussions with TKK, our non-binding, good faith payment relieves us from further obligations to TKK with respect to past shipments of catalysts covered by the agreements, there can be no assurance that TKK will not assert claims and pursue available remedies, any of which could have an adverse effect on our business.

Failure of one or more key suppliers to timely deliver could prevent, delay or limit us from supplying products. Delays in delivery times for PGM purchases could also result in losses due to fluctuations in prices. Delays in the delivery times and the cost impact of the world-wide shortage of rare earth metals could delay us from supplying products and could result in lower profits.

Due to customer demands and specifications, we are required to source critical materials and components such as ceramic substrates from single suppliers. In 2014, our three largest suppliers accounted for over 50% of our raw material purchases and in 2013, our three largest suppliers accounted for over 40% of our raw material purchases. Failure of one or more of the key suppliers to deliver timely could prevent, delay or limit us from supplying products because we would be required to qualify an alternative supplier. For certain products and customers, we are required to purchase PGM materials. As commodities, PGM materials are subject to daily price fluctuations and significant volatility, based on global market conditions. Historically, the cost of PGMs used in the manufacturing process has been passed through to the customer. This limits the economic risk of changes in market prices to PGM metal usage in excess of nominal amounts allowed by the customer. However, going forward there can be no assurance that we will continue to be successful in passing PGM price risk onto our current and future customers to minimize the risk of financial loss. Additionally, PGM material is accounted for as inventory and therefore subject to lower of cost or market adjustments on a regular basis. A drop in market prices relative to the purchase price of PGMs could result in a write-down of inventory. Due to the high value of PGM materials, special measures have been taken to secure and insure the inventory. There is a risk that these measures may be inadequate and expose us to financial loss. We utilize rare earth metals in the production of some of our catalysts. Due to a reduction in export from China of these materials, there has been a world-wide shortage, leading to a lack of supply and higher prices. We risk delays in shipment due to this constrained supply and potentially lower margins if we are unable to pass the increased costs on to our customers.

Qualified management, marketing, and sales personnel are difficult to locate, hire and train, and if we cannot attract and retain qualified personnel, it will harm the ability of the business to grow.

Our success depends, in part, on our ability to retain current key personnel, attract and retain future key personnel, additional qualified management, marketing, scientific, and engineering personnel, and develop and maintain relationships with research institutions and other outside consultants. Competition for qualified management, technical, sales and marketing employees is intense. In addition, some employees might leave our Company and go to work for competitors. The loss of key personnel or the inability to hire or retain qualified personnel, or the failure to assimilate effectively such personnel could have a material adverse effect on our business, operating results and financial condition. 

Any liability for environmental harm or damages resulting from technical faults or failures of our products could be substantial and could adversely affect our business and results of operations.

Customers rely upon our products to meet governmental emissions control standards. Failure of our products to meet such standards could expose us to claims from customers. Our products are also integrated into goods manufactured by our consumers, and therefore, a malfunction or the inadequate design of our products could subject us and our customers to product liability claims. Any liability for environmental harm or damages resulting from technical faults or failures could be substantial and could adversely affect our business and results of operations. In addition, a well-publicized actual or perceived problem could adversely affect the market’s perception of our products, which would materially impact our financial condition and operating results.

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We have entered into contractual agreements in connection with the sale of certain of our assets, which may expose us to liability for claims for indemnification under such agreements.

We have entered into various agreements by which we may be obligated to indemnify the other party with respect to certain matters. Generally, these indemnification provisions provide that we agree to hold the indemnified party harmless against losses arising from a breach of the contract terms. Payments by us under such indemnification clauses are generally conditioned on the other party making a claim. Such claims are generally subject to challenge by us and to dispute resolution procedures specified in the particular contract. Further, our obligations under these arrangements may be limited in terms of time and/or amount and, in some instances, we may have recourse against third parties for certain payments made by us. It is not possible to predict the maximum potential amount of future payments under these indemnification agreements due to the conditional nature of our obligations and the unique facts of each particular agreement.

Risks Related to Our Industry

Future growth of our business depends, in part, on market acceptance of our catalyst products, successful verification of our products and retention of our verifications.

While we believe that there exists a viable market for our developing catalyst products, there can be no assurance that such technology will succeed as an alternative to competitors’ existing and new products. The development of a market for the products is affected by many factors, some of which are beyond our control. The adoption cycles of our key customers are lengthy and require extensive interaction with the customer to develop an effective and reliable catalyst for a particular application. While we continue to develop and test products with key customers, there can be no guarantee that all such products will be accepted and commercialized. Our relationships with our customers are based on purchase orders rather than long-term formal supply agreements. Generally, once a catalyst has successfully completed the testing and certification stage for a particular application, it is generally the only catalyst used on that application and therefore unlikely that, unless there are any defects, the customer will try to replace that catalyst with a competing product. However, our customers usually have alternate suppliers for their products and there is no assurance that we will continue to win the business. Also, although we work with our customers to obtain product verifications in accordance with their projected production requirements, there is no guarantee that we will be able to receive all necessary approvals for our catalysts by the time a customer needs such products, or that a customer will not accelerate its requirements. If we are not successful in having verified catalyst products to meet customer requirements, it will have a negative effect on our revenues, which could have a material adverse effect on our results of operations.

If a market fails to develop or develops more slowly than anticipated, we may be unable to recover the costs we will have incurred in the development of our products and may never achieve profitability. In addition, we cannot guarantee that we will continue to develop, manufacture or market our products or components if market conditions do not support the continuation of the product or component.

We believe that it is an essential requirement of the U.S. retrofit market that emissions control products and systems are verified under the EPA and/or CARB protocols to qualify for funding from the EPA and/or CARB programs. Funding for these emissions control products and systems is generally limited to those products and technologies that have already been verified. Verification is also useful for commercial acceptability. Notably, EPA verifications were withdrawn on two of our products in January 2009 because available test results were not accepted by the EPA as meeting new emissions testing requirements for nitrogen dioxide (NO2) measurement. As a general matter, we have no assurance that our products will be verified by the CARB or that such a verification will be acceptable to the EPA. If we are not able to obtain or maintain necessary product verifications, it will limit our ability to commercialize such products, which could have a negative effect on our revenues and on our results of operations.

Our results may fluctuate due to certain regulatory, marketing and competitive factors over which we have little or no control.         

The factors listed below, some of which we cannot control, may cause our revenue and results of operations to fluctuate significantly:

·        Actions taken by regulatory bodies relating to the verification, registration or health effects of our products;

·       The extent to which our products obtain market acceptance;

·       The timing and size of customer purchases;

·       Customer concerns about the stability of our business, which could cause them to seek alternatives to our solutions and products; and

·       Increases in raw material costs, particularly platinum group metals and rare earth metals. 

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We face constant changes in governmental standards by which our products are evaluated.

We believe that, due to the constant focus on the environment and clean air standards throughout the world, requirements in the future to adhere to new and more stringent regulations are possible as governmental agencies seek to improve standards required for certification of products intended to promote clean air. In the event our products fail to meet these ever-changing standards, some or all of our products may become obsolete.

We face competition and technological advances by competitors.

There is significant competition among companies that provide solutions for pollutant emissions from internal combustion engines. Several companies market products that compete directly with our products. Other companies offer products that potential customers may consider to be acceptable alternatives to our products and services, including products that are verified by the EPA, the CARB or other environmental authorities. We face direct competition from companies with greater financial, technological, manufacturing and personnel resources. Newly developed products could be more effective and cost-efficient than our current or future products. We also face indirect competition from vehicles using alternative fuels, such as methanol, hydrogen, ethanol and electricity.

New standards, lower environmental limits or stricter regulation for health reasons of platinum or cerium metals could be adopted and affect use of our products.

New standards or environmental limits on the use of platinum or cerium metals by a governmental agency could adversely affect our ability to use our Platinum Plus^® fuel-borne catalyst in some applications. Government or regulatory bodies in countries where we sell our Platinum Plus^® fuel-borne catalyst could adopt limits or regulations with regards to platinum and cerium metals that could impact our ability to sell Platinum Plus^® and related fuel borne catalysts.

Risks Related to Our Common Stock

The price of our common stock may be adversely affected by the sale by us or our shareholders of a significant number of new common shares.

The sale, or availability for sale, of substantial amounts of our common stock could adversely affect the market price of our common stock and could impair our ability to raise additional working capital through the sale of equity securities. For example, on April 4, 2014, we issued 2,030,000 shares of our common stock and warrants to purchase 812,000 shares of our common stock in a registered direct offering under our shelf registration statement. Also, on November 4, 2014, we entered into subscription agreements to issue 1,385,000 shares of our common stock, series A warrants to purchase up to 388,393 shares of common stock and series B warrants to purchase up to 168,571 shares of common stock under our shelf registration statement. Resale of shares, including shares received upon exercise of warrants, that we may issue from time to time by the holders thereof could contribute to downward pressure on the trading price of our stock.

There has been and may continue to be significant volatility in the volume and price of our common stock on the NASDAQ Capital Market and an investment in our stock could suffer a decline in value.

CDTI’s common stock began trading on the NASDAQ Capital Market effective October 3, 2007. In the period immediately following the Merger and the reverse stock split, we experienced significantly higher trading volume than typical for our Company. Unusual trading volume in our shares has continued to occur from time to time. For example, the trading volume in our common stock exceeded thirty-five million shares on October 30, 2014, whereas the average trading volume for the three weeks prior to that date was 86,200 shares per day. The market price of our common stock also has been and may continue to be highly volatile. During the last two weeks of October 2010 following the Merger and the reverse stock split, the price for a share of our common stock ranged from as low as $1.50 per share to as high as $44.38 per share. On March 2, 2015, the closing price for a share of our common stock was $2.01 per share. Factors, including announcements of technological innovations by us or other companies, regulatory matters, new or existing products or procedures, concerns about our financial position, operations results, litigation, government regulation, developments or disputes relating to agreements, patents or proprietary rights, may have a significant impact on the market volume and price of our stock.

As a publicly traded company, CDTi is assessed periodically by securities analysts. Changes in assessments by such analysts may increase the volatility or our stock price and may result in a decline in value if the assessments are negative. 

We have not paid and do not intend to pay dividends on shares of our common stock.

We have not paid dividends on our common stock since inception, and do not intend to pay any dividends to our stockholders in the foreseeable future. We intend to reinvest earnings, if any, in the development and expansion of our business.

ITEM 1B.  UNRESOLVED STAFF COMMENTS

ITEM 2.    PROPERTIES

        Our Catalyst division uses approximately 52,000 square feet of space in Oxnard, California under three separate lease agreements, one that is month-to-month, one that expires on December 31, 2016 and one that expires on April 30, 2018. Our Oxnard facilities include our corporate headquarters, contain a warehouse that is used for shipping and receiving, and are also used for manufacturing and research and development. Our Catalyst division also leases approximately 800 square feet of space in Tokyo, Japan under a lease agreement that expires on June 14, 2016, which is used for sales and marketing purposes.

        Our Heavy Duty Diesel Systems division uses approximately 51,000 square feet of space in Ontario, Canada under a lease agreement that expires on December 31, 2018 for administrative, research and development, manufacturing, sales and marketing functions; approximately 4,300 square feet of space in Malmö, Sweden for administrative, research and development and European sales and marketing; and an office in a shared office suite complex in Whyteleafe, Surrey, United Kingdom (outside London) for administrative and sales and marketing which we lease on a month-to-month basis.

         We do not anticipate the need to acquire additional space in the near future and consider our current capacity to be sufficient for current operations and projected growth. As such, we do not expect that our rental costs will increase substantially from the amounts historically paid in 2014.

ITEM 3.    LEGAL PROCEEDINGS

          Refer to Note 16, “Commitments and Contingencies”.

ITEM 4.    MINE SAFETY DISCLOSURES

PART II

ITEM 5.  MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES                                                 

ITEM 6.    SELECTED FINANCIAL DATA    

ITEM 7.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

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We are currently conducting vehicle testing to validate our Spinel^™ technology for specific introductory products for global OEMs, with a goal of accelerating broad commercialization of this technology. Once validated, we intend to make it available to OEMs and other catalytic coaters for potential use in proprietary powder form and/or through licensing. We foresee multiple paths to market this technology to complement our existing business model.

We plan to continue to maintain our current world-class manufacturing capability, and deploy it selectively where it adds value for our customers; to explore new joint ventures and partnerships; and to pursue new verticals. We intend to continue to evaluate and refine our strategic plan in order to seize opportunities as they arise.  

Since 2013, we have filed nearly 100 patents pertaining to our advanced low-PGM and ZPGM^™ catalysts. The development of our advanced low-PGM and ZPGM^™ catalysts utilizing our Spinel^™ technology and their commercialization is a strategic priority and will require investment in research, development, marketing and sales.

Recent Developments

     2014 Equity Offerings

On April 4, 2014, we closed a registered direct offering in which we sold 2,030,000 shares of common stock and warrants to purchase 812,000 shares of common stock. The securities were sold in units at $3.40 per unit, with each unit consisting of one share of common stock and 0.4 of a warrant to purchase one share of common stock. The warrants have an exercise price of $4.20 per share and can be exercised during the period commencing after six months and ending five and a half years from the date of issuance. We received net proceeds of $6.1 million after deducting placement agent fees and other offering expenses.

On November 4, 2014, we completed a registered direct offering in which we sold 1,385,000 shares of common stock, warrants to purchase up to an aggregate of 388,393 shares of common stock with an exercise price of $3.25 per share (the “Series A Warrants”), for a combined purchase price of $2.80 per share and 0.28 of one Series A Warrant, and other warrants to purchase up to an aggregate of 168,571 shares of common stock with an exercise price of $0.01 per share (the “Series B Warrants”) for a purchase price of $2.79 per Series B Warrant. We received net proceeds of $3.8 million after deducting placement agent fees and other offering expenses.

We plan to use the net proceeds from our recent offerings for general corporate purposes, including working capital, general and administrative expenses, capital expenditures and implementation of our strategic priorities. We may also use a portion of the net proceeds to acquire or invest in businesses, products and technologies that are complementary to our current business, although we have no present commitments or agreements for any such transactions.

Sale of Standard Exhaust and Specialty Parts Business

On October 20, 2014, we completed the sale of our Reno, Nevada-based custom fabricated exhaust parts and accessories business, or the Reno Business, for $1.3 million in cash. Historically, the Reno Business was included in our Heavy Duty Diesel Systems division, and we have now classified it as held for sale and the operations have been reported as discontinued operations. The sale of this non-core business increases our ability to fund key investments to broaden our growing intellectual property portfolio and to bring to market new products. The net assets held for sale of the Reno Business were eliminated from our balance sheet as of the sale date, and we recognized a gain of $0.2 million.

All discussions and amounts in Management's Discussion and Analysis for all periods presented relate to continuing operations only, unless otherwise noted.

Letter Agreement to Amend Shareholder Notes Payable

On November 11, 2014, we and Kanis S.A. entered into a letter agreement whereby Kanis S.A. agreed to amend the terms of the outstanding loans made to us, such that (i) the maturity dates of all outstanding loans were extended to October 1, 2016; and (ii) the early redemption feature applicable to one of the outstanding loans was removed. For additional information, refer to Note 9, “Debt”.   

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On March 13, 2015, we amended our existing agreements with Tanaka Holdings Kabushiki Kaisha, a Japanese company, which together with its subsidiary Tanaka Kikinzoku Kogyo Kabushiki Kaisha is referred to herein as TKK, and TC Catalyst, Inc., or TCC, a joint venture formed by us and TKK, to, among other things, enable us to sell in the Territory (i) coated substrates or certain catalytic materials utilizing the technology we sold to TKK for a 4% royalty to TKK; (ii) coated substrates and certain catalytic materials utilizing solely new technology developed by us after we sold TKK the prior technology, as well as licenses of such technology related to catalysts for heavy-duty commercial vehicles and applications and light duty vehicles, for a 3% royalty to TKK; (iii) products used in vehicles without a royalty, provided that the ultimate user of the vehicle which contains the product purchases the vehicle outside the Territory; (iv) limited quantities of coated substrates or certain catalytic materials sold for the purpose of customer testing, evaluation and approval without a royalty; (v) limited quantities of coated substrates sold during an extended period of time after mass production ends for a specified vehicle model year program without a royalty; and (vi) once an aggregate amount of approximately $16.6 million in royalties has been paid by us to TKK, any technology (or otherwise commercialize such technology) without a royalty. For additional information, refer to Note 15, “Equity Investments” and “Item 1.A. Risk Factors—We are subject to restrictions and must pay a royalty on certain sales of our products and technology in specified countries in Asia.”

Sources of Revenues and Expenses

        We generate revenues primarily from the sale of our emission control systems and products. We generally recognize revenues from the sale of our emission control systems and products upon shipment of these products to our customers. However, for certain customers, where risk of loss transfers at the destination (typically the customer’s warehouse), revenue is recognized when the products are delivered to the destination.

        Our cost of revenues consists primarily of direct costs for the manufacture of emission control systems and products, including cost of raw materials, costs of leasing and operating manufacturing facilities and wages and benefits paid to personnel involved in production, manufacturing, quality control, testing and supply chain management. In addition, cost of revenues include normal scrap and shrinkage associated with the manufacturing process and expenses from write-downs of obsolete and slow moving inventory. We include the direct material costs and factory labor as well as factory overhead expense in cost of revenues. Indirect factory expense includes the costs of freight (inbound and outbound for direct material and finished goods), purchasing and receiving, inspection, testing, warehousing, utilities and deprecation of facilities and equipment utilized in the production and distribution of products.

        Our selling, general and administrative expenses, or SG&A, includes the salary and benefits for sales, marketing and administrative staff as well as samples provided at no-cost to customers, marketing materials, travel, legal, accounting and other professional fees, corporate expenses, regulatory fees and bad debt. Also included is any depreciation related to assets utilized in the SG&A functions, as well as amortization of acquired intangible assets.

         Our research and development expenses, or R&D, consists of costs associated with research related to new product development and product enhancement expenditures. R&D also includes costs associated with vehicle testing of our catalysts on engines and vehicles in independent testing facilities, getting our heavy duty diesel systems verified and approved for sale by the EPA, the CARB and other regulatory authorities. R&D includes the salary and benefits for the research and development staff as well as travel, research materials, testing and legal expense related to patenting intellectual property. Also included is any depreciation related to assets utilized in the development of new products.

        Other income (expense) primarily reflects interest expense, including amortization of debt discounts and premiums and amortization of debt issuance costs, our portion of loss or income from unconsolidated affiliates and changes in the fair value of our liability-classified warrants. It also includes loss on foreign exchange and interest income.

Critical Accounting Policies and Estimates 

        The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires the use of estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures in the financial statements. Critical accounting policies are those accounting policies that may be material due to the levels of subjectivity and judgment necessary to account for highly uncertain matters or the susceptibility of such matters to change, and that have a material impact on financial condition or operating performance. While we base our estimates and judgments on our experience and on various other factors that we believe to be reasonable under the circumstances, actual results may differ materially. For additional information relating to these and other accounting policies, refer to Note 2, “Significant Accounting Policies”.   

        We believe the following accounting policies and estimates are most critical to the understanding of our consolidated financial statements.

Revenue Recognition.  We generally recognize revenue when products are shipped and the customer takes ownership and assumes risk of loss, collection of the related receivable is reasonably assured, persuasive evidence of an arrangement exists, and the sales price is fixed or determinable. When terms of sale include subjective customer acceptance criteria, we defer revenue until the acceptance criteria are met. Concurrent with the shipment of the product, we accrue estimated product return reserves. Critical judgments include the determination of whether or not customer acceptance criteria are perfunctory or inconsequential. The determination of whether or not the customer acceptance terms are perfunctory or inconsequential impacts the amount and timing of the revenue that we recognize.

Allowance for Doubtful Accounts.  The allowance for doubtful accounts involves estimates based on our judgment, review of individual receivables and analysis of historical bad debts. We monitor collections and payments from our customers and maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. We also assess current economic trends that might impact the level of credit losses in the future. If the financial condition of our customers were to deteriorate, resulting in difficulties in their ability to make payments as they become due, additional allowances could be required, which would have a negative effect on our results of operations and working capital.

 Inventory Valuation.  Inventory is stated at the lower of cost or market. Cost is determined on the first-in, first-out method. We write-down inventory for slow-moving and obsolete inventory based on assessments of future demands, market conditions and customers who are expected to reduce purchasing requirements as a result of experiencing financial difficulties. Such assessments require us to exercise significant judgment. If these factors were to become less favorable than those projected, additional inventory write-downs could be required, which would have a negative effect on our results of operations and working capital.

Product Warranty Reserves.  We provide warranties on certain of our Heavy Diesel Division products for varying periods. Generally, the warranty periods range from one to five years and may also contain mileage limitations. We provide for the estimated cost of product warranties in cost of sales, at the time product revenue is recognized. Warranty costs are estimated primarily using historical warranty information in conjunction with current engineering assessments applied to our expected repair or replacement costs. The adequacy of the provision is assessed at each quarter end. Should actual performance rates or repair costs differ from estimates, revision to the estimated warranty liability would be required, which would have a negative effect on our results of operations and working capital.

Accounting for Income Taxes.  Our income tax expense is dependent on the profitability of our various international subsidiaries including Canada, Sweden and the United Kingdom (“U.K.”). These subsidiaries are subject to income taxation based on local tax laws in their respective countries. Our U.S. operations have continually incurred losses since inception.

        Our annual tax expense is based on our income, statutory tax rates and tax planning opportunities available to us in the various jurisdictions in which we operate. Tax laws are complex and subject to different interpretations by the taxpayer and respective governmental taxing authorities. Significant judgment is required in determining our tax expense and in evaluating our tax positions including evaluating uncertainties. We recognize the effect of income tax positions only if those positions are more likely than not of being sustained. Changes in recognition or measurement are reflected in the period in which the change in judgment occurs. We record interest and penalties related to unrecognized tax benefit in income tax expense. We review our tax positions quarterly and adjust the balances as new information becomes available. If these factors were to become less favorable than those projected, or if there are changes in the tax laws in the jurisdictions in which we operate, there could be an increase in tax expense and a resulting negative effect on our results of operations and working capital.  

        Deferred income tax assets represent amounts available to reduce income taxes payable on taxable income in future years. Such assets arise because of temporary differences between the financial reporting and tax bases of assets and liabilities, as well as from net operating loss and tax credit carry-forwards. We evaluate the recoverability of these future tax deductions by assessing the adequacy of future expected taxable income from all sources, including reversal of taxable temporary differences, forecasted operating earnings and available tax planning strategies. These sources of income inherently rely on estimates. To provide insight, we use our historical experience and our short- and long-range business forecasts. We believe it is more likely than not that a portion of the deferred income tax assets may expire unused and have established a valuation allowance against them. Although realization is not assured for the remaining deferred income tax assets, primarily related to foreign tax jurisdictions, we believe it is more likely than not that the deferred tax assets will be fully recoverable within the applicable statutory expiration periods. However, deferred tax assets could be reduced in the near term if our estimates of taxable income in certain jurisdictions are significantly reduced or available tax planning strategies are no longer viable.

Impairment of Long-Lived Assets Other Than Goodwill.  We evaluate long-lived assets, including intangible assets other than goodwill, for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. An impairment is considered to exist if the total estimated future cash flows on an undiscounted basis are less than the carrying amount of the assets. If an impairment does exist, we measure the impairment loss and record it based on discounted estimated future cash flows. In estimating future cash flows, we group assets at the lowest level for which there are identifiable cash flows that are largely independent of cash flows from other asset groups. Considerable judgment is necessary to estimate the fair value of the assets and, accordingly, actual results could vary significantly from such estimates. Our most significant estimates and judgments relating to the long-lived asset impairments include the timing and amount of projected future cash flows. These estimates and judgments are based upon, among other things, certain assumptions about expected future operating performance and growth rates and other factors, actual results of which may vary significantly.

        In 2014, we considered whether any events or changes in circumstance indicated that the carrying amount of our long-lived assets may not be recoverable and concluded that no such triggering event had occurred during 2014 that would lead us to believe that the assets were impaired. Therefore, no further testing was performed. To the extent additional events or changes in circumstances occur, we may conclude that a non-cash impairment charge is required, which would have an adverse effect on our financial condition and results of operations.

Warrant Derivative Liability.  In light of the terms of certain of our outstanding warrants, we have determined that we are required to carry them at fair value until exercised or expired, and record changes in their fair value in our results of operations in each reporting period. At December 31, 2014, we had a liability of $1.5 million related to liability-classified warrants. For the year ended December 31, 2014, we recorded a non-cash loss of $0.5 million to other income (expense), net in our consolidated statement of comprehensive loss to reflect the change in fair value of these liability-classified warrants. The determination of fair value requires us to use of judgment. For common stock warrants with market conditions, we use the Monte Carlo pricing model to determine fair value. For other common stock warrants, we use the Black-Scholes option-valuation model, which requires that we make certain assumptions regarding: (i) the expected volatility in the market price of our common stock; (ii) dividend yield; (iii) risk-free interest rates; and (iv) the contractual terms of the warrants. These variables are projected based on our historical data, experience, and other factors. Changes in any of these variables could result in material adjustments to the non-cash gain or loss recognized for changes in the valuation of the warrant derivative liability.

Recently Issued Accounting Guidance

Refer to the “Recently Issued Accounting Guidance” discussion in Note 2, “Significant Accounting Policies”.   

Factors Affecting Future Results

Technology Strategy

Our strategy is to transition from being a niche manufacturer of emissions control solutions for the automotive OEM, retrofit and aftermarket markets to becoming an advanced materials technology provider for these markets. In support of this strategy, we have filed a significant number of patents that underpin next-generation technology for our advanced low-PGM catalysts including synergized-PGM, or SPGM^™, as well as ZPGM^™ catalysts. It is our intention to invest in developing and commercializing these catalyst technologies. As a consequence, we anticipate that we will continue to expand our intellectual property portfolio with additional patents in 2015 and beyond. In addition, we will invest in other development and marketing activities, including hiring of personnel and incurring outside testing and consulting expenses in support of our technology strategy that could result in higher operating expenses. As the development of our intellectual property portfolio has recently begun to ramp, we cannot be certain of the timing of future technology commercialization and customer acceptance, if at all.

  Spinel^™

We were recently awarded two significant patents for our new Spinel^™ technology, a proprietary clean emissions exhaust platform aimed at improved catalytic performance, which we believe will dramatically reduce the cost of compliance with more stringent clean-air requirements. Additionally, we have filed numerous other patents associated with this new technology. We are currently conducting vehicle testing to validate our Spinel^™ technology into specific introductory products for global OEMs, with a goal of accelerating broad commercialization of this technology. Once validated, we intend to make it available to OEMs and other catalytic coaters for potential use in proprietary powder form and/or through licensing. As validation of this technology is in-process, the results of testing and ability to commercialize it, if successful, will affect future results of operations.  

DuraFit^™

        In the second quarter of 2014, we introduced the CDTi manufactured DuraFit^™ OEM replacement diesel particulate filters through our channel of distributors to provide an alternative to OEM manufactured parts. According to market analysis firm Power System Research, manufacturers in North America have produced an average of 250,000 heavy duty on-road diesel vehicles equipped with diesel particulate filters each year since 2007 to comply with EPA requirements. The typical OEM warranty on diesel particulate filters is 5 years and has expired for many of these vehicles with more continuing to expire in the coming years. As 2007 and newer diesel particulate filters from OEMs fail and require replacement, non-OEM diesel particulate filters will be needed as replacements. According to a 2012 industry report, the market for medium and heavy duty vehicle after-treatment maintenance and repair is projected to grow from $0.3 billion in 2010 to $3.0 billion by 2017. As expected, sales from this activity were modest in 2014, with increased sales expected in 2015 and beyond.  

Customer Dependency

Historically, we have derived a significant portion of our revenue from a limited number of customers. For example, sales to Honda represented 98% and 95% of Catalyst division revenues and 52% and 41% of consolidated revenues for the years ended December 31, 2014 and 2013, respectively. While we continually seek to broaden our customer base, it is likely that for the foreseeable future we will remain dependent on Honda to supply a substantial portion of our revenue. Manufacturers typically seek to have two or more sources of critical components. However, there can be no assurance that manufacturers for which we are a shared supplier will not sole source the products we supply. Once our product is designed into a vehicle model, we generally supply our component for the life of that model. There can be no assurance, however, that our customers will retain us for a full model term. In this regard, relationships with our customers are based on purchase orders rather than long-term formal supply agreements and customers can discontinue or materially reduce orders without warning or penalty. In addition, while new models tend to remain relatively stable for a few years, there can be no assurance that manufacturers will not change models more rapidly, or change the performance requirements of components used in those models, and use other suppliers for these new or revised models.

        The nature of our business is heavily influenced by government funding of emissions control projects and increased emission control regulations and mandates. Compliance with these regulatory initiatives drives demand for our products and the timing of the implementation of emission reduction projects. We believe that, due to the constant focus on the environment and clean air standards throughout the world, it can be expected that new and more stringent regulations, both domestically and abroad, will continually be adopted, requiring the ongoing development of new products that meet these standards. However, emission reduction programs are often one-off, or have staggered compliance dates, which mean they do not generally result in a regular source of recurring revenues for our company.

Macroeconomic Factors Impacting the Automotive Industry

Since the customers of our Catalyst division are primarily OEM auto makers, this division is generally affected by macroeconomic factors impacting the automotive industry. Demand for our products is tied directly to the demand for vehicles. Accordingly, factors that affect the truck and automobile markets have a direct effect on our business, including factors outside of our control, such as vehicle sales slowdowns due to economic concerns, or as a result of natural disasters, including earthquakes and/or tsunamis.

        In addition, our business, operations, results of operation and financial condition may be affected by other factors, including those discussed in Part I, Item 1A “Risk Factors” of this Annual Report on Form 10-K, and our other filings with the SEC.

Results of Operations

        The tables in the discussion that follow are based upon the way we analyze our business. For additional information regarding our reportable segments, refer to Note 17, “Segment Reporting”.   

Revenues 

Gross Profit

        The increase in gross margin for our Heavy Duty Diesel Systems division was a result of improved manufacturing efficiency, lower substrate costs due to introduction of a second source supplier and favorable product mix.   

        The increase in gross margin for our Catalyst division was due to a favorable product mix resulting from an expansion of models sold to our Japanese OEM, lower costs of certain chemicals, lower diesel substrate costs as well as a change from purchased to consigned for certain substrates used in product sold to our Heavy Duty Diesel Systems division.

Operating Expenses

SG&A

The decrease in selling, general and administrative expenses was primarily due to $1.0 million of savings due to employee related costs and a $0.3 million gain on the sale of a building at one of our foreign locations, partially offset by a $0.3 million payment to a joint venture partner related to discussions concerning conducting business in the Asia territory and increased professional fees. For additional information regarding SG&A cost savings, refer to the “Severance and Other Charges” discussion below. For additional information regarding the payment to a joint venture partner, refer to Note 15, “Equity Investments”.

R&D

The increase in research and development was primarily due to development work and outside testing related to new products, employee related costs, patent filings and consultant costs to support our technology initiatives.

Severance and Other Charges

During the year ended December 31, 2013, we incurred severance costs related to our North American, European and Asian locations, including severance benefits covering a one year period for our former chief executive officer, pursuant to a separation and release agreement. We also incurred lease termination costs related to the exit of a lease in North America and asset impairment expense related to the exit of this facility as well as to the exit of a leased facility in the U.K. Also included in severance and other charges was $0.6 million related to a legal settlement, dated March 13, 2014, with a former chief financial officer and legal expenses incurred related to the matter. This settlement included a lump sum amount of $0.4 million and 75,000 shares of our common stock.

       During the year ended December 31, 2014, we incurred severance costs related to our North American and U.K. locations, including severance benefits covering a one year period for our former chief financial officer, pursuant to a separation and release agreement. The Company incurred additional lease exit costs related to the exit of leases in North America. Also included in severance and other charges was an additional $0.1 million related to the increase in fair value of our common stock associated with the aforementioned legal settlement, dated March 13, 2014, and $0.1 million related to the settlement of a customer dispute.   

Other Expense, Net

        The decrease in interest expense was due to lower average balances outstanding under the Faunus Group International, Inc. (“FGI”) facility. For additional information regarding the FGI facility, refer to the “Description of Indebtedness” discussion below.  

        The decrease in other expense, net was primarily attributable to completing the dissolution of a joint venture with Pirelli during 2014 and favorable exchange gains primarily due to changes in the value of the Canadian dollar in relation to the U.S. dollar. Partially offsetting these decreases were additional losses from the change in fair value of our liability-classified warrants and additional offering costs attributable to the fair value of warrants issued. 

Income taxes

        We incurred income tax expense of $0.1 million and $0.3 million during the years ended December 31, 2014 and 2013, respectively. Our effective income tax rate was (2)% for the year ended December 31, 2014, compared to (5)% for the year ended December 31, 2013. The differences between our effective tax rate and the U.S. statutory tax rate was primarily related to the valuation allowance offsetting the deferred tax assets in both the U.S. and U.K. jurisdictions, as well as Swedish and Canadian foreign tax rate differentials.

Liquidity and Capital Resources 

        Historically, the revenue that we have generated has not been sufficient to fund our operating requirements and debt servicing needs. Notably, we have suffered recurring losses since inception. As of December 31, 2014, we had an accumulated deficit of approximately $191.1 million compared to $181.7 million at December 31, 2013. We have also had negative cash flows from operations from inception through the year ended December 31, 2014. Our primary sources of liquidity in recent years have been asset sales, credit facilities and other borrowings and equity sales.

        At December 31, 2014 and 2013, $1.4 million and $1.6 million, respectively, of our cash was held by foreign subsidiaries in Canada, Sweden and the U.K. We do not intend to repatriate any amount of this cash to the United States as it will be used to fund our subsidiaries’ continued operations. If we decide to repatriate unremitted foreign earnings in the future, it could have negative tax implications.

        We have a $7.5 million secured demand financing facility with FGI backed by our receivables and inventory that terminates on August 15, 2015 and may be extended at our option for additional one-year terms. However, FGI can cancel the facility at any time. For additional information regarding the FGI facility, refer to the “Description of Indebtedness” discussion below. At December 31, 2014, we had $2.8 million in borrowings outstanding with $4.7 million available under our FGI credit facility, subject to the availability of eligible accounts receivable and inventory balances for collateral. However, there is no guarantee that we will be able to borrow to the full limit of $7.5 million if FGI chooses not to finance a portion of our receivables or inventory.

        On May 15, 2012, we filed a shelf registration statement on Form S-3 with the SEC (the "Shelf Registration"), which permits us to sell, from time to time, up to an aggregate of $50.0 million of various securities. However, we may not sell our securities in a primary offering pursuant the Shelf Registration or any other registration statement on Form S-3 with a value exceeding one-third of our public float in any 12-month period, unless our public float rises to $75.0 million or more. The Shelf Registration is intended to provide us with additional flexibility to access capital markets for general corporate purposes, subject to market conditions and our capital needs.

On July 3, 2013, we completed a public offering under the Shelf Registration in which we sold 1,730,000 shares of common stock and warrants to purchase up to 865,000 shares of common stock and received net proceeds of $1.7 million after deducting discounts and commissions to the underwriter and offering expenses. During the year ended December 31, 2014, these warrant holders exercised an aggregate of 800,000 of warrants for gross proceeds of $1.0 million. Also, in July 2013, we also sold 54,347 shares of common stock to one of our directors in a private placement, pursuant to an agreement dated June 28, 2013, and received proceeds of $0.1 million. For additional information, refer to Note 10, “Stockholders’ Equity” and Note 11, “Warrants”.   

        On April 4, 2014, we completed a registered direct offering under the Shelf Registration in which we sold 2,030,000 shares of common stock and warrants to purchase 812,000 shares of common stock and received net proceeds of $6.1 million after deducting placement agent fees and other offering expenses. For additional information, refer to Note 10, “Stockholders’ Equity” and Note 11, “Warrants”.

        On October 20, 2014, we sold our Reno Business for $1.3 million in cash. For additional information, refer to Note 2, “Significant Accounting Policies”, Note 9, “Debt” and Note 18, “Discontinued Operations”.

        On November 4, 2014, we completed a registered direct offering under the Shelf Registration in which we sold 1,385,000 shares of common stock, Series A Warrants to purchase up to an aggregate of 388,393 shares of common stock, and Series B Warrants to purchase up to an aggregate of 168,571 shares of common stock. We received net proceeds of $3.8 million after deducting placement agent fees and other estimated offering expenses. For additional information, refer to Note 10, “Stockholders’ Equity” and Note 11, “Warrants”.

        On November 11, 2014, we and Kanis S.A. entered into a letter agreement whereby Kanis S.A. agreed to amend the terms of the outstanding loans made to us, such that (i) the maturity dates of all outstanding loans were extended to October 1, 2016; and (ii) the early redemption feature applicable to one of the outstanding loans was removed. For additional information, refer to Note 10, “Stockholders’ Equity” and Note 11, “Warrants”.

        We continue to pursue revenue generating opportunities relating to special government mandated retrofit programs in California and potentially others in various jurisdictions domestically and internationally. Opportunities such as these require cash investment in operating expenses and working capital such as inventory and receivables prior to realizing profits and cash from sales. Additionally, as previously discussed, we intend to pursue aggressive development of our materials science platform which will require cash investment.

        We had $7.2 million in cash at December 31, 2014 compared to $3.9 million at December 31, 2013. Based on our current cash levels and expected cash flows from operations, we believe our current cash position is not sufficient to fund our cash requirements during the next twelve months. Our credit facility with FGI is a demand facility, which can be cancelled at any time by FGI. As such, we may seek additional financing in the form of funding from outside sources. There is no assurance that we will be able to raise additional funds or reduce our discretionary spending at a level sufficient for our working capital needs. These matters raise substantial doubt about our ability to continue as a going concern.

       The following table and discussion summarizes our cash flows from continuing operations for the years ended December 31, 2014 and 2013.

       Our primary uses of cash for operating activities are for purchasing inventory in support of the products that we sell, personnel related expenditures, facilities costs and payments for general operating matters. The increase in cash used in operating activities was primarily attributable to the operational impact of increased on-hand inventory resulting from a sharp downturn in retrofit demand coupled with DuraFit™ sales that have not yet begun to ramp. Additionally, we experienced an increase in tax obligations associated with a foreign location.

       The increase in net cash provided by investing activities is primarily attributable to the sale of the Reno Business, the sale of a building at one of our foreign locations and completing the dissolution of a joint venture with Pirelli during 2014.

        The increase in net cash provided by financing activities is primarily attributable to our offerings of common stock and warrants under the Shelf Registration discussed above, net borrowings under our FGI facility and proceeds from the exercise of warrants and stock options.

Description of Indebtedness

        We have a $7.5 million secured demand facility with FGI backed by our receivables and inventory. The FGI facility expires on August 15, 2015 and may be extended at our option for additional one-year terms. However, FGI can cancel the facility at any time.

        Under the FGI facility, FGI can elect to purchase eligible accounts receivables from us and certain of our subsidiaries at up to 80% of the value of such receivables (retaining a 20% reserve). At FGI’s election, FGI may advance us up to 80% of the value of any purchased accounts receivable, subject to the $7.5 million limit. Reserves retained by FGI on any purchased receivable are expected to be refunded to us net of interest and fees on advances once the receivables are collected from customers. We may also borrow against eligible inventory up to the inventory sublimit as determined by FGI subject to the aggregate $7.5 million limit under the FGI facility and certain other conditions. At December 31, 2014, the inventory sublimit was the lesser of $1.5 million or 50% of the aggregate purchase price paid for accounts receivable purchased under the FGI facility. While the overall credit limit and inventory sublimit were not changed, in the first quarter of 2015, borrowing against Honda inventory has been limited to $0.2 million by FGI due to their concerns about customer concentration.

        The interest rate on advances or borrowings under the FGI facility is the greater of (i) 6.50% per annum and (ii) 2.50% per annum above the prime rate, as defined in the FGI facility, and was 6.50% at December 31, 2014 and 2013.

        We were in compliance with the terms of the FGI facility at December 31, 2014. However, there is no guarantee that we will be able to borrow the full limit of $7.5 million if FGI chooses not to finance a portion of our receivables or inventory.

        For additional information regarding our indebtedness, refer to Note 9, “Debt”.

Capital Expenditures

        As of December 31, 2014, we had no material commitments for capital expenditures and no material commitments are anticipated in the near future.

Off-Balance Sheet Arrangements

        As of December 31, 2014 and 2013, we had no off-balance sheet arrangements.

Commitments and Contingencies

        As of December 31, 2014 and 2013, other than office leases, employment agreements with key executive officers and the obligation to fund our portion (5%) of the losses of our Asian investment, we had no material commitments other than the liabilities reflected in our consolidated financial statements included elsewhere in this Annual Report on Form 10-K. For additional information, refer to Note 16, "Commitments and Contingencies".

ITEM 7A. QUANTITATIVE AN QUALITATIVE DISCLOSURES ABOUT MARKET RISK

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA 

See “Index to Financial Statements”, located on page F-1 of this Annual Report on Form 10-K.

 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

ITEM 9A. CONTROLS AND PROCEDURES

        This annual report does not include an attestation report of our registered public accounting firm regarding internal control over financial reporting. Management's report was not subject to attestation by our registered public accounting firm pursuant to rules of the SEC that permit us to provide only management's report in this annual report.

ITEM 9B. OTHER INFORMATION

        On March 13, 2015, Catalytic Solutions, Inc., one of our subsidiaries, entered into an amendment to certain of its agreements with TKK and TCC, including a purchase and sale agreement dated December 22, 2008, as amended, second purchase and sale agreement dated December 18, 2009 and new shareholders agreement dated December 18, 2009. The amendment generally permits us to sell certain products and technology in specified Asian countries, which we refer to as the Territory, pursuant to a royalty arrangement. Once an aggregate amount of approximately $16.6 million in royalties has been paid by us to TKK, we may generally commercialize any technology without a royalty, including inside the Territory. Royalty payments payable by us to TKK must be made within 30 days after the end of each calendar quarter and, if not paid by such time, may bear interest at a rate of 14% per annum at the election of TKK. The amendment also contains other provisions regarding confidentiality and retention and inspection of books and records. For additional information regarding the amendment and the parties’ relationship, refer to Item Part I, “Item 1A. Risk Factors—We are subject to restrictions and must pay a royalty on certain sales of our products and technology in specified countries in Asia." The foregoing description of the amendment is qualified in its entirety by reference to the terms of the amendment, a copy of which is attached as exhibit 10.44 to this Annual Report on Form 10-K and incorporated herein by reference.

PART III

ITEM 10.  DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

         Information required by this item regarding our directors and executive officers will be set forth under the captions “Directors and Executive Officers of CDTi”, “Corporate Governance—Section 16(a) Beneficial Ownership Reporting Compliance”, “Corporate Governance—Code of Business Ethics and Conduct”, “Committees of the Board—Compensation and Nominating Committee—Nominating”, “Committees of the Board—Audit Committee” in our proxy statement related to the 2015 annual meeting of stockholders and is incorporated by reference.    

ITEM 11.  EXECUTIVE COMPENSATION

ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

ITEM 14.  PRINCIPAL ACCOUNTING FEES AND SERVICES

PART IV

ITEM 15.  EXHIBITS, FINANCIAL STATEMENT SCHEDULES

SIGNATURES

CLEAN DIESEL TECHNOLOGIES, INC.

Index to Financial Statements

Report of Independent Registered Public Accounting Firm

Board of Directors and Stockholders

Clean Diesel Technologies, Inc.

Oxnard, California

The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As described in Note 1 to the consolidated financial statements, the Company has suffered recurring losses from operations and negative cash flows from operations since inception, resulting in an accumulated deficit of $191.1 million as of December 31, 2014, that raise substantial doubt about its ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note 1. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty. Our opinion is not modified with respect to this matter.

/s/BDO USA, LLP           

BDO USA, LLP

Los Angeles, California

March 18, 2015