UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the quarterly period ended March 31, 1999
or
[ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from ______ to ______
Commission file number 0-27803
COVOL TECHNOLOGIES, INC.
(Exact name of registrant as specified in its charter)
Delaware 87-0547337
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
3280 North Frontage Road
Lehi, Utah 84043
(Address of principal executive offices) (Zip Code)
(801) 768-4481
(Registrant's telephone number, including area code)
Not applicable
(Former name, former address and former fiscal year,
if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No ____
The number of shares outstanding of the Registrant's common stock as of May 14,
1999 was 12,471,985.
COVOL TECHNOLOGIES, INC.
TABLE OF CONTENTS
Page No.
PART I - FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL INFORMATION (Unaudited)
Consolidated Balance Sheets - As of September 30, 1998
and March 31, 1999........................................... 3
Consolidated Statements of Operations - For the three
months ended March 31, 1998 and 1999 and the six months
ended March 31, 1998 and 1999................................ 5
Consolidated Statement of Changes in Stockholders' Equity -
For the six months ended March 31, 1999...................... 6
Consolidated Statements of Cash Flows - For the six months
ended March 31, 1998 and 1999................................ 7
Notes to Consolidated Financial Statements..................... 8
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS...................................... 19
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS................................................ 25
ITEM 2. CHANGES IN SECURITIES............................................ 25
ITEM 3. DEFAULTS UPON SENIOR SECURITIES.................................. 26
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.............. 26
ITEM 5. OTHER INFORMATION................................................ 26
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K................................. 27
SIGNATURES.................................................................. 28
Certain statements in this Report, constitute forward-looking statements within
the meaning of the Private Securities Litigation Reform Act of 1995. As such,
actual results may vary materially from current expectations. For a discussion
of certain of the factors that could cause actual results to differ from
expectations, please see the information set forth under the caption entitled
"Forward Looking Statements" in ITEM 2 hereof. There can be no assurance that
Covol's results of operations will not be adversely affected by such factors.
Covol undertakes no obligation to revise or publicly release the results of any
revision to these forward-looking statements. Readers are cautioned not to place
undue reliance on these forward looking statements, which reflect management's
opinion only as of the date hereof.
2
ITEM 1. CONSOLIDATED FINANCIAL INFORMATION (Unaudited)
COVOL TECHNOLOGIES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Unaudited)
September 30, March 31,
(thousands of dollars) 1998 1999
- ------------------------------------------------------------------------------------------- ---------------- -----------------
ASSETS
Current assets:
Cash and cash equivalents $ 727 $6,879
Receivables 2,879 2,707
Due from related party 1,012 1,706
Inventories 1,645 2,039
Advances on inventories, current 2,522 473
Notes receivable - related parties, current 229 239
Facilities held for sale 28,405 28,389
Prepaid expenses and other current assets 682 664
---------------- -----------------
Total current assets 38,101 43,096
---------------- -----------------
Property, plant and equipment, net of accumulated depreciation 14,902 14,499
---------------- -----------------
Other assets:
Restricted investments 748 698
Advances on inventories, non-current -- 2,825
Notes and accrued interest receivable, non-current 7,646 7,859
Notes receivable - related parties, non-current 2,869 2,746
Intangible assets, net of accumulated amortization 3,118 3,976
Deposits and other assets 525 1,678
---------------- -----------------
Total other assets 14,906 19,782
---------------- -----------------
Total assets $67,909 $77,377
================ =================
(continued)
The accompanying notes are an integral
part of the consolidated financial statements
3
COVOL TECHNOLOGIES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS, continued
(Unaudited)
September 30, March 31,
(thousands of dollars and shares) 1998 1999
- -------------------------------------------------------------------------------------------- --------------- ----------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $3,036 $2,616
Due to related party 1,609 2,029
Accrued liabilities 2,858 2,544
Notes payable, current 22,049 16,689
--------------- ----------------
Total current liabilities 29,552 23,878
--------------- ----------------
Long-term liabilities:
Notes payable, non-current 13,930 25,612
Accrued interest payable, non-current 566 206
Notes and accrued interest payable - related parties, non-current 147 69
Deferred revenues from advance license fees 1,400 1,400
Deferred compensation 236 202
--------------- ----------------
Total long-term liabilities 16,279 27,489
--------------- ----------------
Total liabilities 45,831 51,367
--------------- ----------------
Minority interest in consolidated subsidiaries 507 109
--------------- ----------------
Commitments and contingencies (Note 8)
Redeemable convertible preferred stock, $.001 par value, issued and outstanding
0 shares at September 30, 1998 and 60 shares at March 31, 1999 (aggregate
liquidation preference of $6,016 at March 31, 1999) (Note 6) -- 4,354
--------------- ----------------
Stockholders' equity:
Convertible preferred stock, $0.001 par value; authorized 10,000 shares,
issued and outstanding 316 shares at September 30, 1998 and 31 shares at
March 31, 1999 (aggregate liquidation preference of $4,514 at March 31, 1999) 1 1
Common stock, $0.001 par value; authorized 25,000 shares, issued and outstanding
11,272 shares at September 30, 1998 and 12,472 shares at March 31, 1999 11 12
Capital in excess of par value 69,284 77,763
Accumulated deficit (36,177) (45,755)
Notes and interest receivable - related parties, from issuance of, or collateralized
by, common stock, net of allowance (7,773) (7,024)
Deferred compensation from stock options (3,775) (3,450)
--------------- ----------------
Total stockholders' equity 21,571 21,547
--------------- ----------------
Total liabilities and stockholders' equity $67,909 $77,377
=============== ================
The accompanying notes are an integral
part of the consolidated financial statements
4
COVOL TECHNOLOGIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
Three Months Ended March 31, Six Months Ended March 31,
(thousands of dollars, except per-share amounts) 1998 1999 1998 1999
- -------------------------------------------------------------- ---------------- ---------------- ---------------- ---------------
Revenues:
License fees $3,586 $ 320 $4,586 $ 794
Binder sales -- 423 -- 956
Binder and coal fine sales - related party 1,989 42 1,996 183
Other 36 132 70 139
---------------- ---------------- ---------------- ---------------
Total revenues 5,611 917 6,652 2,072
---------------- ---------------- ---------------- ---------------
Operating costs and expenses:
Cost of coal briquetting operations 670 2,380 1,119 5,875
Cost of binder -- 274 -- 650
Cost of binder and coal fines - related party 1,964 10 1,972 35
Selling, general and administrative 1,150 1,233 1,891 2,162
Research and development 72 190 228 343
Compensation expense from stock options, stock
warrants and issuance of common stock 239 163 446 325
---------------- ---------------- ---------------- ---------------
Total operating costs and expenses 4,095 4,250 5,656 9,390
---------------- ---------------- ---------------- ---------------
Operating income (loss) 1,516 (3,333) 996 (7,318)
---------------- ---------------- ---------------- ---------------
Other income (expense):
Interest income 181 306 303 1,137
Interest expense (1,180) (1,377) (2,292) (2,413)
Minority interest in net losses of consolidated
subsidiaries 52 -- 138 --
Write-up (write-down) of notes receivable - related
parties, collateralized by common stock 270 (178) 563 (749)
Other 93 (100) 107 (76)
---------------- ---------------- ---------------- ---------------
Total other income (expense) (584) (1,349) (1,181) (2,101)
---------------- ---------------- ---------------- ---------------
Net income (loss) $ 932 $(4,682) $ (185) $(9,419)
================ ================ ================ ===============
Basic income (loss) per common share $.09 $(.38) $(.03) $(.78)
================ ================ ================ ===============
Diluted income (loss) per common share $.07 $(.38) $(.03) $(.78)
================ ================ ================ ===============
The accompanying notes are an integral
part of the consolidated financial statements
5
COVOL TECHNOLOGIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
For the Six Months Ended March 31, 1999
(Unaudited)
Notes and
interest
receivable
-related
parties, from
Convertible Preferred Common Stock issuance of,
Stock or Deferred
-------------------------------------------- Capital in collateralized compensation
(thousands of excess of par Accumulated by, common from stock
dollars and shares) Shares Amount Shares Amount value deficit stock options
- --------------------- ------- -------- --------- --------- ------------- ------------ ------------- -------------
Balances at
September 30, 1998 316 $1 11,272 $11 $69,284 $(36,177) $(7,773) $(3,775)
Common stock issued
to purchase minority
interests in 70 -- 519
subsidiaries
Common stock issued
for cash, including
exercise of
stock options 776 1 3,774
Value of common
stock warrants issued
under terms of
existing debt
agreement -- -- 247
Common stock issued
for rights to
technology 60 -- 375
Common stock issued
on conversion of
preferred stock
and in payment of
accrued but
undeclared dividends (286) -- 308 -- 159 (159)
Return of previously
issued common stock
by a director (14) -- --
Value of common
stock options
issued in connection
with debt -- -- 175
financing
Preferred stock
issued for cash, net
of offering costs 1 -- 899
Value of common
stock warrants issued
in connection with
redeemable convertible
preferred stock and
convertible debt 2,331
Write-down of notes
receivable - related
parties 749
Amortization of
deferred compensation
from stock options 325
Net loss for the
six months ended
March 31, 1999 (9,419)
----------------------------------------------------------------------------------------------------------
Balances at
March 31, 1999 31 $1 12,472 $12 $77,763 $(45,755) $(7,024) $(3,450)
==========================================================================================================
The accompanying notes are an integral
part of the consolidated financial statements
6
COVOL TECHNOLOGIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Six Months Ended March 31,
(thousands of dollars) 1998 1999
- ------------------------------------------------------------------------------------------------- ----------------- -------------
Cash flows from operating activities:
Net loss $(185) $(9,419)
Adjustments to reconcile net loss to net cash from operating activities:
Depreciation and amortization 178 901
Write-down (write-up) of notes receivable - related parties (563) 749
Interest expense related to amortization of debt discount and debt issuance costs 2,266 326
Amortization of deferred compensation from stock options 446 325
Minority interest in net losses of consolidated subsidiaries (138) --
Loss (gain) on disposition of equipment (78) 103
Decrease from changes in assets and liabilities, net of effects from investing and
financing activities (1,918) (2,688)
----------------- -------------
Net cash provided by (used in) operating activities 8 (9,703)
----------------- -------------
Cash flows from investing activities:
Purchase of property, plant and equipment and facilities held for sale (21,916) (323)
Proceeds from sale of equipment -- 170
Purchase of rights to technology -- (128)
Issuance of notes receivable (1,257) --
Proceeds from notes receivable - related parties 119 112
Advances on binder facility 791 --
Decrease in restricted investment -- 50
----------------- -------------
Net cash used in investing activities (22,263) (119)
----------------- -------------
Cash flows from financing activities:
Proceeds from issuance of notes payable and warrants 16,338 10,498
Payments on notes payable -- (4,602)
Payments on notes payable - related parties (342) (90)
Proceeds from issuance of preferred stock and warrants, net 90 6,394
Proceeds from issuance of common stock, net 1,072 3,774
Proceeds from receivable - stock subscriptions 577 --
Proceeds from notes receivable - related parties, collateralized by common stock 302 --
Other (3) --
----------------- -------------
Net cash provided by financing activities 18,034 15,974
----------------- -------------
Net increase (decrease) in cash and cash equivalents (4,221) 6,152
Total cash and cash equivalents, beginning of period 4,780 727
----------------- -------------
Total cash and cash equivalents, end of period $ 559 $ 6,879
================= =============
Supplemental schedule of non-cash investing and financing activities:
Common stock issued for purchase of minority interests in subsidiaries $ -- $ 519
Common stock issued on conversion of preferred stock and undeclared dividends -- 2,159
Common stock issued for rights to technology -- 375
Notes payable issued for rights to technology -- 427
Notes payable issued for equipment 1,153 213
Common stock issued on conversion of notes payable and related accrued interest 7,000 --
Common stock issued for notes receivable - related parties 45 --
Notes receivable issued for sale of synthetic fuel facility 6,500 --
Preferred stock dividends not accrued or paid 155 126
The accompanying notes are an integral
part of the consolidated financial statements
7
COVOL TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
----------
1. Nature of Operations and Basis of Presentation
Covol Technologies, Inc. and Subsidiaries ("Covol") primary business is to
commercialize its binder technologies which are used to recycle waste
by-products from the coal, steel and other industries into marketable fuel
and resources. Through June 30, 1998, Covol's focus was on the construction
of facilities and the licensing of its binder technologies to companies
that constructed facilities that convert coal fines into synthetic fuel
briquettes. At March 31, 1999, Covol and its licensees were operating 28
facilities in ten states at various levels of production, including four
facilities which are using a technology that Covol acquired during the six
months ended March 31, 1999. The four Covol-owned facilities are expected
to be sold in 1999. Covol has no current plans to construct additional
synthetic fuel facilities.
Covol anticipates that earned license fees or royalties from the production
and sale of synthetic fuel will continue to increase during 1999. As
production levels increase, sales of the binder materials by Covol to its
licensees are expected to increase proportionately. Funds received by Covol
from these activities are not expected to be sufficient to cover Covol's
operating costs and expenses until late 1999. Any extended delay in the
sale of facilities held for sale may require Covol to seek additional debt
or equity financing.
To provide funding for Covol's operations and debt repayment requirements
until late 1999, Covol expects to utilize existing working capital and
excess proceeds from the sale of facilities. During November 1998, Covol
issued common stock and common stock warrants for total net proceeds of
approximately $3,729,000. During January 1999, Covol issued convertible
preferred stock and warrants for total net proceeds of approximately
$900,000. During March 1999, Covol issued convertible secured debt,
convertible redeemable preferred stock and common stock warrants for total
net proceeds of approximately $14,800,000. Covol believes current working
capital, excess proceeds from the sale of facilities, payments for license
fees and binder sales, and funds raised in additional financings, if
necessary, will be sufficient to fund Covol's operations until its
operating activities begin producing positive cash flow. The ability of
Covol to repay its debt as it matures is dependent primarily upon Covol's
ability to sell the facilities which are held for sale. Covol believes the
sale of facilities or extensions of existing debt repayment terms will
enable it to meet these debt requirements.
The accompanying unaudited consolidated financial statements have been
prepared in accordance with the rules and regulations of the Securities and
Exchange Commission. In the opinion of management, all adjustments
(consisting of normal recurring adjustments) considered necessary for a
fair presentation have been included. The results of operations for the
periods presented are not necessarily indicative of the results to be
expected for the full year. Certain information and footnote disclosures
normally included in financial statements prepared in accordance with
generally accepted accounting principles have been condensed or omitted. It
is suggested that these financial statements be read in conjunction with
the consolidated financial statements and notes thereto included in Covol's
Annual Report on Form 10-K for the year ended September 30, 1998 and in
Covol's Quarterly Report on Form 10-Q for the quarter ended December 31,
1998.
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities, the
disclosure of contingent assets and liabilities at the date of the
financial statements, and the reported amounts of revenues and expenses
during the reporting periods. Actual results could differ from those
estimates and any differences could be material.
Certain prior period amounts have been reclassified to conform to the March
31, 1999 presentation.
8
COVOL TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
(Unaudited)
----------
2. Advances on Inventories
During 1997, Covol entered into an agreement to purchase coal fines and
through March 31, 1999 has made payments totaling approximately $3,520,000,
of which $222,000 has been transferred to cost of coal briquetting
operations. The net amount paid has been recorded as advances on
inventories. Covol expects to either utilize or sell these coal fines, at
which time the related costs will be expensed.
Under the agreement, Covol is obligated to pay a total of $5,500,000
between February 1997 and May 2000 for the removal of 2 million tons of
coal fines (a price of $2.75 per ton) from the property. Quarterly payments
of approximately $396,000 are required under the agreement. The agreement
also provides for removal of an additional 500,000 tons at $2.75 per ton.
No payment is required for removal of any coal fines in excess of 2.5
million tons.
3. Change in Carrying Value of Note Receivable
During the three and six months ended March 31, 1999, Covol increased the
allowance on the $5,000,000 face value note receivable from a stockholder
by approximately $178,000 and $749,000, respectively, resulting in an
adjusted carrying value of $860,000 as of March 31, 1999. During the three
and six months ended March 31, 1998, Covol decreased the allowance by
approximately $270,000 and $563,000, respectively. The changes in the
allowance were based solely on changes in the market value of Covol's
common stock and common stock options held as collateral for the note
receivable. The note is personally guaranteed by the buyer of certain
construction companies sold by Covol to him in 1996, and is collateralized
by 150,000 shares of Covol's common stock held by Covol, and also by
options expiring in January 2006 to acquire 25,000 shares of Covol's common
stock at $1.50 per share. The allowance is subject to future fluctuations
in the value of Covol's common stock. During the three months ended March
31 1999, Covol received interest payments totaling $225,000 from the Note
holder.
4. Notes Payable
Notes payable consist of the following:
September 30, March 31, 1999
(thousands of dollars) 1998
-------------------------------------------------------------------------------------------- ----------------- ---------------
Note payable to a corporation, bearing interest at 15%, collateralized by a
synthetic fuel facility in Pennsylvania, held for sale, with all unpaid
principal and interest due at the earlier of the sale of the facility or
August 1999. $5,800 $5,800
Note payable to a corporation bearing interest at prime (7.75% at March 31,
1999) plus 2%, collateralized by plant and equipment, principal and interest
due December 1999. 2,900 2,900
Note payable to the same corporation referred to in the preceding paragraph,
bearing interest at 6%, principal and interest due January 2000,
collateralized by a coal wash plant in Utah. 4,263 4,288
9
COVOL TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
(Unaudited)
----------
4. Notes Payable, continued
September 30, March 31, 1999
(thousands of dollars) 1998
-------------------------------------------------------------------------------------------- ----------------- ---------------
Notes payable to the same corporation referred to in the preceding paragraphs,
bearing interest at 6%. 50% of accrued interest due February 2000 with
remaining accrued interest and principal due February 2001. Collateralized by
a synthetic fuel facility in West Virginia, held for sale. $6,680 $6,500
Note payable to a limited liability company issued in conjunction with funds
advanced for the construction of a synthetic fuel facility in West Virginia,
held for sale. As of September 30, 1998, the loan was collateralized by the
facility, bore no interest and was originally due at the earlier of the sale
of the facility or January 1999. In December 1998, this entity modified the
terms of the note and agreed to loan to Covol additional amounts up to $1,500.
This entity had an option to purchase the facility, which expired unexercised
in January 1999. Covol agreed to pay interest on all outstanding amounts at a
rate of 10%, payable monthly through June 1999. Beginning July 1999 through
May 2000, monthly payments of $350 will be required, with all unpaid principal
and interest due in June 2000. Alternatively, if Covol sells the facility
before the loan repayment date, Covol must repay the loan from sale proceeds.
Also, Covol granted additional collateral to the corporation in the form of
certain license fees receivable by Covol from other synthetic fuel facilities. 8,242 9,191
Convertible secured note payable to an investment company issued at a
discount, bearing a stated interest rate of 2.5% on the $20,000 face amount.
The note is due March 2004 if not earlier redeemed or converted into common
stock. Interest is payable semiannually on January 1 and July 1, beginning
July 1, 1999. The note is collateralized by license fees payable to Covol from
the production and sale of synthetic fuel from four synthetic fuel facilities
located in Virginia and West Virginia. See Note 6. -- 8,921
Note payable to a corporation originally due June 1999, collateralized by a
promissory note receivable and by certain future license fees receivable by
Covol. Warrants to purchase 100,000 shares of common stock were granted in
October 1998 based on the outstanding principal balance. The warrants
originally had an exercise price of $7.44 per share, expired in October 2000
and were valued at approximately $247. The terms of this note were amended in
May 1999 to provide that $1,000 of principal is due in December 1999 and
$3,000 of principal is due in April 2000. Accordingly, $3,000 has been
classified as long-term in the balance sheet. Interest is payable at a rate of
22% through the original due date of June 12, 1999. Thereafter interest is
payable monthly at a rate of 14%. The terms of existing warrants for the
purchase of 185,713 shares of common stock were amended to extend the exercise
periods for one year and to lower the exercise prices to market value of
Covol's common stock. A member of Covol's Board of Directors is affiliated
with this corporation. 4,000 4,000
10
COVOL TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
(Unaudited)
----------
4. Notes Payable, continued
September 30, March 31, 1999
(thousands of dollars) 1998
-------------------------------------------------------------------------------------------- ----------------- ---------------
Note payable to the same corporation referred to in the preceding paragraph, bearing
interest at 14%. Principal and accrued interest were paid in March 1999. $ 4,000 $ --
Other 94 701
----------------- ---------------
35,979 42,301
Less: current portion 22,049 16,689
================= ===============
Total non-current $13,930 $25,612
================= ===============
Substantially all of Covol's property, plant and equipment and facilities
held for sale are collateral for the notes payable. The weighted average
interest rate on notes payable was 8.5% at September 30, 1998 and 16.8% at
March 31, 1999.
Interest Costs
During the six months ended March 31, 1999, Covol incurred total interest
cost of approximately $2,413,000 (including approximately $326,000 of
amortization of debt discount and debt issuance costs, none of which was
capitalized. During the six months ended March 31, 1998, Covol incurred total
interest cost of approximately $2,983,000 (including approximately $2,266,000
of non-cash interest expense resulting from issuance of convertible debt and
warrants at a discount), of which approximately $691,000 was capitalized.
5. Basic and Diluted Loss per Share
Three Months Ended March 31, Six Months Ended
March 31,
(thousands of dollars and shares, except per-share data) 1998 1999 1998 1999
---------------------------------------------------------- -------------- --------------- ---------------- ---------------
Numerator:
Net income (loss) $932 $(4,682) $(185) $(9,419)
Preferred stock dividends (undeclared) (85) (77) (85) (137)
Imputed preferred stock dividends -- (40) -- (40)
-------------- --------------- ---------------- ---------------
Net income (loss) attributable to common
stockholders $847 $(4,799) $(270) $(9,596)
============== =============== ================ ===============
Denominator:
Denominator for basic income (loss) per share -
weighted-average shares outstanding 9,574 12,472 9,382 12,224
-------------- --------------- ---------------- ---------------
Effect of dilutive securities:
Common stock options 1,216
Common stock warrants 500
Convertible preferred stock 741
-------------- --------------- ---------------- ---------------
Dilutive potential common shares 2,457 -- -- --
-------------- --------------- ---------------- ---------------
Denominator for diluted income (loss) per
share - adjusted weighted-average shares
and assumed conversions $12,031 $12,472 $9,382 $12,224
============== =============== ================ ===============
Basic income (loss) per common share $.09 $(.38) $(.03) $(.78)
============== =============== ================ ===============
Diluted income (loss) per common share $.07 $(.38) $(.03) $(.78)
============== =============== ================ ===============
11
COVOL TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
(Unaudited)
----------
6. Financing Transaction
On March 17, 1999, Covol completed a financing transaction (the "Financing")
with OZ Master Fund, Ltd., an affiliate of the Och-Ziff Capital Management
Group. The Financing consisted of the issuance of $20,000,000 face value of
convertible secured debt, issued at a 50% discount, and the issuance of
$6,000,000 of cumulative convertible preferred stock, for total gross
proceeds of $16,000,000. Costs related to the Financing totaled approximately
$1,200,000, and consisted of private placement fees of $800,000, legal
expenses of approximately $350,000 and other expenses of approximately
$50,000. Warrants for the purchase of common stock were also issued as part
of the Financing. Covol received net cash proceeds of approximately
$14,800,000, which are being used to retire maturing short-term debt and
related accrued interest of approximately $4,900,000, for working capital
uses and other general corporate purposes. So long as any debt or preferred
stock issued in connection with this Financing is outstanding, the holders
have the right, as a group, to elect one director to Covol's Board of
Directors.
Convertible Secured Note Payable
The convertible secured debt has a five-year term and bears interest at a
stated rate of 2.5% per annum on the $20,000,000 face amount, with interest
payable semiannually on January 1 and July 1, beginning July 1, 1999. After
consideration of the 50% discount and the value assigned to warrants, the
imputed interest rate is approximately 38%. The debt is redeemable by Covol
at any time prior to September 17, 2001 for an amount equal to the face
amount of the debt. The debt is redeemable by Covol from September 18, 2001
and prior to March 17, 2002 for an amount equal to 109.85% of the face amount
of the debt. The debt is convertible into common stock of Covol at the option
of the noteholder at a discount to the market price at the time of conversion
as described below. The debt is not convertible by the holder until after
March 17, 2002 except upon the occurrence of an event of default. If
converted, the number of shares into which the debt can be converted would be
calculated based on a price per share of common stock equal to 33% of the
then market price at the time of conversion, but not less than $6.67 per
share nor more than $10.00 per share. Covol's present intent is to redeem the
debt prior to March 17, 2002, assuming sufficient cash from operations or
future equity or debt financing is available.
A deferred asset was recorded for the portion of financing costs allocated to
the debt. This asset is being amortized over 30 months, the most likely
period of time over which the debt is expected to remain outstanding.
Amortization is computed using the straight-line method. Paid-in capital was
credited for the relative value of the warrants directly related to the
issuance of debt and the warrants allocated to the issuance of debt, as
compared to the total combined fair values of the warrants and debt. A
liability was recorded for $20,000,000, the face value of the debt. Debt
discount was recorded so as to yield a level interest rate on the net amount
of debt outstanding between the issue date and 30 months from the issue date.
Each period, interest expense is recorded consisting of the total of 1)
interest expense based on the stated interest rate and the face value of the
debt; 2) amortization of debt discount; and 3) amortization of debt issue
costs.
Covol will be in default of the provisions of the debt agreement if certain
events occur. These events include, in addition to events commonly considered
defaults, incurring one or more judgments in excess of $5,000,000, which
judgments are not discharged, stayed or otherwise satisfied within 30 days of
the judgments, and the failure to meet certain earnings targets. The earnings
targets apply initially to the quarter ending December 31, 1999, and then to
subsequent quarterly periods. Consolidated earnings of $5,000,000 or more
before interest, taxes, depreciation, and amortization, and certain other
adjustments as defined in the applicable agreement, are required for the
quarter ending December 31, 1999. In subsequent quarters, earnings targets
increase incrementally up to $6,500,000 for the quarter ending December 31,
2001 and subsequent quarters. There are provisions for the carryover of
earnings which exceed the targets to subsequent quarters, if necessary,
subject to certain limitations. The debt is collateralized by license fees
payable to Covol from the production and sale of synthetic fuel from
12
COVOL TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
(Unaudited)
----------
6. Financing Transaction, continued
Convertible Secured Note Payable, continued
four synthetic fuel facilities located in Virginia and West Virginia. The
owner of these facilities has entered into licensing agreements to use
Covol's technologies in return for a royalty based on the production and sale
of synthetic fuel, subject to prescribed adjustments.
In the event of default, the interest rate on the debt increases immediately
by 1% and increases automatically by 1% at the end of each succeeding 90-day
period, to the extent permitted by law, until the event is cured. Depending
on the nature of the event of default, in most instances, either 1) all
unpaid principal and interest become immediately due and payable; or 2) the
note and accrued interest become immediately convertible into common stock
and the conversion price is subject to adjustment, based on the market price
of Covol's common stock and other factors, as provided for in the loan
agreement.
Redeemable Cumulative Convertible Preferred Stock
The preferred stock consists of 60,000 shares of a new series of preferred
stock, Series D Cumulative Convertible Preferred Stock, with a liquidation
value of $100 per share. This series of preferred stock is senior, with
respect to dividend rights, payments upon liquidation, or redemption, to all
other capital stock of Covol, including the other series of preferred stock
which are outstanding or which may be issued in the future. Dividends accrue
at a rate of 7% per annum whether or not declared or paid. At Covol's option,
dividends can be paid in additional shares of preferred stock in lieu of
cash. Dividends are payable quarterly beginning July 1, 1999. Holders of the
preferred stock have voting rights as to all matters voted on by the holders
of common stock and are entitled to one vote for each share of common stock
issuable upon conversion of the preferred stock. In addition, holders of the
preferred stock and debt vote as a group for one director.
The preferred stock is redeemable at Covol's option through March 17, 2002 at
125% of its liquidation value, subject to adjustment for changes in the value
of Covol's common stock. The preferred stock is redeemable at the option of
the preferred stockholder only upon occurrence of a change in control. The
preferred stock is convertible at the option of the stockholders beginning
June 15, 1999, up to a maximum of 20% of the outstanding shares of preferred
stock. Each month thereafter, the amount of preferred stock that can be
converted increases by 20% until October 13, 1999, at which time all of the
preferred stock can be converted into common stock. On March 17, 2002, all
outstanding preferred stock automatically converts to common stock. The
number of shares of common stock into which the preferred stock is
convertible is determined by multiplying the number of preferred shares by
$100 and dividing by the lesser of $5.25 or 90% of the market value of
Covol's common stock on the date of conversion.
The portion of financing costs allocated to the preferred stock were netted
against proceeds. Paid-in capital was credited for the relative value of the
warrants directly related to the issuance of preferred stock and the warrants
allocated to the issuance of preferred stock, as compared to the total
combined fair values of the warrants and preferred stock. Because the
preferred stock can be redeemed by the preferred stock holders (only upon the
occurrence of a change in control), it has been classified outside the equity
section in the balance sheet. Because the conversion price of the preferred
stock was less than the fair market value of Covol's common stock on the date
of issuance, an imputed dividend will affect the earnings per share
calculation as it is amortized over the period from issue date to date of
first conversion.
13
COVOL TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
(Unaudited)
----------
6. Financing Transaction, continued
Warrants
Warrants for the purchase of a total of approximately 1,300,000 shares of
common stock were issued in connection with the Financing. The number of
shares issuable upon exercise of the warrants is subject to certain
antidilution provisions including but not limited to the issuance of common
stock at prices below the market price of Covol's common stock. Warrants to
purchase 400,000 shares of common stock are initially exercisable at prices
of $5.00 per share for 200,000 shares and $10.00 per share for 200,000
shares, for the period of time beginning on March 17, 2002 through March 17,
2004, subject to adjustment upon the occurrence of certain events. Warrants
to purchase 883,626 shares of common stock are initially exercisable at
prices ranging from $5.25 to $6.56 per share for the period of time beginning
on September 13, 1999 through March 17, 2002, subject to adjustment upon the
occurrence of certain events.
The warrants issued in this transaction were valued at approximately
$3,000,000 using the Black-Scholes option valuation model. Some warrants were
issued in connection with the convertible debt, some were issued in
connection with the convertible preferred stock and some were issued in
connection with both the debt and equity securities. The value of the
warrants issued in connection with both the debt and equity securities was
allocated between debt and preferred stock on a pro-rata basis, based on the
debt and equity portions of the total financing.
Registration Rights
The restricted common stock issuable pursuant to the conversion of the
convertible secured debt and related interest, convertible preferred stock,
preferred stock dividends, and exercise of approximately 971,000 warrant
shares have been provided demand and piggyback registration rights. The
remaining warrants have been provided piggyback registration rights.
Other Significant Obligations or Restrictions
Terms of the agreements entered into by Covol in connection with the
Financing provide for limits and restrictions common to such financing
arrangements, as well as certain additional specific limitations or
restrictions.
7. Equity Transactions
Technology Acquisition
Effective in November 1998, Covol acquired a coal-based synthetic fuel
technology, and related licensing and patent rights for $128,000 in cash,
60,000 shares of restricted common stock valued at $375,000 and a commitment
to make installment payments ranging from $5,000 to $12,500 per month for 60
months with interest imputed at 15%. This acquisition transferred to Covol
patent ownership and licensor rights and obligations to existing license
agreements with a company that sublicensed the technology to a developer of
four synthetic fuel facilities. The total cost of approximately $930,000 is
being amortized on a straight-line basis over approximately nine years.
14
COVOL TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
(Unaudited)
----------
7. Equity Transactions, continued
Sale of Series C Convertible Preferred Stock
During January 1999, Covol completed a financing transaction with a previous
stockholder that consisted of the sale of 1,000 shares of a new series of
non-voting preferred stock, designated as Series C 7% Convertible Preferred
Stock. Covol received $900,000 in net proceeds from the issuance of this
preferred stock, which has the following rights and privileges:
o Dividends on the preferred stock are cumulative and accrue whether or
not they have been declared or whether Covol has any profits. The
dividend rate is 7% per year of the liquidation value of $1,000 per
share.
o The preferred stock is convertible into common shares in incremental
stages beginning April 1999 through July 1999, at which time all of the
outstanding shares may be converted to common stock. The number of
common shares to be received upon conversion is determined by
multiplying the number of preferred shares by $1,000 and dividing that
number by the conversion price (currently $5.50 per share, subject to
adjustment). Upon conversion, all accrued and unpaid dividends will be
paid or converted into shares of common stock.
o Covol may at its option redeem the outstanding preferred stock
beginning July 1999 for a redemption price equal to 125% of the
liquidation value plus any accrued and unpaid dividends thereon.
Warrants for the purchase of 72,727 shares of common stock were issued in
conjunction with this preferred stock. These warrants are exercisable from
April 1999 through July 2001 at an exercise price of $6.88 per share, subject
to adjustment. The exercise deadline for certain other warrants with an
exercise price of $7.00 per share held by this stockholder were extended to
June 2000 and certain additional warrants with an exercise price of $30.00
per share were relinquished and have been cancelled. Covol granted
registration rights for the restricted common shares issuable upon conversion
of the preferred stock or upon exercise of the common stock warrants.
The new and extended warrants were valued at approximately $500,000. Issuance
costs were netted against proceeds and paid-in capital was credited for the
relative value of the warrants, as compared to the total combined fair values
of the warrants and preferred stock.
Stock Options
During the six months ended March 31, 1999, Covol granted options for the
purchase of a total of 382,000 shares of common stock. Options for the
purchase of 150,000 shares of common stock were granted to three officers and
options for the purchase of 172,000 shares were granted to four independent
directors. Covol also granted options for the purchase of 60,000 shares of
common stock to four individuals for services rendered in connection with the
financing of a synthetic fuel facility pursuant to a consulting arrangement
originally entered into in 1997 and revised in August 1998. These options
were assigned a value of approximately $175,000 which is being amortized over
the life of the related financing. In December 1998, three officers exercised
options for the purchase of 30,000 shares of common stock, for which Covol
received proceeds of $45,000.
15
COVOL TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
(Unaudited)
----------
8. Commitments and Contingencies
Commitments and contingencies as of March 31, 1999 not disclosed elsewhere,
are as follows:
Letters of Credit
During fiscal 1998, Covol entered into letter of credit arrangements with a
bank that provide for the issuance of letters of credit totaling up to
$938,000. As of March 31, 1999, there were $698,000 of outstanding letters of
credit. Certificates of deposit totaling $698,000 that are included in
restricted investments in the accompanying balance sheet collateralize these
arrangements.
Legal or Contractual Matters
Included in accrued liabilities at September 30, 1998 and March 31, 1999 is
$755,000 related to construction contracts that contain a "failure to
proceed" liability clause.
In December 1996, Covol entered into indemnification agreements in connection
with construction contracts for certain synthetic fuel facilities entered
into between the construction contractor and independent third parties. These
contracts called for liquidated damages of $750,000 per contract if
construction of the facilities were not completed by June 1, 1998. Covol
indemnified the contractor for these potential liabilities. The maximum
contingent liability Covol may have had under these indemnification
agreements would have been $2,250,000. The contractor and the contracting
party initiated claims in arbitration against each other but have settled
their claims, including a release of claims against Covol for liquidated
damages.
In March 1997, Covol sold the Utah Synfuel #1 facility to Coaltech. In
connection with this sale, Utah Synfuel #1 licensed Coaltech to use Covol's
binder technologies for an advance license fee of $1,400,000 and an earned
license fee that is payable quarterly and is based upon synthetic fuel
produced and sold at the Utah facility by Coaltech. Covol contracted with
Coaltech to operate the facility for which Covol receives a quarterly fee,
which is also based upon synthetic fuel produced and sold. Coaltech has an
option wherein they can require Covol to purchase this facility under certain
conditions for a price equal to fair market value, but not to exceed 50% of
the amounts paid to Covol by Coaltech. Additionally, Covol entered into a
supply and purchase agreement wherein Covol agreed to provide to Coaltech
coal fines for processing into synthetic fuel at a price equal to Covol's
cost. Covol agreed to purchase from Coaltech the synthetic fuel produced, at
Coaltech's cost plus one dollar per ton. Based upon expected manufacturing
costs and current coal prices, Covol expects to incur a loss under this
supply and purchase agreement which will reduce the earned license fees
received. Covol believes that in total the earned license fees will exceed
the losses incurred under the supply and purchase agreement. Because of the
initial expected losses under this supply and purchase agreement, revenue
recognition of the advance license fee of $1,400,000 has been deferred as of
September 30, 1998 and March 31, 1999.
In June 1996, Covol formed Alabama Synfuel #1, Ltd. to construct a synthetic
fuel facility. In connection with the construction of this facility, Covol
entered into a supply agreement for coal fines to be used at the facility,
under which Covol was obligated to purchase a minimum of 20,000 tons of coal
fines per month through December 2001. Covol assigned this agreement to the
purchaser of the facility and accordingly, has no ongoing obligation. Covol
has been paid for most of the coal fines purchased but has a dispute with the
provider of the coal fines for a portion of the coal fines Covol paid for.
The resolution of this dispute is not expected to have a material impact on
Covol.
16
COVOL TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
(Unaudited)
----------
8. Commitments and Contingencies, continued
Legal or Contractual Matters, continued
In May 1995, Covol entered into an agreement with Geneva Steel Company to
build and operate a commercial briquetting plant. The facility never reached
commercial operating levels and the equipment has been moved from the Geneva
site. Covol intends to use this equipment for the production of synthetic
fuel, for testing purposes, or other potential applications of Covol's
technology.
In December 1996, Covol entered into license agreements with affiliates of
Pace Carbon Fuels, L.L.C. (collectively "Pace") for the use of Covol's binder
technologies at four synthetic fuel manufacturing facilities developed by
Pace. In 1998 Pace requested a reduction in the license fees payable to Covol
under the license agreements. Upon condition of immediate payment by Pace of
advance license fees, Covol agreed to a reduction in future earned license
fees. This reduction was accomplished by a ten-year loan agreement whereby
Covol would loan to Pace up to $750,000 each quarter beginning in November
1998. This loan will be repaid to Covol at the end of the ten years only if
the Pace projects have accumulated sufficient prescribed earnings. Revenues
from earned license fees will be recognized by Covol only to the extent that
amounts exceed the loan commitment. Pace has requested three quarterly loans
totaling $2,250,000. Covol believes that its current loan obligation to Pace
is limited to the earned license fees receivable by Covol for the quarters
ended September 30, 1998 and through March 31, 1999, which amounts are
estimated at $854,000 in total. Pace and Covol are renegotiating their
license agreements, which negotiations could result in a reduction and/or
deferral of the receipt of future license royalty payments. Covol expects
revised agreements to replace the ten-year loan arrangements.
In January 1996, a manager of Covol entered property owned by Nevada Electric
Investment Company, a subsidiary of Nevada Power Corporation, in connection
with an offer by Covol to purchase the property, and with certain other
employees of Covol, removed some asbestos over a two-day period. In May 1996,
Covol received a notice of violation and order for compliance from the State
of Utah, Division of Air Quality alleging that asbestos was improperly
handled, removed, and disposed of. Covol complied with the order and in
September 1996 entered into a settlement agreement with the State of Utah and
paid a fine in the amount of $11,000. In late 1997, the U.S. Environmental
Protection Agency began its own investigation, referring the matter to the
U.S. Attorney's office which proceeded with a grand jury inquiry. Covol was
served in September 1998 with a grand jury subpoena for records, with which
Covol has complied. Covol does not know the results of the grand jury inquiry
or whether the inquiry is completed. Covol does not believe that the
resolution of this matter will have a material adverse effect on Covol.
As of September 30, 1998 and December 31, 1998, Covol had recorded
liabilities to The Industrial Company ("TIC") totaling approximately
$735,000. In November 1998, Covol was served with two liens from TIC in
amounts totaling approximately $1,150,000 for construction payments TIC
claimed were due for certain synfuel facilities. Covol increased the recorded
liability to TIC to $945,000 as of March 31, 1999, which amount was paid in
April 1999 for the settlement and release of both liens.
17
COVOL TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
(Unaudited)
----------
8. Commitments and Contingencies, continued
Legal or Contractual Matters, continued
In September 1996, Covol entered into an agreement with Coalco Corporation
whereby Coalco was to advise Covol with respect to the financing and sale of
certain synthetic fuel manufacturing facilities. To date, Covol has paid
Coalco approximately $347,000 pursuant to the agreement. A dispute has arisen
between Covol and Coalco about services rendered or to be rendered by Coalco
and the amount and timing for payment for such services. There have been
ongoing discussions between Covol and Coalco in an attempt to resolve their
differences. The potential liability to Covol, if any, is not known. While
Covol's management believes the dispute will be resolved and will not have a
significant financial impact, it can give no assurance as to the ultimate
effect on Covol. Pelletco, an affiliate of Coalco, is a licensee of Covol.
18
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following Management's Discussion and Analysis should be read in conjunction
with the accompanying unaudited consolidated financial statements and notes
thereto.
Three Months Ended March 31, 1999 Compared to Three Months Ended March 31, 1998
Revenues. Total revenues for the three months ended March 31, 1999 ("1999")
decreased by $4,694,000 to $917,000 as compared to $5,611,000 for the three
months ended March 31, 1998 ("1998"). During 1999, Covol recognized license fees
totaling $320,000 while license fees of $3,586,000 were recognized during 1998.
The license fees in 1999 consisted solely of earned license fees or royalty
payments, while the license fees in 1998 consisted solely of one-time advance
license fees from several licensees. Earned license fees or royalty payments are
due quarterly based upon synthetic fuel produced and sold as reported to Covol
by its licensees. Advance license fees are normally due when construction of the
related synthetic fuel facility begins, when construction is completed, or when
certain construction milestones or other specified conditions are met. Covol
expects to receive additional advance license fees during 1999 upon the sale of
synthetic fuel facilities currently owned by Covol and upon the achievement of
certain production levels at two other synthetic fuel facilities. Earned license
fees or royalty payments are expected to increase at a moderate level in the
near term with increases expected in late 1999.
Covol provides binder material to its licensees either at a fixed price or at
Covol's cost plus a contracted markup. Covol purchases binder material under a
long-term contract with a large chemical company. Total binder sales to
non-related parties during 1999 were $423,000, with a corresponding direct cost
to Covol of $274,000, excluding related labor and overhead. In 1998, Covol had
no binder sales to non-related parties. Covol had sales of binder and coal fines
to related parties during 1999 totaling $42,000 compared to $1,989,000 during
1998. These revenues resulted primarily from coal fines that were sold to a
related party under a non-recurring contractual obligation at Covol's cost, as
provided for under the binder and license agreement with this entity.
Covol expects an increase during 1999 of production and sales of synthetic fuel
by its licensees as they improve production capability and establish marketing
agreements for the synthetic fuel produced. This will result in a corresponding
increase in earned license fees or royalty payments and sales of binder
products. However, Covol cannot assure increases in license fees, royalty
payments, and binder sales because Covol's licensees must successfully obtain
adequate feedstock or coal fines, process fines into synthetic fuel, and develop
markets for synthetic fuel. Covol believes that its licensees have made progress
in these areas during the quarter ended March 31, 1999, but significant
improvement is still needed and continued progress and eventual success cannot
be assured.
Operating Costs and Expenses. Operating costs and expenses increased by $155,000
to $4,250,000 during 1999 from $4,095,000 during 1998. Cost of coal briquetting
operations increased $1,710,000 from $670,000 during 1998 to $2,380,000 during
1999, and cost of binder and coal fines - related parties decreased $1,954,000
from $1,964,000 during 1998 to $10,000 during 1999. During 1999, Covol incurred
significantly higher operating expenses in connection with the continued
refinement and commercialization of the briquetting process in connection with
the 24 facilities placed in service during 1998, and in particular the four
facilities owned by Covol which are currently held for sale. These expenses
primarily related to labor and operating expenses at the four Covol synthetic
fuel facilities and the wash plant located in Utah, losses related to the
write-down of Coaltech inventory, and costs incurred in providing assistance to
Covol's licensees in resolving ramp-up issues at their synthetic fuel
facilities. Covol expects to continue incurring operating losses during 1999
until the four facilities held for sale are sold, even though it expects to
realize a gain from these sales.
Covol operates one of the synthetic fuel facilities for Coaltech, a partnership
for which Covol is the general partner. Under this operating agreement, Covol is
contractually obligated to purchase the synthetic fuel produced by Coaltech at
cost plus $1 per ton. Production of synthetic fuel from this facility during
1999 and 1998 was not significant and accordingly, the cost per ton is well in
excess of the current market value. These costs and the corresponding write-down
of this inventory to its market value are included in the cost of coal
briquetting
19
operations. The write-down was approximately $650,000 during 1999 and $250,000
during 1998. The excess cost per ton should decrease in the remainder of 1999 as
production volumes at the Coaltech facility increase.
Selling, general and administrative expenses increased $83,000 or 7% to
$1,233,000 during 1999 from $1,150,000 for 1998. Except for amortization of
intangible assets in 1999 and commissions in 1998, the largest components of
selling, general and administrative expenses for 1999 and 1998 were payroll,
professional services, and travel expenses. Payroll costs increased
approximately $115,000 from 1998 to 1999 due to increased headcount.
Amortization of intangible assets increased approximately $96,000 related to the
late 1998 exchange of common stock of Covol for limited partnership interests.
Commission expense decreased $250,000 due to a nonrecurring commission in 1998
related to a licensee relationship. Changes in the other categories from year to
year were not material.
Research and development costs increased $118,000 to $190,000 from 1998 to 1999
primarily because Covol has focused additional resources on further refinement
of its binder technologies relative to the synthetic fuel industry and to a
lesser extent as a result of the application of its binder technologies into
other areas.
Compensation expense from stock options, stock warrants, and issuance of common
stock decreased $76,000 to $163,000 for 1999 from $239,000 for 1998. This
expense relates to options granted in prior periods that vest over several years
and the compensation value that is being recognized as an expense over the
vesting period. This amount is expected to remain relatively level for the
remainder of 1999.
Other Income and Expense. During 1999, Covol had net other expenses of
$1,349,000 compared to $584,000 for 1998. This increase of $765,000 relates
primarily to a change between periods of $448,000 in the mark-to-market
adjustment of the carrying value of the related party note receivable
collateralized by common stock, an increase in interest expense of $197,000; and
a loss on disposition of equipment in 1999 of $103,000.
During 1996, Covol sold certain construction companies and received as
consideration a $5,000,000 note receivable ("Note"). The Note is "marked to
market" each quarter based upon the market value of Covol's common stock and is
reflected in the balance sheet at the underlying value of the collateral. This
adjustment resulted in a write-down of $178,000 during 1999, compared to a
write-up of $270,000 during 1998 for a net change of $448,000. As of March 31,
1999, the Note had a carrying value of $860,000.
Interest expense in 1998 of $1,180,000 consisted primarily of expense based upon
the issuance of convertible debt and warrants at a discount. Interest expense of
$1,377,000 in 1999 consisted of interest accrued on notes payable used to
finance the construction of synthetic fuel facilities held for sale and for
operating needs and includes only $121,000 of amortization of debt discount.
Interest expense is expected to increase by approximately $900,000 per quarter
as a result of the debt issued in March 1999, which increase will be offset by
reduced interest as a result of any future repayments of debt related to
facilities held for sale.
Net loss. For 1999, the net loss of $4,682,000 represented a change of
$5,614,000 from net income of $932,000 reported for 1998. This is primarily due
to the significant decrease in one-time advance license fee revenues and the
increase in cost of briquetting operations. Covol did not recognize any income
tax benefit in 1999 or 1998 since the realization of its deferred tax asset of
approximately $14,000,000, consisting primarily of net operating loss
carryforwards, is dependent on generation of future taxable income.
Six Months Ended March 31, 1999 Compared to Six Months Ended March 31, 1998
Revenues. Total revenues for the six months ended March 31, 1999 ("1999")
decreased by $4,580,000 to $2,072,000 as compared to $6,652,000 for the six
months ended March 31, 1998 ("1998"). During 1999, Covol recognized license fees
totaling $794,000 while license fees of $4,586,000 were recognized during 1998.
The license fees in 1999 consisted solely of earned license fees or royalty
payments, while the license fees in 1998 consisted solely of one-time advance
license fees from several licensees.
Total binder sales to non-related parties during 1999 were $956,000, with a
corresponding direct cost to Covol of $650,000. In 1998, Covol had no binder
sales to non-related parties. Covol had sales of binder and coal fines to
related parties during 1999 totaling $183,000 compared to $1,996,000 during
1998. These revenues resulted
20
primarily from coal fines that were sold to a related party under a
non-recurring contractual obligation at Covol's cost as provided for under the
binder and license agreement with this entity.
Operating Costs and Expenses. Operating costs and expenses increased by
$3,734,000 to $9,390,000 during 1999 from $5,656,000 during 1998. Cost of coal
briquetting operations increased $4,756,000 from $1,119,000 during 1998 to
$5,875,000 during 1999, and cost of binder and coal fines - related parties
decreased $1,937,000 from $1,972,000 during 1998 to $35,000 during 1999. During
1999, Covol incurred significantly higher operating expenses in connection with
the continued refinement and commercialization of the briquetting process in
connection with the 24 facilities placed in service during 1998, and in
particular the operating costs of the four facilities owned by Covol which are
currently held for sale. These expenses primarily related to labor and operating
expenses at the four Covol synthetic fuel facilities and the wash plant located
in Utah, losses related to the writedown of Coaltech inventory, and costs
incurred in providing assistance to Covol's licensees in resolving ramp-up
issues at their synthetic fuel facilities.
Covol is contractually obligated to purchase the synthetic fuel produced by
Coaltech at cost plus $1 per ton. Production of synthetic fuel from this
facility during 1999 and 1998 was not significant and accordingly, the cost per
ton is well in excess of the current market value. These costs and the
corresponding write-down of this inventory to its market value are included in
the cost of coal briquetting operations. The write-down was approximately
$1,800,000 during 1999 and $500,000 during 1998. The excess cost per ton should
decrease as 1999 production volumes at the Coaltech facility increase.
Selling, general and administrative expenses increased $271,000 or 14% to
$2,162,000 during 1999 from $1,891,000 for 1998. Except for amortization of
intangible assets during 1999 and commissions in 1998, the largest components of
selling, general and administrative expenses for 1999 and 1998 were payroll,
professional services, and travel expenses. Payroll costs and professional
services each increased approximately $150,000 from 1998 to 1999 due to
increased headcount and higher legal costs, respectively. Amortization of
intangible assets increased approximately $192,000 related to the 1998 exchange
of common stock of Covol for limited partnership interests. Commission expense
decreased approximately $305,000 due primarily to a nonrecurring commission in
1998 related to a licensee relationship. Changes in the other categories from
year to year were not material.
Research and development costs increased $115,000 to $343,000 from 1998 to 1999
primarily because Covol has focused additional resources on further refinement
of its binder technologies relative to the synthetic fuel industry and to a
lesser extent as a result of the application of its binder technologies into
other areas.
Compensation expense from stock options, stock warrants, and issuance of common
stock decreased $121,000 to $325,000 for 1999 from $446,000 for 1998. This
expense relates to options granted in prior periods that vest over several years
and the compensation value that is being recognized as an expense over the
vesting period. This amount is expected to remain relatively level for the
remainder of 1999.
Other Income and Expense. During 1999, Covol had net other expenses of
$2,101,000 compared to $1,181,000 for 1998. This increase of $920,000 relates
primarily to a change between periods of $1,312,000 in the mark-to-market
adjustment of the carrying value of the related party note receivable
collateralized by common stock, partially offset by an increase in interest
income of $834,000. Also contributing to the net increase in other expenses was
an increase in interest expense of $121,000, a decrease in minority interest in
losses of consolidated subsidiaries of $138,000, and a loss on disposition of
equipment in 1999 of $103,000.
During 1996, Covol sold certain construction companies and received as
consideration a $5,000,000 note receivable ("Note"). The Note is "marked to
market" each quarter based upon the market value of Covol's common stock and is
reflected in the balance sheet at the underlying value of the collateral. This
adjustment resulted in a write-down of $749,000 during 1999, compared to a
write-up of $563,000 during 1998 for a net change of $1,312,000. A $515,000
payment on the Note was due in January 1999, of which $225,000 has been
received. The balance of the January payment is expected to be received in the
quarter ending June 30, 1999. Included in interest income for 1999 is $515,000
related to this Note.
21
Interest expense in 1998 of $2,292,000 consisted primarily of expense based upon
the issuance of convertible debt and warrants at a discount. Interest expense of
$2,413,000 in 1999 consisted of interest accrued on notes payable used to
finance the construction of synthetic fuel facilities held for sale and for
operating needs and includes only $203,000 of amortization of debt discount.
Interest expense is expected to increase by approximately $900,000 per quarter
as a result of the debt issued in March 1999, which increase will be offset by
reduced interest as a result of any future repayments of debt related to
facilities held for sale.
During September 1998, Covol offered the limited partners of Utah Synfuel #1 and
Alabama Synfuel #1 common stock of Covol in exchange for their limited
partnership interests. These exchanges, most of which were accounted for in
September 1998, were substantially completed by November 1998, at which time
Utah Synfuel #1 became a wholly-owned subsidiary of Covol and Alabama Synfuel #1
became a 98%-owned subsidiary of Covol. As a result of these exchanges, minority
interest in the losses of consolidated subsidiaries decreased from approximately
$138,000 in 1998 to approximately $0 in 1999. Covol believes the combined
operations of these partnerships will result in operating losses in the
near-term future, which losses will be included in Covol's statement of
operations.
Net loss. For 1999, the net loss increased $9,234,000 from $185,000 to
$9,419,000. The increase is primarily due to the significant decrease in
one-time advance license fee revenues and the increase in cost of briquetting
operations. Covol did not recognize any income tax benefit in 1999 or 1998 since
the realization of its deferred tax asset, consisting primarily of net operating
loss carryforwards, depends on generation of future taxable income.
Liquidity and Capital Resources
Liquidity. During the fiscal year 1998, Covol and its licensees completed the
construction of and began operations at 24 synthetic fuel facilities. Covol
currently owns four facilities which it constructed and which are being offered
for sale. Covol anticipates sale of these facilities during the year ending
September 30, 1999. The majority of the funds received from sale of these
facilities will be used to retire debt that was incurred principally in
connection with the construction and operation of these facilities and
activities relative to the completion of the other synthetic fuel facilities.
Operating expenses associated with the owned facilities currently cost
approximately $600,000 per month.
Net cash used in operating activities for the six months ended March 31, 1999
("1999") was $9,703,000. During the six months ended March 31, 1998 ("1998"),
net cash of $8,000 was provided by operations. Substantially all of this change
in cash flow from operations is attributable to the increase in net loss from
$185,000 in 1998 to $9,419,000 in 1999. Covol was able to fund its operating
activities, including the continued refinement and commercialization of its
patented binder technologies, through the incurrence of debt and the issuance of
convertible preferred stock, common stock and common stock warrants. During
1999, proceeds from the issuance of notes payable totaled approximately
$10,498,000, proceeds from the issuance of preferred stock totaled $6,394,000
and proceeds from the issuance of common stock totaled $3,774,000.
Capital Resources. During 1999, Covol's investing activities were not
significant. Investing activities in 1998 consisted primarily of the purchase of
property, plant and equipment and the four facilities held for resale, with most
of the funds for these activities coming from the issuance of notes payable
($16,338,000) and from working capital. Covol believes that funds required for
investing activities will continue to be significantly lower during 1999 as
compared to 1998 because the construction of facilities that produce synthetic
fuel that qualifies for federal income tax credits under Section 29 of the IRC
were completed during fiscal 1998. In order to receive tax credits under IRC
Section 29, the synthetic fuel sold must be produced at facilities placed in
service by June 30, 1998.
Covol's long term existence depends on the ability of Covol's licensees to
produce and sell synthetic fuel which will generate license fees to Covol. There
are 24 synthetic fuel plants that utilize Covol's patented technology and from
which Covol intends to earn license fees. These facilities do not presently
operate at levels needed to generate significant revenues to Covol. Improved
operations at each of these plants depend on the ability of the plant owner to
produce synthetic fuel that meets market specifications in order for the plant
owner to market the
22
synthetic fuel. Covol is assisting the plant owners in their efforts to overcome
production and marketing problems.
Covol anticipates that earned license fees or royalties from the production and
sale of synthetic fuel will continue to increase during 1999. As production
levels increase, sales of the binder materials by Covol to its licensees are
expected to increase proportionately. Funds received by Covol from these
activities are not expected to be sufficient to cover Covol's operating costs
and expenses until late 1999. Any extended delay in the sale of facilities held
for sale may require Covol to seek additional debt or equity financing.
To provide funding for Covol's operations and debt repayment requirements until
late 1999, Covol expects to utilize existing working capital and excess proceeds
from the sale of facilities. During November 1998, Covol issued common stock and
common stock warrants for total net proceeds of approximately $3,729,000. During
January 1999, Covol issued convertible preferred stock and warrants for total
net proceeds of approximately $900,000. During March 1999, Covol issued
convertible secured debt, convertible redeemable preferred stock and common
stock warrants for total net proceeds of approximately $14,800,000. Covol
believes current working capital, excess proceeds from the sale of facilities,
payments for license fees and binder sales, and funds raised in additional
financings, if necessary, will be sufficient to fund Covol's operations until
its operating activities begin producing positive cash flow. The ability of
Covol to pay its debt as it matures is dependent primarily upon Covol's ability
to sell the facilities which are held for sale. Covol believes the sale of
facilities or extensions of existing debt repayment terms will enable it to meet
these debt requirements.
Covol has agreed to certain covenants contained in the recently completed
financing documents. One covenant requires Covol to meet earnings targets for
the quarter ending December 31, 1999 and for subsequent quarters. Consolidated
earnings before interest, taxes, depreciation and amortization, and certain
other adjustments, of $5,000,000 or more are required for the quarter ending
December 31, 1999. The earnings target increases in subsequent quarters.
Non-compliance could result in penalty charges, acceleration of repayment,
increased interest or the assignment of royalty payments from related
collateral. There are other terms and conditions in these loan documents that
will restrict or prohibit certain activities.
Covol May Be Adversely Affected By Year 2000 Non-Compliance of Computer
Applications
The Year 2000 issue is the result of computer programs being written to define
the applicable year using two digits rather than four digits. Thus, programs
that are date sensitive may recognize a date using "00" as the year 1900 rather
than 2000. This could result in a systems failure or miscalculations causing
disruptions of operations including a temporary inability to engage in normal
business activities. This systems issue creates risk for Covol from unforseen
problems in its own computer systems and electronic equipment and from third
parties with which Covol conducts business. Such failures of Covol's and third
parties' computer systems could potentially have a material adverse impact on
Covol's business and results of operations. While the risks discussed in this
section have a possible material impact, management believes the actions and
contingency plans that are being developed and implemented will significantly
reduce the probability and potential impact of these identified risks.
The information systems and electronic equipment utilized in Covol's business
include a computer network system utilized for intra-company communication and
Internet access and an accounting software package utilized for billing,
procurement, payroll and accounting. Non-information technology electronic
equipment includes programmable logic controllers, micro-controllers,
specialized software packages for operations activities and miscellaneous
systems for lab equipment.
As a part of the information technology systems mentioned above, Covol's
computer network system was upgraded in 1998 with year 2000 compliant equipment.
The provider of the accounting software has indicated that this software package
is not currently compliant but can be upgraded at nominal cost. This work will
be undertaken during the third quarter of fiscal 1999 and tested prior to the
close of the fiscal year.
All of the synthetic fuel facilities constructed by Covol and its licensees were
completed and placed in service between December 1996 and June 30, 1998, with
the majority being completed during 1998. As such, the electronic equipment
utilized in the facilities is of recent vintage (within 18 months of the June 30
date) and is year 2000 compliant. Suppliers of the major electronic equipment
for Covol's four owned synthetic fuel facilities
23
have notified Covol that their equipment is compliant. This includes critical
programmable logic controllers, micro-controllers and software operating
packages.
Licensees utilize proprietary technology provided by Covol including flow sheets
and equipment recommended by Covol in the construction of their facilities.
These licensees have represented to Covol that equipment within these facilities
is compliant or that operations will not be impacted in the event of an
equipment failure due to the Year 2000 issue. Malfunctions occurring in the
synthetic fuel operations could potentially have an adverse material effect to
Covol by reducing the sale of binder formulation materials to the facilities by
Covol and the collection by Covol of royalties on the production of synthetic
fuel.
Covol's relationships with its third-party suppliers and transportation
providers is critical to the operation of the synthetic fuel facilities. Covol
is also dependent upon its customers who purchase and consume the synthetic fuel
produced. Covol's suppliers have represented to Covol that their computer
systems and equipment are year 2000 compliant.
The most reasonably likely worst case scenarios would be the extended inability
of major suppliers to deliver binder formulation materials and other bulk
materials required for the operation of the synthetic fuel facilities and the
failure of customers to be able to receive synthetic fuel production due to
unforseen shutdown due to non-compliant equipment.
As a contingency plan for the reasonably likely worst case events, Covol intends
to stock up on bulk materials in the last half of the fourth quarter of 1999 so
that operations can continue for several days into the new year without
interruption. Covol has designed its facilities to accommodate bulk deliveries.
Electrical power suppliers have notified Covol that power interruptions are not
anticipated but that additional crews will be on hand to respond to problems as
they may occur at the change to the new year. Covol and its licensees are also
prepared to bypass automated controls and operate facility systems manually if
the automated control systems fail. As supply contracts are written for
operating materials, Covol is striving to negotiate terms such that year 2000
issues are not an excuse for non-performance.
Costs attributable to Year 2000 issues are expected to be minimal. The only cost
anticipated to date is for the upgrade to Covol's accounting software package.
This cost is estimated to be less than $5,000. Costs associated with increased
levels of bulk materials simply redistributes normal operating costs but does
not affect the ultimate financial performance of Covol.
Covol plans to continue to monitor the Year 2000 issue throughout the remainder
of 1999. Should this monitoring reveal other developments, whether they be
internal or third party, or identify additional electronic equipment and
software that may be at risk, Covol will assess the situation and take
appropriate action. There can be no assurance that Covol will discover all Year
2000 issues in the course of the remainder of 1999 or that Covol will be able to
remedy any or all discoveries in a timely or cost effective manner such that the
Year 2000 issues will not have a material adverse impact on Covol's business,
financial condition and results of operations.
Forward Looking Statements
Statements in this Item 2 regarding Covol's expectations that relate to future
plans, financial results or performance and other information presented herein
that are not purely historical in nature, constitute forward-looking statements
within the meaning of the Private Securities Litigation Reform Act of 1995.
Although Covol believes that its expectations are based on reasonable
assumptions within the bounds of its knowledge of its business and operations,
there can be no assurance that actual results will not differ materially from
its expectations. In addition to matters affecting Covol's industry or the coal
industry or the economy generally, factors which could cause actual results to
differ from expectations set forth in the above-identified forward looking
statements include but are not limited to: Covol's ability to sell company-owned
synthetic fuel facilities, the ability of Covol to conserve its capital through
cost reductions until operating revenues exceed expenses, favorable IRS tax
treatment, the ability of Covol to complete specific research and development
projects, commercial viability of technologies, the availability of natural
resources and suitable raw materials, ability of Covol's licensees to achieve
expected production levels at the synthetic fuel and engineered resource
facilities, ability to market synthetic fuel and engineered resources produced,
market penetration by competing
24
technologies, the ability of Covol to meet performance criteria required in
financing agreements, and the ability of Covol to continue to find suitable
partners and licensees.
See "ITEM 1. BUSINESS--Forward Looking Statements" in Covol's Annual Report on
Form 10-K for the year ended September 30, 1998 for a description of additional
factors which could cause actual results to differ from expectations.
Other Items
Covol has reviewed all recently issued, but not yet adopted, accounting
standards in order to determine their effects, if any, on the results of
operations or financial position of Covol. Based on that review, Covol believes
that none of these pronouncements will have any significant effects on current
or future financial position or results of operations.
PART II -- OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Asbestos Investigation. In January 1996, a manager of Covol entered property
owned by Nevada Electric Investment Company, a subsidiary of Nevada Power
Corporation, in connection with an offer by Covol to purchase the property, and
with certain other employees of Covol, removed some asbestos over a two-day
period. In May 1996, Covol received a notice of violation and order for
compliance from the State of Utah, Division of Air Quality alleging that
asbestos was improperly handled, removed, and disposed of. Covol complied with
the order and in September 1996 entered into a settlement agreement with the
State of Utah and paid a fine in the amount of $11,000. In late 1997, the U.S.
Environmental Protection Agency began its own investigation, referring the
matter to the U.S. Attorney's office which proceeded with a grand jury inquiry.
Covol was served in September 1998 with a grand jury subpoena for records, with
which Covol has complied. Covol does not know the results of the grand jury
inquiry or whether the inquiry is completed. Covol does not believe that the
resolution of this matter will have a material adverse effect on Covol.
Indemnification to Centerline. In December 1996, Covol entered into six
indemnification agreements with Centerline whereby Covol agreed to indemnify
Centerline should it be required to pay liquidated damages to PacifiCorp under
various design and construction agreements for six synthetic fuel facilities.
Under the original terms of the various design and construction agreements, if
the facilities were not completed by June 1, 1998 then $750,000 in liquidated
damages for each facility would be due and payable by Centerline. The
indemnification agreement only applied if PacifiCorp actually decided to build
the facilities with Centerline as the design/builder. PacifiCorp elected to not
build three of the projects, and therefore the indemnity agreement with respect
to those facilities no longer applies. Accordingly, the maximum amount of
contingent liability to Covol under the indemnification agreements was
$2,250,000 ($750,000 per design and construction agreement). Centerline and
PacifiCorp initiated claims in arbitration against each other but have settled
their claims, including a release of claims against Covol for liquidated
damages.
ITEM 2. CHANGES IN SECURITIES
Recent Sales of Unregistered Securities
The following sets forth all securities issued by Covol within the past fiscal
quarter without registering the securities under the Securities Act of 1933, as
amended. No underwriters were involved in any stock issuances.
The issuance of qualified options is required to be based on market value.
Accordingly, the exercise price is set based on the market price of Covol's
common stock, even though the options convert into restricted stock.
25
Covol believes that the following issuances of shares of common stock or
securities for contingently issuable common stock were exempt from the
registration requirements of the Securities Act of 1933, as amended, pursuant to
the exemption set forth in Section 4(2) or 4(6) thereof or Regulation D
promulgated thereunder and the certificate for each security bears a restrictive
legend. Each investor made representations to Covol that it was accredited as
that term is defined in Regulation D and that the security was acquired for
investment purposes.
In January 1999, Covol issued to four accredited investors, pursuant to a
consulting compensation agreement dated August 1998, options to purchase an
aggregate of 60,000 shares of Covol common stock, at an exercise price of $12.75
per share. The exercise price will be reduced to $8.58 per share if a consulting
fee is not paid to the accredited investors as set forth in the consulting
compensation agreement. The options are nontransferable and include piggy-back
registration rights, which may be exercised two times. The options are
exercisable until August 2003, after which any unexercised options will expire.
Reference is made to the sale of series C convertible preferred stock and common
stock warrants described in Note 7 to the consolidated financial statements and
to the sale of series D redeemable cumulative convertible preferred stock and
common stock warrants described in Note 6 to the consolidated financial
statements.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
An annual meeting of stockholders of Covol was held on March 17, 1999 for the
following purposes:
1. To elect three class II directors of Covol to serve until the 2002
annual meeting of stockholders, or until their successors are duly
elected and qualified;
2. To ratify a grant by the Board of options to purchase 250,000 shares of
common stock to Brent M. Cook at $12.97 per share to vest pro rata over
60 months beginning on May 1, 1998;
3. To ratify the selection by the Board of PricewaterhouseCoopers LLP as
independent auditors of Covol for the fiscal year ending September 30,
1999.
A total of 8,648,365 shares were voted. The results of voting on these matters
were as follows:
1. Mr. Raymond J. Weller as a class II director: for - 8,179,645; withheld
authority - 468,720. Mr. DeLance W. Squire as a class II director: for
- 8,098,345; withheld authority - 550,020. Mr. Kirk A. Benson as a
class II director: for - 8,472,274; withheld authority 176,091.
2. To approve the 250,000 share option grant to Mr. Cook: for - 7,855,106,
against - 434,199; abstain -- 359,060.
3. To ratify the selection of PricewaterhouseCoopers LLP as auditors for
fiscal 1999: for - 8,334,938; against - 5,915, abstain - 307,512.
ITEM 5. OTHER INFORMATION
None.
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ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) The following exhibits are included herein:
10.59. Secured Draw Down Promissory Note dated June 12, 1998 executed by Covol
in favor of Trans Pacific Stores, Ltd.
10.59.1 Loan and Security Agreement dated June 12, 1998 executed by Covol in
favor of Trans Pacific Stores, Ltd.
10.59.2 Letter Amendment dated May 6, 1999 between Covol and Trans Pacific
Stores, Ltd.
27.1 Financial Data Schedule
(b) A report on Form 8-K was filed on March 24, 1999.
27
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
COVOL TECHNOLOGIES, INC.
Date: May 14, 1999 By: /s/ Kirk A. Benson
-----------------------------------
Kirk A. Benson, Chief Executive Officer
and Principal Executive Officer
Date: May 14, 1999 By: /s/ Steven G. Stewart
-----------------------------------
Steven G. Stewart, Chief Financial
Officer and Principal Financial Officer
28