UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q/A
[X] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the quarterly period ended December 31, 1998
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
February 12, 1999 was 12,494,029.
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 December 31, 1998........................................ 3
Consolidated Statements of Operations - For the three
months ended December 31, 1997 and 1998...................... 5
Consolidated Statement of Changes in Stockholders' Equity -
For the three months ended December 31, 1998................. 6
Consolidated Statements of Cash Flows - For the three
months ended December 31, 1997 and 1998...................... 7
Notes to Consolidated Financial Statements..................... 8
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS...................................... 18
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS.............................................. 23
ITEM 2. CHANGES IN SECURITIES.......................................... 23
ITEM 3. DEFAULTS UPON SENIOR SECURITIES................................ 24
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS............ 24
ITEM 5. OTHER INFORMATION.............................................. 25
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K............................... 25
SIGNATURES................................................................. 26
Statements in this Report, including those concerning the Registrant's
expectations regarding its business, and certain of the other information
presented 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 such expectations. For a discussion of certain
of the factors that could cause actual results to differ from expectations,
please see the caption entitled "Forward Looking Statements" in ITEM 2 hereof.
There can be no assurance that the Registrant's results of operations will not
be adversely affected by such factors. The Registrant 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)
As of As of
September 30, December 31,
(thousands of dollars) 1998 1998
- ------------------------------------------------------------------------------------------- ---------------- -----------------
ASSETS
Current assets:
Cash and cash equivalents $ 727 $ 675
Receivables 2,879 2,891
Due from related party 1,012 1,337
Inventories 1,645 1,805
Advances on inventories, current 2,522 990
Facilities held for sale 28,405 28,415
Prepaid expenses and other current assets 682 811
---------- ----------
Total current assets 37,872 36,924
---------- ----------
Property, plant and equipment, net of accumulated depreciation 14,986 15,088
---------- ----------
Other assets:
Restricted investments 748 891
Advances on inventories, non-current --- 1,914
Facility-dependent notes and accrued interest receivable, non-current 7,646 7,829
Facility transferred under note receivable arrangement 3,166 3,036
Intangible assets, net of accumulated amortization 3,118 3,617
Deposits and other assets 525 846
---------- ----------
Total other assets 15,203 18,133
---------- ----------
Total assets $ 68,061 $ 70,145
========== ==========
(continued)
The accompanying notes are an integral
Part of the consolidated financial statements
3
COVOL TECHNOLOGIES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS, continued
(Unaudited)
As of As of December
September 30, 31,
(thousands of dollars and shares) 1998 1998
- -------------------------------------------------------------------------------------------- --------------- ----------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 3,036 $ 3,366
Due to related party 1,609 1,870
Accrued liabilities 2,858 3,310
Notes payable, current 22,049 23,065
---------- ----------
Total current liabilities 29,552 31,611
---------- ----------
Long-term liabilities:
Notes payable, non-current 13,930 13,973
Notes and accrued interest payable - related parties, non-current 147 69
Accrued interest payable, non-current 566 157
Deferred revenues from advance license fees 8,377 8,150
Deferred compensation 236 239
---------- ----------
Total long-term liabilities 23,256 22,588
---------- ----------
Total liabilities 52,808 54,199
---------- ----------
Minority interest in consolidated subsidiaries 507 109
---------- ----------
Commitments and contingencies (Note 7)
Stockholders' equity:
Convertible preferred stock, $0.001 par value; authorized 10,000 shares,
issued and outstanding 316 shares at September 30, 1998 and 30 shares at
December 31, 1998 (aggregate liquidation preference of $3,454 at
December 31, 1998) 1 1
Common stock, $0.001 par value; authorized 25,000 shares, issued and
outstanding 11,272 shares at September 30, 1998 and 12,494 shares at
December 31, 1998 11 12
Capital in excess of par value - preferred 5,184 3,184
Capital in excess of par value - common 64,100 71,174
Accumulated deficit (43,002) (47,719)
Notes and interest receivable - related parties, from issuance of, or
collateralized by, common stock, net of allowance (7,773) (7,202)
Deferred compensation from stock options (3,775) (3,613)
---------- ----------
Total stockholders' equity 14,746 15,837
---------- ----------
Total liabilities and stockholders' equity $ 68,061 $ 70,145
========== ==========
The accompanying notes are an integral
Part of the consolidated financial statements
4
COVOL TECHNOLOGIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS (Note 1)
(Unaudited)
Three Months Ended December 31,
(thousands of dollars, except per-share amounts) 1997 1998
- ---------------------------------------------------------------------------------- --------------------- ---------------------
Revenues:
License fees $ 56 $ 701
Binder sales -- 533
Binder and coal fine sales - related party 7 141
Other 34 7
---------------- -----------------
Total revenues 97 1,382
---------------- -----------------
Operating costs and expenses:
Cost of coal briquetting operations 458 3,493
Cost of binder -- 376
Selling, general and administrative 741 929
Research and development 156 153
Compensation expense on stock options, stock warrants and
issuance of common stock 207 162
---------------- -----------------
Total operating costs and expenses 1,562 5,113
---------------- -----------------
Operating loss (1,465) (3,731)
---------------- -----------------
Other income (expense):
Interest income 39 756
Interest expense (1,112) (1,036)
Minority interest in net losses of consolidated subsidiaries 86 --
Write-up (write-down) of notes receivable - related parties,
collateralized by common stock 293 (571)
Other 15 24
---------------- -----------------
Total other income (expense) (679) (827)
---------------- -----------------
Net loss $ (2,144) $ (4,558)
================ =================
Basic and diluted net loss per common share $ (.24) $ (.39)
================ ================
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
(Unaudited)
Notes and
interest
receivable -
Convertible Preferred Stock Common Stock related parties,
------------------------------- -------------------------------- from issuance of, Deferred
Capital Capital or collaterlized compensation
(thousands of dollars excess of excess of Accumulated by, common from stock
and shares) Shares Amount par value Shares Amount par value deficit stock options
- ------------------- -------- -------- ----------- ---------- -------- ----------- ------------- --------------- ------------
Balances at
September 30, 1998 316 $1 $5,184 11,272 $11 $64,100 $(43,002) $(7,773) $(3,775)
Common stock issued
to purchase minority
interests in 92 -- 519
subsidiaries
Common stock issued
for cash, including
exercise of 776 1 3,774
stock options
Value of common
stock warrants
issued under
terms of
existing debt -- -- 247
agreement
Common stock issued
for rights to
certain technology 60 -- 375
Common stock issued
on conversion of
preferred stock
and accrued (286) -- (2,000) 308 -- 2,159 (159)
but undeclared
dividends
Return of previously
issued common stock
by a director (14) -- --
Write-down of notes
receivable - related
parties 571
Amortization of
deferred compensation
from stock options 162
Net loss for the
quarter ended
December 31, 1998 (4,558)
-------- -------- ----------- ---------- -------- ----------- ------------- --------------- ------------
Balances at
December 31, 1998 30 $1 $3,184 12,494 $12 $71,174 $(47,719) $(7,202) $(3,613)
======== ======== =========== ========== ======== =========== ============= =============== ============
The accompanying notes are an integral
Part of the consolidated financial statements
6
COVOL TECHNOLOGIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Three Months Ended December 31,
(thousands of dollars) 1997 1998
- ----------------------------------------------------------------------------------------- ------------------- -------------------
Cash flows from operating activities:
Net loss $ (2,144) $ (4,558)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization 65 408
Write-down (write-up) of notes receivable - related parties (293) 571
Interest expense related to amortization of value of common stock warrants -- 82
Interest expense based upon issuance of convertible debt and warrants at a 1,112 --
discount
Amortization of deferred compensation from stock options 207 162
Losses applicable to minority interests in subsidiaries (86) --
Increase (decrease) from changes in assets and liabilities, net of effects
from investing and financing activities 86 (887)
--------------- --------------
Net cash used in operating activities (1,053) (4,222)
--------------- --------------
Cash flows from investing activities:
Purchase of property, plant and equipment and facilities held for sale (4,978) (410)
Purchase of rights to technology -- (100)
Issuance of notes receivable (812) --
Proceeds from facility transferred under note receivable arrangement 84 130
Purchase of restricted investment -- (143)
--------------- --------------
Net cash used in investing activities (5,706) (523)
--------------- --------------
Cash flows from financing activities:
Proceeds from issuance of notes payable 3,095 1,049
Payments on notes payable - related parties (56) (78)
Proceeds from issuance of preferred stock, net 90 --
Proceeds from issuance of common stock, net 836 3,774
Proceeds from receivable - stock subscriptions 577 --
Other 2 (52)
--------------- --------------
Net cash provided by financing activities 4,544 4,693
--------------- --------------
Net decrease in cash and cash equivalents (2,215) (52)
Total cash and cash equivalents, beginning of period 4,780 727
--------------- --------------
Total cash and cash equivalents, end of period $ 2,565 $ 675
=============== ==============
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 accrued but
undeclared dividends -- 2,159
Common stock issued for rights to technology -- 375
Note payable issued for inventory 400 --
Note payable issued for equipment 1,971 --
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's primary business is to commercialize its binder technologies 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 December 31, 1998, Covol and its licensees
were operating 24 of these facilities in eight states at various levels of
production. 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 recurring 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. Covol also
anticipates receiving the final amounts of advance license fees totaling
approximately $4,000,000 during 1999. Funds received by Covol from these
activities are not expected to be sufficient to cover Covol's operating
costs and expenses until the third quarter of 1999. Covol anticipates that
these operating activities will be producing operating cash flow by the end
of 1999.
To provide funding for Covol's operations and debt repayment requirements
during early 1999, Covol will utilize proceeds from financing transactions
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. Covol is presently negotiating and finalizing definitive
agreements with respect to previously negotiated term sheets for the sale
of up to $16,000,000 of additional convertible preferred stock, which
financing is expected to close in February 1999. Covol believes the funds
raised in these financings and others, if necessary, excess proceeds from
the sale of facilities, and payments for license fees and binder sales will
be sufficient to fund Covol's operations and debt repayment requirements
until its operating activities begin producing positive cash flow.
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.
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.
Restatements and Reclassifications
After discussion with the staff of the Securities and Exchange Commission
("SEC") in September 1999, the Company has restated its 1998 and 1997
financial statements for the following items:
8
COVOL TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
(Unaudited)
----------
o To recognize cash received for non-refundable advance license fees on
a straight-line basis over the contractual term of the license
agreements, which is through 2007. Previously, the Company recognized
non-refundable advance license fees when received which was normally
when certain synthetic fuel facility construction milestones were met
or when the facilities were certified operational for their intended
use. This change in accounting policy does not affect the timing of
cash flows, and all amounts which have been received are
non-refundable. Also, the Company believes prior disclosures
concerning the amount and nature of these one-time fees were complete
and accurate and accordingly, no changes are being made to those
disclosures. The total amount of revenue ultimately recognized over
the period covered by the Company's license agreements with licensees
will not change, only the period in which the revenue is recognized.
o To de-recognize the sale of the Utah facility in 1997 and account for
this transaction in a manner similar to SEC guidance for the
divestiture of a business operation, as outlined under Staff
Accounting Bulletin (SAB) Topic 5:E. The note receivable related to
this transaction has been classified as a facility transferred under
note receivable arrangement. All note payments, including interest,
reduce the carrying amount of the recorded asset.
The combined effect of all of the above items is to decrease the 1998 net
loss by $179,000 and to increase the 1997 net loss by $1,028,000, as shown
in the following table.
(thousands of dollars) 1997 1998
---------------------------------------------------------------------------
As As As As
Reported Restated Reported Restated
------------------- --------------------
Total revenues $1,041 $97 $1,155 $1,382
Operating costs and expenses 1,561 1,562 5,140 5,113
------------------- ------------------
Operating loss (520) (1,465) (3,985) (3,731)
Other income (expense) (596) (679) (752) (827)
------------------- ------------------
Net loss ($1,116) ($2,144) ($4,737) ($4,558)
=================== ==================
Basic and diluted loss per
common share ($0.13) ($0.24) ($0.40) ($0.39)
=================== ==================
In addition to the above restatements, certain prior year amounts were
reclassified to conform with the current year's presentation. The
reclassifications had no effect on net loss or total assets.
2. Advances on Inventories
During 1997, Covol entered into an agreement to purchase coal fines and
through December 31, 1998 has made payments totaling approximately
$3,125,000, of which $221,000 has been transferred to cost of coal
briquetting operations. The net amount paid has been recorded as advances
on inventories. Covol expects to utilize some of these coal fines during
1999, 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.
9
COVOL TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
----------
3. Change in Carrying Value of Note Receivable
During the three months ended December 31, 1998, Covol increased the
allowance on the $5,000,000 face value note receivable from a stockholder
received from the 1996 sale of certain construction companies by
approximately $571,000, which adjusted the carrying value to $1,038,000 as
of December 31, 1998. During the three months ended December 31, 1997,
Covol decreased the allowance by approximately $293,000. 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 guaranteed by the buyer, who is the sole
stockholder of the construction companies, by 150,625 shares of Covol's
common stock held by Covol, and by options expiring in January 2006 to
acquire 25,000 shares of Covol's common stock committed by the stockholder
to be provided to Covol. The allowance is subject to future fluctuations in
the value of Covol's common stock. In February 1999, Covol received an
interest payment of $75,000 from the Note holder.
4. Notes Payable
Notes payable consist of the following:
September 30, December 31,
(thousands of dollars) 1998 1998
--------------------------------------------------------------------------------------- ------------------ ------------------
Note payable to a corporation bearing interest at prime (7.75% at December
31, 1998) 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 October 1999,
collateralized by a coal wash plant in Utah. 4,263 4,276
Notes payable to a corporation, bearing interest at 6%. 50% of accrued
interest due February 1999 and balance of accrued interest and principal due
February 2001. Collateralized by a synthetic fuel facility in West Virginia,
held for sale. 6,680 6,680
10
COVOL TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
----------
4. Notes Payable, continued
September 30, December 31,
(thousands of dollars, except per-share data) 1998 1998
------------------------------------------------------------------------------------- ------------------ ------------------
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 (see Note 8). 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 June 2000. 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 8,895
Note payable to a corporation, bearing interest at 15%, collateralized by a
synthetic fuel facility in Pennsylvania, held for sale, and 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 22%, 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 have an exercise price of $7.44 per share, expire in
October 2000 and were valued at approximately $247,000. A member of Covol's
Board of Directors is affiliated with this corporation. 4,000 4,000
Note payable to the same corporation referred to in the preceding paragraph,
bearing interest at 14%. Principal and accrued interest due March 1999,
collateralized by certain future license fees receivable by Covol. 4,000 4,000
Other 94 487
------------ -----------
35,979 37,038
Less: current portion 22,049 23,065
============ ===========
Total non-current $13,930 $13,973
============ ===========
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 11.4% at
December 31, 1998.
11
COVOL TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
----------
4. Notes Payable, continued
Interest Costs
During the three months ended December 31, 1998, Covol incurred total
interest costs of approximately $1,036,000 (including approximately $82,000
of amortization of value of common stock warrants issued under terms of an
existing agreement), none of which were capitalized. During the three months
ended December 31, 1997, Covol incurred total interest costs of
approximately $1,397,000 (including approximately $1,112,000 of non-cash
interest expense resulting from issuance of convertible debt at a discount),
of which approximately $285,000 was capitalized.
5. Basic and Diluted Loss per Share
(thousands of dollars and shares, except per-share data) 1997 1998
----------------------------------------------------------------------------------- ------------------- ------------------
Numerator:
Net loss $(2,144) $(4,558)
Preferred stock dividends (undeclared) (88) (60)
=================== ==================
Net loss attributable to common stockholders $(2,232) $(4,618)
=================== ==================
Denominator - weighted average shares outstanding 9,194 11,976
=================== ==================
Basic and diluted net loss per share $(.24) $(.39)
=================== ==================
6. Equity Transactions
Purchase of Limited Partners' Interests in Subsidiaries
In 1996, Covol formed two limited partnerships, Alabama Synfuel #1 Ltd. and
Utah Synfuel #1 Ltd., to assist with the financing of construction at two
synthetic fuel manufacturing facilities. These two facilities have been sold
and are now owned by Birmingham Syn Fuel, L.L.C. and Coaltech No. 1 L.P. In
September 1998, Covol offered the limited partners in Alabama Synfuel #1 and
Utah Synfuel #1 an exchange of Covol's common stock for their limited
partnership interests. The exchange ratio was based in part on an
independent valuation of the limited partnerships' assets and other factors
including but not limited to current and future expected cash flows of the
partnerships and the market value of Covol's common stock at the date of the
offer, which was $9.00 per share. As of November 10, 1998, all of the
limited partners in Utah Synfuel #1 and all but one of the limited partners
in Alabama Synfuel #1 had agreed to exchange their limited partnership
interests for shares of Covol's common stock, and accordingly Utah Synfuel
#1 became a wholly-owned subsidiary of Covol and Alabama Synfuel #1 became a
98%-owned subsidiary of Covol. Covol recorded this exchange using the market
values of Covol's common stock on the dates the limited partners tendered
acceptance of Covol's offer. These market values ranged from $6.75 to $11.13
per share. The excess of the value of the consideration paid for the
purchase of the limited partners' interests in subsidiaries over the fair
values of the related assets, which fair values approximated their carrying
cost, was recorded as an intangible asset.
12
COVOL TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
----------
6. Equity Transactions, continued
Sale of Common Stock
During November and December 1998, Covol completed a sale of 745,875 units
at $5.00 per unit, for total proceeds of approximately $3,729,000. Each unit
consisted of one share of restricted common stock, plus a warrant to
purchase one additional share of restricted common stock at an exercise
price of $7.50 per share. The warrants expire in November 1999 if not
exercised. Covol provided piggyback registration rights for the restricted
common shares and the shares issuable upon exercise of the warrants.
Technology Acquisition
Effective in November 1998, Covol acquired a coal-based synthetic fuel
technology, and related licensing and patent rights for $100,000 in cash,
60,000 shares of restricted common stock valued at $375,000 and a commitment
to make installment payments of $5,000 per month for 60 months if certain
events occur. 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. In connection with the acquisition of the technology, Covol
entered into a consulting agreement with the previous owner of the patent
rights to provide consulting services related to iron revert, coke,
charcoal, waste recycling, and other related applications. The consulting
agreement provides for monthly payments of $7,500 through November 2001. The
total cost of $475,000 is being amortized on a straight-line basis over
approximately nine years.
Preferred Stock Conversion
In October 1998, a total of approximately 308,000 shares of the common stock
were issued on conversion of approximately 286,000 shares of series B
preferred stock and related accrued but unpaid dividends.
Return of Stock Issued to Director
Covol previously issued 34,000 shares of common stock to a director as
compensation for services and financial assistance. Following negotiations
between Covol and this director, 14,000 shares of stock were cancelled in
December 1998. Reference is made to paragraph 7 in "Recent Sales of
Unregistered Securities" in Part II, Item 1. for a more detailed description
of this transaction.
Stock Options
During the quarter ended December 31, 1998, Covol granted options for the
purchase of a total of 322,000 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. In addition to these grants, in January 1999, Covol
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. 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.
13
COVOL TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
----------
7. Commitments and Contingencies
Commitments and contingencies as of December 31, 1998 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 December 31, 1998, there was $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 December 31, 1998
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 call 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 under these indemnification
agreements would be $2,250,000. The contractor and the contracting party
have initiated arbitration against each other including claims for
liquidated damages. Covol is closely monitoring the arbitration and believes
that payment of a material amount by Covol is unlikely.
In March 1997, Covol transferred the Utah Synfuel #1 facility to Coaltech.
In connection with this transaction, Utah Synfuel #1 licensed Coaltech to
use Covol's binder technologies for a non-refundable advance license fee of
$1,400,000, which is being recognized as income over the contractual term of
the license agreement of 2007, and a recurring license fee that is payable
quarterly and that 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. The limited partners of Coaltech have an
option wherein they can require Covol to repurchase this facility under
certain conditions. This put option can be exercised if 1) all of the
limited partners are unable to utilize the federal income tax credits under
Section 29 of the tax code, 2) the economic benefits accruing to or
experienced by all of the Coaltech limited partners differ significantly
from what was initially projected, or 3) there is a permanent force majeure
or material damage or destruction of the Utah facility. If the put option is
exercised prior to March 2000, the option price will be equal to the fair
market value of the limited partnership interests of the optionees on a
going concern basis, but in no event will the option price exceed 50% of the
capital contributions paid to Covol by Coaltech. If the put option is
exercised after March 2000, the option price will be $10. In accordance with
generally accepted accounting principles and after discussions with the
staff of the Securities and Exchange Commission, this transaction has not
been reflected as a sale for accounting purposes. The original cost of the
facility less cash payments received from Coaltech, is reflected in the
consolidated balance sheet as a facility transferred under note receivable
arrangement.
Additionally, Covol entered into a supply and purchase agreement with
Coaltech 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. As a result of this
14
COVOL TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
----------
7. Commitments and Contingencies, continued
Legal or Contractual Matters, continued
commitment to purchase Coaltech's production, Covol has experienced losses
related to the write-down of the synthetic fuel purchased to the lower of
cost or market. This write-down to date has approximated 85% of the amount
Covol has paid for the synthetic fuel. 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. Also, Covol
believes Coaltech can not require Covol to purchase product for which Covol
does not have outside third party sales, and further, Covol believes it has
the right to stop all production at the Utah facility in order to limit or
eliminate such losses.
In June 1996, Covol formed Alabama Synfuel #1 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 a dispute with the provider of the coal fines, the resolution of which
is not expected to have a material impact on Covol.
In May 1995, Covol entered into an agreement with Geneva Steel Company to
build and operate a commercial briquetting plant. The facility is not
currently operational and is expected to be moved from the Geneva site in
the near future. Covol may use this equipment for the production of
synthetic fuel or for testing purposes.
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. Covol's loan to Pace will be repaid 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 two quarterly loans totaling $1,500,000. 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 December
31, 1998, which amounts are believed to be approximately $612,000 in total.
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.
15
COVOL TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
----------
7. Commitments and Contingencies, continued
As of September 30, 1998 and December 31, 1998, Covol has recorded
liabilities to The Industrial Company ("TIC") totaling approximately
$735,000. In November 1998, Covol was served with liens from TIC in amounts
totaling approximately $1,150,000 for construction payments TIC claims are
due for certain synfuel facilities. Covol is negotiating with TIC for the
settlement and release of the liens and believes that payment of a material
amount beyond what has been accrued by Covol is unlikely.
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. Covol and
Coalco are negotiating to 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.
Covol is also involved in several legal proceedings that have arisen out of
the normal course of business. Covol believes that many of these claims are
without merit and in all cases intends to vigorously defend their position.
Management does not believe that the outcome of these activities will have a
significant effect upon the operations or the financial position of Covol.
Employment Contract
In January 1999, Covol entered into an employment agreement with an officer.
This agreement has a term of three years and provides for annual salaries
and benefits ranging from approximately $107,000 to $142,000. The agreement
provides for termination benefits under specific conditions of an amount
equal to one year's annual base salary.
8. Events Subsequent to December 31, 1998
Events subsequent to December 31, 1998 not disclosed elsewhere are as
follows:
Sale of Series C Convertible Preferred Stock
During January 1999, Covol completed a financing transaction with a
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
16
COVOL TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
----------
8. Events Subsequent to December 31, 1998, continued
$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.
Other
Covol is presently finalizing definitive agreements with respect to
previously negotiated term sheets for the sale of up to $16,000,000 of
additional convertible preferred stock, which financing is expected to close
in February 1999.
In May 1998, Covol entered into a construction and operation financing
agreement and a purchase option agreement to sell the Mountaineer synthetic
fuel facility to Mountaineer Synfuel, L.L.C., a Delaware limited liability
company. The purchase option expired unexercised on January 29, 1999. Under
the financing agreement, Covol is obligated to repay the loan (approximately
$8,895,000 at December 31, 1998 and $9,191,000 at January 29, 1999) with ten
percent interest in monthly interest only installments through June 1999 and
monthly principal and interest installments thereafter of $350,000, with a
balloon payment on June 30, 2000. Alternatively, if Covol sells the facility
before the loan repayment date, Covol must repay the loan from sale
proceeds. Covol continues to operate the project under contract with Savage
Industries Inc. Anker Energy Corporation supplies the facility with
feedstock and provides marketing services for the synthetic fuel produced.
Covol is actively seeking a purchaser for the Mountaineer facility and
expects the facility to be sold in its fiscal year 1999. However, Covol
cannot give assurance that it will successfully sell the facility.
17
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. Covol has restated its 1998 and 1997 financial statements as
described in Note 1 to the financial statements, Nature of Operations and Basis
of Presentation, Restatements and Reclassifications.
Three Months Ended December 31, 1998 Compared to Three Months Ended December 31,
1997
Revenues. Total revenues for the three months ended December 31, 1998
("1998") increased by $1,285,000 to $1,382,000 as compared to $97,000 for the
three months ended December 31, 1997 ("1997"). During 1998, Covol recognized
license fees totaling $701,000 while license fees of $56,000 were recognized
during 1997. The license fees in 1998 consisted of recurring license fees or
royalty payments of $475,000, substantially all of which were from a single
licensee, and the straight-line amortization of one-time non-refundable advance
license fees of $226,000, while the license fees in 1997 consisted solely of
amortization of one-time non-refundable advance license fees. Recurring 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 received when construction of the related synthetic fuel facility
begins, when construction is completed, or when certain construction milestones
or other specified conditions are met, but are recognized on a straight-line
basis over the period covered by Covol's license agreements with licensees.
Covol expects to receive approximately $4,000,000 of additional advance license
fees during 1999 upon the sale of certain synthetic fuel facilities currently
owned by Covol and upon the achievement of certain production levels at two of
the synthetic fuel facilities. Recurring license fees or royalty payments are
expected to increase at a moderate level in the near term with significant
increases expected during mid to 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
during 1998 were $533,000 with a corresponding direct cost to Covol of $376,000.
Covol had sales of binder and coal fines to a related party during 1998 totaling
$141,000 compared to $7,000 during 1997. These revenues resulted primarily from
coal fines that were sold to the related party at Covol's cost as provided for
under the binder and license agreement with this party.
Covol expects an increase during 1999 of production of synthetic fuel
by its licensees as licensees improve production capability and establish
marketing agreements for end product. 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 licensees must successfully obtain
adequate feedstock coal fines, process fines into synthetic fuel, and develop
markets for synthetic fuel. Covol believes that its licensees have made
significant progress in these areas during the quarter ended December 31, 1998,
but continued success cannot be assured.
Synthetic fuel is a relatively new product and competes with standard
coal products. Industrial coal users must be satisfied that the synthetic fuel
is a suitable substitute for standard coal products. Moisture content, hardness,
special handling requirements and other characteristics of the synthetic fuel
product may affect its marketability, including sales price. Many industrial
coal users are also limited in the amount of synthetic fuel product they can
purchase because they have committed to purchase a substantial portion of their
coal requirements through long-term contracts. Reliance on spot markets and the
overall downward trend in coal prices have generally produced lower sales prices
compared to long-term coal supply contracts in the utility industry. To date,
Covol owned facilities and licensees have secured contracts for the sale of only
a portion of their production. The suitability of synthetic fuel as a coal
substitute, particularly the quality characteristics of synthetic fuel, and the
traditional long-term supply contract practices of fuel buying in the utility
industry have made the identification of purchasers of synthetic fuel difficult.
Because synthetic fuel is a coal substitute, the market and price are as broad
and varied as the coal market itself. The US coal market exceeds one billion
tons annually, and the prices range from approximately $12 to $35 per ton in the
areas where facilities using the Covol technology are located. Prices are
dependent on many factors, including Btu content, ash and sulfur content,
18
moisture, location, etc. Covol believes that once initial market resistance is
overcome long-term contracts will be secured for the synthetic fuel, and that
Covol and its licensees will be able to market all synthetic fuel produced at
prices similar to coal.
Our accounting and valuation procedures assume all of the Covol owned
facilities qualify for section 29 tax credits so that synthetic fuel production
will continue to be the highest and best use of our equipment and facilities. If
the facilities lost their qualification under Section 29, the equipment and
facilities' carrying value would likely be higher than the fair value based on
the alternative highest and best use, which could result in an impairment charge
at that time.
Operating Costs and Expenses. Operating costs and expenses increased by
$3,551,000 to $5,113,000 during 1998 from $1,562,000 during 1997. Cost of coal
briquetting operations accounted for most of this variance as these costs
increased $3,035,000 from $458,000 during 1997 to $3,493,000 during 1998. During
1998, 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 and synthetic fuel plant
located in Utah, discussed below, costs incurred in providing assistance to
Covol's licensees during the ramp-up of their synthetic fuel facilities, and
increased personnel costs. Covol expects to continue incurring losses into 1999
until the four facilities which it owns are sold, but 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 all of the synthetic
fuel produced by Coaltech at cost plus $1 per ton. Production of synthetic fuel
from this facility during 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
$1,150,000 during 1998 and $240,000 during 1997. Covol expects the excess cost
per ton to decrease in 1999 as production volumes increase. Covol believes that
it can limit or stop the amount of production at the Utah facility at any time
to production amounts that Covol is able to sell to independent third parties.
Covol has operated the Utah facility at a loss because of the need to
gain operating experience (it was the first synthetic fuel facility Covol built
and operated), test alternative production methods, maintain operational status
for Section 29 qualification, maintain the relationship with AJ Gallagher, an
owner of the Utah facility who is a major licensee and partner of Covol, and
other related business reasons.
Selling, general and administrative expenses increased $188,000 or 25%
to $929,000 during 1998 from $741,000 for 1997. The largest components of
selling, general and administrative expenses for both periods were payroll,
professional services and travel expenses. Payroll costs increased approximately
$45,000 and professional services increased approximately $172,000, while travel
costs decreased approximately $37,000. Most of the increase in professional
services was due to increased legal costs.
Research and development costs decreased marginally during 1998. Covol
expects that research and development costs will increase in 1999 as Covol
focuses resources on further refinement of its binder technologies relative to
the synthetic fuel industry and the application of its binder technologies into
other areas.
Compensation expense on stock options, stock warrants, and issuance of
common stock decreased $45,000 to $162,000 for 1998 from $207,000 for 1997. 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.
Other Income and Expense. During 1998, Covol had net other expenses of
$827,000 compared to $679,000 for 1997. This increase of $148,000 relates
primarily to a change between periods of $864,000 in the
19
mark-to-market adjustment of the carrying value of related party notes
receivable collateralized by common stock, offset in part by an increase in
interest income of $717,000.
During 1996, Covol sold certain construction companies and received as
consideration a $5,000,000 note receivable ("Note") with interest at 6% payable
over five years. It was determined that the Note should be discounted to an
appropriate market rate and accordingly, the Note was discounted at 10.25%
resulting in a discount of $1,281,000. The Note is guaranteed by the buyer of
the construction companies and is collateralized by stock and stock options of
Covol. Accordingly, 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 $571,000 during 1998, compared to a write-up of $293,000 during 1997. A
$515,000 payment on the Note was due in January 1999, of which $75,000 was
received. The balance of the January payment is expected to be received in the
quarter ending March 31, 1999. As of December 31, 1998 the Note had a carrying
value of $1,038,000. Included in interest income for 1998 is $515,000 related to
this Note.
Interest expense in 1997 consisted solely of expense based upon the
issuance of convertible debt and warrants at a discount. During December 1997,
Covol executed an amendment to a loan agreement with a licensee, which provided
funding for completing construction of a synthetic fuel facility in Alabama and
acquiring coal fines and for other purposes related to the facility. The
modification increased the amount available for borrowing with a provision that
borrowings were convertible into common stock under the same terms as the
original agreement. Based on the revised terms, an expense of approximately
$714,000 was recognized during the quarter for conversion rights issued at a
price below market. In October 1997, Covol entered into an agreement with
another licensee whereby the licensee agreed to finance a wash plant being
constructed by Covol to provide washed coal fines to a synthetic fuel facility
in Utah. As additional consideration to the licensee for the financing
arrangement, Covol granted warrants to purchase Covol common stock, resulting in
the recognition of approximately $398,000 of interest expense in that quarter.
Interest expense in 1998 consists of interest accrued on notes payable used to
finance the construction of synthetic fuel facilities held for sale and for
operating needs and includes $82,000 of amortization of value of common stock
warrants issued under terms of an existing debt agreement. Interest expense is
expected to decrease after the repayment 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
$86,000 in 1997 to approximately $0 in 1998. 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 1998, the net loss increased by $2,414,000 from
$2,144,000 for 1997 to $4,558,000. The increase is primarily due to the
significant increase in the cost of briquetting operations, which was partially
offset by increased license fees and increased interest income as discussed
previously. Covol did not recognize any income tax benefit in 1998 or 1997 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 either under option to purchase or 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.
20
Net cash used in operating activities increased by $3,169,000 to
$4,222,000 during 1998 from $1,053,000 during 1997. 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 related common stock
warrants. During 1998, proceeds from the issuance of notes payable totaled
approximately $1,049,000 and issuances of common stock totaled $3,774,000.
Capital Resources. During the quarter ended December 31, 1998, Covol
used net cash in its investing activities totaling $523,000 compared to
$5,706,000 for 1997. These uses consisted principally of purchases of property,
plant and equipment. In 1997, a major portion of the purchases related to the
four facilities currently held for sale. Covol believes that funds required for
investing activities will be significantly less during 1999 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.
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. Covol also anticipates
receiving the final amounts of advance license fees totaling approximately
$4,000,000 during 1999. Funds received by Covol from these activities are not
expected to be sufficient to cover Covol's operating costs and expenses until
the third quarter of 1999. Covol anticipates that these operating activities
will be producing operating cash flow by the end of 1999.
In order for operating activities to produce significant positive cash
flows, Covol and its licensees must successfully address certain operating
issues and marketing difficulties which have negatively affected cash flows and
increased capital requirements. Operating issues which must be addressed
include, but are not limited to, feedstock availability, cost, moisture content,
Btu content, correct application of binder formulation, operability of
equipment, product durability, resistance to water absorption and overall costs
of operations, which in many cases to date have resulted in unit costs in excess
of synthetic fuel sale prices. Marketing difficulties which must be addressed
relate to market acceptance of products manufactured using our technology.
Industrial coal users must be satisfied that the synthetic fuel is a suitable
substitute for standard coal products. Moisture content, hardness, special
handling requirements and other characteristics of the synthetic fuel product
may affect its marketability and its sales price. Many industrial coal users are
also limited in the amount of synthetic fuel product they can purchase from us
and our licensees because they have committed to purchase a substantial portion
of their coal requirements through long-term contracts. Reliance on spot markets
and the overall downward trend in coal prices have generally produced lower sale
prices compared to long-term coal supply contracts in the utility industry. To
date, our owned facilities and licensees have secured contracts for the sale of
only a portion of their production. The suitability of synthetic fuel as a coal
substitute, particularly the quality characteristics of synthetic fuel, and the
traditional long-term supply contract practices of fuel buying in the utility
industry have made the identification of purchasers of synthetic fuel difficult.
Covol believes that once initial market resistance is overcome, long term
contracts will be secured for the synthetic fuel, and that Covol and its
licensees will be able to market all synthetic fuel produced at prices similar
to coal.
To provide funding for Covol's operations and debt repayment
requirements during early 1999, Covol will utilize proceeds from financing
transactions 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.
Covol is presently negotiating and finalizing definitive agreements with respect
to previously negotiated term sheets for the sale of up to $16,000,000 of
additional convertible preferred stock, which financing is expected to close in
February 1999. Covol believes the funds raised in these financings and others,
if necessary, excess proceeds from the sale of facilities, and payments for
license fees and binder sales will be sufficient to fund Covol's operations and
debt repayment requirements until its operating activities begin producing
positive cash flow.
21
Forward Looking Statements
Statements in this Item 2 regarding Covol's expectations as to the
financing, development and operation of facilities utilizing Covol's binder
technologies, the receipt of licensing and royalty fees, revenues, the receipt
of fees for sale of binder materials, and other information presented herein
that are not purely historical by 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 in part, the following:
o the ability of licensees to produce and sell synthetic fuel at or near
the rated capacity of the synthetic fuel facilities;
o ability to obtain needed additional capital on terms acceptable to
Covol;
o changes in governmental regulation or failure to comply with existing
regulations which may result in operational shutdowns of its facilities;
and
o the availability of tax credits under Section 29 of the tax code.
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.
Year 2000 Issues
The year 2000 issue results from computer programs and electronic
circuitry that do not differentiate between the year 1900 and year 2000 because
they are written using two-digit rather than four-digit dates to define the
applicable year. Many computer applications and date-sensitive devices could
fail or produce erroneous results when processing data after December 31, 1999.
Covol does not have any computer applications that it believes are
mission critical to the operation of synthetic fuel facilities that it operates.
While Covol has not formally verified Year 2000 compliance with licensees that
utilize Covol's technology in their synthetic fuel facilities, it is believed
that the computer applications used in the operations of these facilities are
not mission critical. Accordingly, it is believed that Year 2000 issues will not
be significant to these computer applications and accordingly, upgrading or
modifications to these applications to make them Year 2000 compliant will not be
significant.
During fiscal year 1998, Covol upgraded its network operating system
and believes that system is Year 2000 compliant and that any additional
upgrading to that system will not be significant. Covol utilizes computer
applications in the finance and accounting departments and in the corporate
office that utilize a two-digit date that will need to be upgraded in order to
be Year 2000 compliant. Covol has contacted the providers of this software and
they have indicated that Year 2000 compliant software will be available in early
1999. Covol believes the cost to purchase this upgraded software and to convert
the applicable applications to this new software will be less than $50,000.
Covol anticipates that this conversion will be completed by June 30, 1999.
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.
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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 is $2,250,000
($750,000 per design and construction agreement). Counsel for Centerline has
notified Covol that a dispute exists between Centerline and PacifiCorp, which
may require indemnification by Covol. Covol has been advised that the dispute is
proceeding to arbitration.
ITEM 2. CHANGES IN SECURITIES
Recent Sales of Unregistered Securities
The following sets forth all securities issued by Covol within the past
fiscal quarter and subsequent to December 31, 1998 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.
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 1996, Covol formed two limited partnerships, Alabama Synfuel #1 Ltd.
and Utah Synfuel #1 Ltd., to assist with the financing of construction at two
synthetic fuel manufacturing facilities. These two facilities have been sold and
are now owned by Birmingham Syn Fuel, L.L.C. and Coaltech No. 1 L.P. On
September 9, 1998, Covol offered the limited partners in Alabama Synfuel #1 and
Utah Synfuel #1 an exchange of Covol's common stock for their limited
partnership interests. The exchange ratio was based in part on an independent
valuation of the limited partnerships' assets and other factors including but
not limited to current and future expected cash
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flow of the partnerships and current market values of Covol's common stock as
quoted on NASDAQ. The exchange ratio for Utah Synfuel #1 was 112.828 shares of
common stock per each limited partnership unit and 125.97 shares for each
Alabama Synfuel #1 limited partnership unit. The limited partnerships' units
originally sold for $1,000 per unit.
As of November 10, 1998, all of the limited partners in Utah Synfuel #1
and all but one of the limited partners in Alabama Synfuel #1 had agreed to
exchange their limited partnership interests for shares of Covol's common stock,
and accordingly Utah Synfuel #1 became a wholly-owned subsidiary of Covol and
Alabama Synfuel #1 became a 98%-owned subsidiary of Covol.
During November 1998, Covol completed a financing transaction that
consisted of $400,000 of debt and approximately $3,500,000 of equity issued to
28 investors. The debt had a term of twelve months, bears interest at 15% per
annum, with an interest only payment due in six months and with the balance of
interest and principal due at maturity. The debt is collateralized by certain
assets of Covol and is due prior to maturity upon the placement of long-term
financing by Covol. The equity transaction consisted of the sale of a unit at a
price of $5.00. A unit consisted of one share of restricted common stock of
Covol plus a warrant to purchase one additional share of restricted common stock
at an exercise price of $7.50. The warrants expire in twelve months if not
exercised. The stock and shares issuable pursuant to the related warrants bear
"piggyback" registration rights.
In March 1996, Raymond G. Weller made a personal loan of $459,250 to
Covol at the request of Covol's then CEO and CFO at a time when Covol was in
great financial need. This loan was repaid in 1996 through the issuance of Covol
common stock to Mr. Weller. It appears that the then management committed Covol
to issue to Mr. Weller up to 34,000 shares of Covol common stock as compensation
for the personal risk taken by Mr. Weller. The CEO and CFO left Covol in October
1996 before the transaction was completed. Mr. Weller continued to support Covol
and provided leadership and guidance as a director through the period of
transition between prior and current management. After confirming the
circumstances surrounding the transaction, Covol's current management negotiated
a resolution of the matter with Mr. Weller, and approved the issuance of 20,000
shares of restricted stock in complete satisfaction of any obligation Covol may
have to Mr. Weller with respect to this transaction. The Board has approved the
resolution.
On December 3, 1998, Covol issued 60,000 shares of Covol common stock
to a single investor as partial consideration for the purchase of a patent and
related intellectual property rights with respect to an alternative method of
production of solid synthetic fuel.
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
described in Note 8 to the consolidated financial statements.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
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ITEM 5. OTHER INFORMATION
Technology Acquisition
Effective as of November 10, 1998, Covol acquired a coal-based
synthetic fuel technology known as Carbontite(R), along with related licensing
and patent rights owned by Dr. James G. Davidson and Adtech, Inc., including
U.S. Patent No. 5,238,692. This acquisition transferred to Covol, in exchange
for $100,000 and the issuance of 60,000 shares of Covol common stock, patent
ownership and licensor rights and obligations to existing license agreements
with Carbontech Energy Corporation ("CEC"), which in turn has sublicensed the
technology to Carbontronics, the developer of the following synthetic fuel
facilities:
Location Rated Annual Capacity
Gibraltar, KY 600,000 tons
Lynnville, IN 600,000 tons
Metropolis, IL 1,200,000 tons
The Gibraltar, Kentucky and Lynnville, Indiana synthetic fuel
facilities are located at Peabody coal mine sites and are operated by Peabody.
The Metropolis facilities are located at the Cook coal terminal operated by
American Electric Power.
As the owner of the Carbontite(R) technology and related license
rights, Covol is to receive from CEC a share of the license fees paid to
Carbontec by sublicensees, plus a prescribed royalty per ton of the finished
product sold in plants operated by CEC or its sublicensees. The existing
assigned license agreements do not provide for sale of chemical binder to
licensees.
In connection with the acquisition of the Carbontite(R) technology,
Covol entered into a consulting agreement with Dr. Davidson to provide
consulting services related to iron revert, coke, charcoal, waste recycling, and
other related applications. In addition, Dr. Davidson granted rights to Covol
for implementation of other technologies related to the business activities of
Covol.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) The following exhibits are included herein:
27.1 Restated Financial Data Schedule
(b) No reports on Form 8-K were filed during the three months ended
December 31, 1998.
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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: October 6, 1999 By: /s/ Kirk A. Benson
----------------------------------------
Kirk A. Benson, Chief Executive Officer
and Principal Executive Officer
Date: October 6, 1999 By: /s/ Steven G. Stewart
----------------------------------------
Steven G. Stewart, Chief Financial
Officer and Principal Financial Officer
26