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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, 2005.
Commission file number: 0-23336
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AROTECH CORPORATION
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(Exact name of registrant as specified in its charter)
Delaware 95-4302784
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
354 Industry Drive, Auburn, Alabama 36830
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(Address of principal executive offices) (Zip Code)
(334) 502-9001
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(Registrant's telephone number, including area code)
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(Former address, 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 |_|
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes |X| No |_|
APPLICABLE ONLY TO CORPORATE ISSUERS:
The number of shares outstanding of the issuer's common stock as of April 30,
2005 was 80,105,018.
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AROTECH CORPORATION
INDEX
PART I - FINANCIAL INFORMATION
Item 1 - Interim Consolidated Financial Statements (Unaudited):
Consolidated Balance Sheets at March 31, 2005 and December 31, 2004............................ 3
Consolidated Statements of Operations for the Three Months Ended March 31, 2005 and 2004....... 5
Consolidated Statements of Changes in Stockholders' Equity during the Three-Month Period Ended
March 31, 2005............................................................................. 6
Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2005 and 2004....... 7
Note to the Interim Consolidated Financial Statements.......................................... 11
Item 2 - Management's Discussion and Analysis of Financial Condition and Results of Operations. 17
Item 3 - Quantitative and Qualitative Disclosures about Market Risk............................ 38
Item 4 - Controls and Procedures............................................................... 39
PART II - OTHER INFORMATION
Item 2 - Unregistered Sales of Equity Securities and Use of Proceeds........................... 41
Item 6 - Exhibits.............................................................................. 41
SIGNATURES.......................................................................................... 42
2
AROTECH CORPORATION
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ITEM 1. INTERIM CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
CONSOLIDATED BALANCE SHEETS
(U.S. Dollars)
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March 31, 2005 December 31, 2004
----------- -----------
ASSETS (Unaudited)
CURRENT ASSETS:
Cash and cash equivalents ............................................... $ 2,672,140 $ 6,734,512
Restricted collateral deposits and restricted held to maturity securities 7,028,142 6,962,110
Available-for-sale marketable securities ................................ 135,147 135,568
Trade receivables (net of allowance for doubtful accounts in the
amount of $53,838 and $55,394 as of March 31, 2005 and December 31,
2004, respectively) ................................................... 6,419,665 8,266,880
Unbilled receivables .................................................... 3,230,552 2,881,468
Other accounts receivable and prepaid expenses .......................... 1,426,548 1,339,393
Inventories ............................................................. 8,846,081 7,277,301
----------- -----------
Total current assets .......................................... 29,758,275 33,597,232
----------- -----------
SEVERANCE PAY FUND .......................................................... 2,022,289 1,980,047
RESTRICTED SECURITIES AND DEPOSITS .......................................... 4,000,000 4,000,000
PROPERTY AND EQUIPMENT, NET ................................................. 4,491,995 4,600,691
OTHER INTANGIBLE ASSETS, NET ................................................ 13,617,569 14,368,701
GOODWILL .................................................................... 39,669,212 39,745,516
----------- -----------
$93,559,340 $98,292,187
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The accompanying notes are an integral part of the
Consolidated Financial Statements.
3
CONSOLIDATED BALANCE SHEETS
(U.S. Dollars, except share data)
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March 31, 2005 December 31, 2004
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(Unaudited)
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES:
Trade payables .......................................................................... $ 4,023,471 $ 6,177,546
Other accounts payable and accrued expenses ............................................. 5,057,280 5,818,188
Current portion of promissory notes due to purchase of subsidiaries ..................... 13,510,325 13,585,325
Short-term bank loans and current portion of long-term loans ............................ 68,851 181,352
Deferred revenues ....................................................................... 715,920 618,229
------------- -------------
Total current liabilities .................................................................... 23,375,847 26,380,640
LONG TERM LIABILITIES
Accrued severance pay ................................................................... 3,543,312 3,422,951
Convertible debenture ................................................................... 2,147,346 1,754,803
Deferred revenues ....................................................................... 141,790 163,781
Long-term note .......................................................................... 10,319 20,891
Long-term portion of promissory note due to purchase of subsidiaries .................... 982,738 980,296
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Total long-term liabilities .................................................................. 6,825,505 6,342,722
MINORITY INTEREST ............................................................................ 128,658 95,842
SHAREHOLDERS' EQUITY:
Share capital -
Common stock - $0.01 par value each;
Authorized: 250,000,000 shares as of March 31, 2005 and December 31,
2004; Issued: 80,659,002 shares as of March 31, 2005 and 80,637,002
shares as of December 31, 2004; Outstanding - 80,103,669 shares as
of March 31, 2005 and 80,081,669 shares as of December 31, 2004 ..................... 806,590 806,370
Preferred shares - $0.01 par value each;
Authorized: 1,000,000 shares as of March 31, 2005 and December 31,
2004; No shares issued and outstanding as of March 31, 2005 and
December 31, 2004 ................................................................... -- --
Additional paid-in capital .............................................................. 189,276,362 189,266,103
Accumulated deficit ..................................................................... (121,410,053) (118,953,553)
Deferred stock compensation ............................................................. (1,025,556) (1,258,295)
Treasury stock, at cost (common stock - 555,333 shares as of March 31,
2005 and December 31, 2004) ........................................................... (3,537,106) (3,537,106)
Notes receivable from stockholders ...................................................... (1,229,850) (1,222,871)
Accumulated other comprehensive income .................................................. 348,943 372,335
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Total shareholders' equity ................................................................... 63,229,330 65,472,983
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$ 93,559,340 $ 98,292,187
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The accompanying notes are an integral part of the
Consolidated Financial Statements.
4
CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
(U.S. Dollars, except share data)
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Three months ended March 31,
----------------------------
2005 2004
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Revenues ............................................................. $ 10,387,445 $ 7,182,254
Cost of revenues ..................................................... 6,371,874 4,557,220
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Gross profit ......................................................... 4,015,571 2,625,034
Operating expenses:
Research and development ........................................ 414,678 463,506
Selling and marketing ........................................... 1,158,820 1,021,084
General and administrative ...................................... 3,356,412 2,088,136
Amortization of intangible assets ............................... 823,088 496,013
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Total operating costs and expenses ................................... 5,752,998 4,068,739
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Operating loss ....................................................... (1,737,427) (1,443,705)
Financial expenses, net .............................................. (468,855) (1,078,545)
------------ ------------
Loss before income taxes ............................................. (2,206,282) (2,522,250)
Income tax income (expenses), net .................................... (217,264) 4,907
------------ ------------
Loss before minority interest in earnings of a subsidiary and income . (2,423,546) (2,517,343)
tax expenses
Minority interest in earnings of a subsidiary ........................ (32,954) (546)
------------ ------------
Net loss ............................................................. (2,456,500) (2,517,889)
Deemed dividend to certain stockholders of common stock .............. -- (1,163,000)
------------ ------------
Net loss attributable to common stockholders ......................... $ (2,456,500) $ (3,680,889)
============ ============
Basic and diluted net loss per share from continuing operations ...... $ (0.03) $ (0.04)
============ ============
Basic and diluted net loss per share ................................. $ (0.03) $ (0.06)
============ ============
Weighted average number of shares used in computing basic net loss per
share .............................................................. 80,102,089 59,406,466
============ ============
The accompanying notes are an integral part of the
Consolidated Financial Statements.
5
AROTECH CORPORATION
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
(U.S. Dollars, except share data)
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Common Stock Additional Deferred
--------------------------- paid-in stock Accumulated Treasury
Shares Amount capital compensation deficit stock
------------- ------------- ------------- ------------- ------------- -------------
BALANCE AT JANUARY 1, 2005 - . 80,637,002 $ 806,370 $ 189,266,103 $ (1,258,295) $(118,953,553) $ (3,537,106)
NOTE 1
CHANGES DURING THE THREE-MONTH
PERIOD ENDED MARCH 31, 2005
Compensation related to
non-recourse loan granted
to shareholder .......... -- -- (11,500) -- -- --
Issuance of shares to
employees ............... 10,000 100 (100) -- -- --
Exercise of options by
employees ............... 12,000 120 14,880 -- -- --
Amortization of deferred
stock compensation ...... -- -- -- 232,739 -- --
Interest accrued on notes
receivable from
shareholders ............ -- -- 6,979 -- -- --
Other comprehensive loss -
foreign currency
translation adjustment .. -- -- -- -- -- --
Other comprehensive loss -
unrealized gain on
available for sale
marketable securities ... -- -- -- -- -- --
Net loss ................... -- -- -- -- (2,456,500) --
------------- ------------- ------------- ------------- ------------- -------------
Total comprehensive loss ... -- -- -- -- -- --
BALANCE AT MARCH 31, 2005 -
UNAUDITED 80,659,002 $ 806,590 $ 189,276,362 $ (1,025,556) $(121,410,053) $ (3,537,106)
============= ============= ============= ============= ============= =============
Notes Accumulated
receivable other Total
from comprehensive comprehensive
shareholders income (loss) loss Total
------------- ------------- ------------- -------------
BALANCE AT JANUARY 1, 2005 - . $ (1,222,871) $ 372,335 $ -- $ 65,472,983
NOTE 1
CHANGES DURING THE THREE-MONTH
PERIOD ENDED MARCH 31, 2005
Compensation related to
non-recourse loan granted
to shareholder .......... -- -- -- (11,500)
Issuance of shares to
employees ............... -- -- -- --
Exercise of options by
employees ............... -- -- -- 15,000
Amortization of deferred
stock compensation ...... -- -- -- 232,739
Interest accrued on notes
receivable from
shareholders ............ (6,979) -- -- --
Other comprehensive loss -
foreign currency
translation adjustment .. -- (24,619) (24,619) (24,619)
Other comprehensive loss -
unrealized gain on
available for sale
marketable securities ... -- 1,227 1,227 1,227
Net loss ................... -- -- (2,456,500) (2,456,500)
------------- ------------- ------------- -------------
Total comprehensive loss ... -- -- $ (2,479,892) --
=============
BALANCE AT MARCH 31, 2005 -
UNAUDITED $ (1,229,850) $ 348,943 $ 63,229,330
============= ============= =============
The accompanying notes are an integral part of the
Consolidated Financial Statements.
6
AROTECH CORPORATION
CONSOLIDATED STATEMENT OF CASH FLOWS (UNAUDITED) (U.S. Dollars)
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Three months ended March 31,
----------------------------
2005 2004
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CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss for the period before deemed dividend to certain stockholders of common stock $ (2,456,500) $ (2,517,889)
Adjustments required to reconcile net loss to net cash used in operating activities:
Depreciation ........................................................................ 298,110 236,408
Amortization of intangible assets ................................................... 823,088 496,013
Amortization of compensation related to warrants issued to the holders of convertible
debentures and beneficial conversion feature ...................................... 392,543 921,684
Amortization of deferred expenses related to convertible debenture issuance ......... 12,128 73,667
Amortization of capitalized research and development projects ....................... 30,710 9,163
Stock-based compensation due to shares granted and to be granted to consultants and
shares granted as a donation ...................................................... 58,560 --
Stock based compensation due to options granted to employees and directors .......... 98,639 --
Stock based compensation due to shares granted to employees ......................... 134,100 --
Adjustment of stock based compensation related to non-recourse note granted to
stockholder ....................................................................... (11,500) 4,500
Write-off of inventory .............................................................. -- 41,487
Earnings to minority ................................................................ 32,954 546
Interest expenses accrued on promissory notes issued to purchase of subsidiary ...... 2,442 --
Interest accrued on certificates of deposit due within one year ..................... (58,188) (33,738)
Amortization of premium related to restricted securities ............................ 38,794 33,993
Capital gain from sale of property and equipment .................................... -- (5,744)
Interest accrued on long-term loans ................................................. -- 449
Liability for employee rights upon retirement, net .................................. 57,666 (383,589)
Decrease (increase) in deferred tax assets .......................................... 72,624 (16,809)
Changes in operating asset and liability items:
Decrease in trade receivables ....................................................... 1,822,948 2,206,100
Decrease (increase) in unbilled receivables ......................................... (349,083) 544,000
Decrease (increase) in other accounts receivable and prepaid expenses ............... (194,297) 76,912
Increase in inventories ............................................................. (1,447,620) (1,398,145)
Decrease in trade payables .......................................................... (2,130,990) (53,819)
Increase (decrease) in deferred revenues ............................................ 75,700 (467,562)
Decrease in accounts payable and accruals ........................................... (754,834) (1,184,388)
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Net cash used in operating activities from continuing operations (reconciled from .... (3,452,006) (1,416,761)
continuing operations)
Net cash used in operating activities from discontinued operations (reconciled from
discontinued operations) ........................................................... -- (56,116)
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Net cash used in operating activities ................................................ (3,452,006) (1,472,877)
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The accompanying notes are an integral part of the
Consolidated Financial Statements.
7
AROTECH CORPORATION
CONSOLIDATED STATEMENT OF CASH FLOWS (UNAUDITED) (U.S. Dollars)
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CASH FLOWS FROM INVESTING ACTIVITIES:
Repayment of promissory note related to purchase of subsidiary ...................... (75,000) (75,000)
Investment in subsidiary(1) ......................................................... -- (7,186,837)
Investment in subsidiary(2) ......................................................... -- (12,106,358)
Purchase of property and equipment .................................................. (342,248) (234,032)
Increase in capitalized research and development projects ........................... (37,293) (67,482)
Proceeds from sale of property and equipment ........................................ -- 10,284
Decrease in demo inventories, net ................................................... -- 1,185
Increase in restricted securities and deposits, net ................................. (50,141) (8,418,569)
------------ ------------
Net cash used in investing activities ................................................ (504,682) (28,076,809)
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FORWARD ................................................................................ $ (3,956,688) $(29,549,686)
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The accompanying notes are an integral part of the
Consolidated Financial Statements.
8
AROTECH CORPORATION
CONSOLIDATED STATEMENT OF CASH FLOWS (UNAUDITED) (U.S. Dollars)
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Three months ended March 31,
----------------------------
2005 2004
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FORWARD ................................................................ $ (3,956,688) $(29,549,686)
------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Increase (decrease) in short-term credit from banks ............... (99,156) 432,858
Proceeds from issuance of share capital, net ...................... -- 17,807,500
Proceeds from exercise of options ................................. 15,000 5,468
Proceeds from exercise of warrants ................................ -- 2,490,723
Payment on capital lease obligation ............................... -- (914)
Repayment of long-term loans ...................................... (22,226) (14,228)
------------ ------------
Net cash provided by financing activities .............................. (106,382) 20,721,407
------------ ------------
DECREASE IN CASH AND CASH EQUIVALENTS .................................. (4,063,070) (8,828,279)
CASH EROSION DUE TO EXCHANGE RATE DIFFERENCES .......................... 698 (4,051)
BALANCE OF CASH AND CASH EQUIVALENTS AT THE BEGINNING OF THE PERIOD .... 6,734,512 13,685,125
------------ ------------
BALANCE OF CASH AND CASH EQUIVALENTS AT THE END OF THE PERIOD .......... $ 2,672,140 $ 4,852,795
============ ============
SUPPLEMENTARY INFORMATION ON NON-CASH TRANSACTIONS:
Issuance of shares and warrants against accrued expenses ............... $ -- $ 1,377,008
============ ============
Investment in subsidiary against promissory note ....................... $ -- $ 2,577,097
============ ============
Exercise of convertible debentures against shares ...................... $ -- $ 1,150,000
============ ============
SUPPLEMENTAL DISCLOSURE OF CASH FLOWS INFORMATION - CASH PAID DURING THE
PERIOD FOR:
Interest ...................................................... $ 110,178 $ 94,865
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The accompanying notes are an integral part of the
Consolidated Financial Statements.
9
AROTECH CORPORATION
CONSOLIDATED STATEMENT OF CASH FLOWS (UNAUDITED) (U.S. Dollars)
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(1) In January 2004, the Company acquired substantially all of the outstanding
ordinary shares of Epsilor Electronic Industries, Ltd. ("Epsilor"). The
net fair value of the assets acquired and the liabilities assumed, at the
date of acquisition, was as follows:
Working capital, excluding cash and cash equivalents ........ $ (533,750)
(unaudited)
Property and equipment (unaudited) .......................... 709,847
Intangible assets and goodwill (unaudited) .................. 9,587,837
------------
9,763,934
Issuance of promissory note (unaudited) ..................... (2,577,097)
------------
$ 7,186,837
============
(2) In January 2004, the Company acquired all of the outstanding common stock
of FAAC Incorporated ("FAAC"). The net fair value of the assets acquired
was as follows:
Working capital, excluding cash and cash equivalents ........ $ 2,647,822
(unaudited)
Property and equipment (unaudited) .......................... 263,669
Intangible assets and goodwill (unaudited) .................. 11,201,695
------------
14,113,186
Issuance of shares, net (unaudited) ......................... (2,006,828)
------------
$ 12,106,358
============
The accompanying notes are an integral part of the
Consolidated Financial Statements.
10
AROTECH CORPORATION
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
NOTE 1: BASIS OF PRESENTATION
a. Company:
Arotech Corporation ("Arotech" or the "Company"), and its subsidiaries provide
defense and security products for the military, law enforcement and homeland
security markets, including advanced zinc-air and lithium batteries and
chargers, multimedia interactive simulators/trainers and lightweight vehicle
armoring. The Company is primarily operating through IES Interactive Training,
Inc. ("IES"), a wholly-owned subsidiary based in Littleton, Colorado; FAAC
Corporation, a wholly-owned subsidiary based in Ann Arbor, Michigan, and FAAC's
80%-owned United Kingdom subsidiary FAAC Limited; Electric Fuel Battery
Corporation, a wholly-owned subsidiary based in Auburn, Alabama; Electric Fuel
Ltd. ("EFL") a wholly-owned subsidiary based in Beit Shemesh, Israel; Epsilor
Electronic Industries, Ltd., a wholly-owned subsidiary located in Dimona,
Israel; MDT Protective Industries, Ltd. ("MDT"), a majority-owned subsidiary
based in Lod, Israel; MDT Armor Corporation, a majority-owned subsidiary based
in Auburn, Alabama; and Armour of America, Incorporated, a wholly-owned
subsidiary based in Los Angeles, California.
b. Basis of presentation:
The accompanying interim consolidated financial statements have been prepared by
Arotech Corporation in accordance with generally accepted accounting principles
for interim financial information, with the instructions to Form 10-Q and with
Article 10 of Regulation S-X, and include the accounts of Arotech Corporation
and its subsidiaries. Certain information and footnote disclosures, normally
included in complete financial statements prepared in accordance with generally
accepted accounting principles, have been condensed or omitted. In the opinion
of the Company, the unaudited financial statements reflect all adjustments
(consisting only of normal recurring adjustments) necessary for a fair
presentation of its financial position at March 31, 2005 and its operating
results and cash flows for the three-month periods ended March 31, 2005 and
2004.
The results of operations for the three months ended March 31, 2005 are not
necessarily indicative of results that may be expected for any other interim
period or for the full fiscal year ending December 31, 2005.
The balance sheet at December 31, 2004 has been derived from the audited
financial statements at that date but does not include all the information and
footnotes required by generally accepted accounting principles for complete
financial statements. These consolidated financial statements should be read in
conjunction with the audited financial statements included in the Company's
Annual Report on Form 10-K for the year ended December 31, 2004.
c. Accounting for stock-based compensation:
The Company has elected to follow Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees" and FASB Interpretation No. 44,
"Accounting for Certain Transactions Involving Stock Compensation" in accounting
for its employee stock option plans. Under APB No. 25, when the exercise price
of the Company's stock options is less than the market price of the underlying
shares on the date of grant, compensation expense is recognized.
11
AROTECH CORPORATION
The Company adopted the disclosure provisions of Statement of Financial
Accounting Standard No. 148, "Accounting for Stock-Based Compensation -
Transition and Disclosure," which amended certain provisions of Statement of
Financial Accounting Standard No. 123, "Accounting for Stock-Based
Compensation." The Company continues to apply the provisions of APB No. 25 in
accounting for stock-based compensation.
Under Statement of Financial Accounting Standard No. 123, pro forma information
regarding net income and net earnings per share is required, and has been
determined as if the Company had accounted for its employee stock options under
the fair value method of SFAS No. 123. The fair value for these options is
amortized over their vesting period and estimated at the date of grant using a
Black-Scholes Option Valuation Model with the following weighted-average
assumptions for the three month periods ended March 31, 2005 and 2004:
Three months ended March 31,
----------------------------
2005 2004
---- --------
(Unaudited)
Risk free interest ............................. -- 2.8%
Dividend yields ................................ -- 0.0%
Volatility ..................................... -- 0.764
Expected life .................................. -- 5 years
Pro forma information under SFAS No. 123:
Three months ended March 31,
----------------------------
2005 2004
------------ ------------
Unaudited
(U.S. Dollars,
except per share data)
Net income (loss) as reported .................. $ (2,456,500) $ (3,680,889)
Add - stock-based compensation expense
determined under APB 25 ..................... 232,739 --
Deduct - stock based compensation expense
determined under fair value method for
all awards .................................. (449,592) (210,283)
============ ============
Pro forma net loss ............................. $ (2,673,353) $ (3,891,172)
============ ============
============ ============
Loss per share:
Basic and diluted, as reported ............. $ (0.03) $ (0.06)
============ ============
Pro forma basic and diluted ................ $ (0.03) $ (0.07)
============ ============
NOTE 2: INVENTORIES
Inventories are stated at the lower of cost or market value. Cost is determined
using the average cost method. The Company periodically evaluates the quantities
on hand relative to current and historical selling prices and historical and
projected sales volume. Based on these evaluations, provisions are made in each
period to write down inventory to its net realizable value. Inventory write-offs
are provided to cover risks arising from slow-moving items, technological
obsolescence, excess inventories, and for market prices lower than cost. In the
three months ended March 31, 2005 the Company did not write off any inventory.
Inventories are composed of the following:
12
AROTECH CORPORATION
March 31, 2005 December 31, 2004
---------- ----------
(Unaudited)
Raw materials ............................ $5,348,653 $4,087,650
Work-in-progress ......................... 2,446,231 1,877,889
Finished goods ........................... 1,051,197 1,311,762
---------- ----------
$8,846,081 $7,277,301
========== ==========
NOTE 3: IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS
On December 16, 2004, the Financial Accounting Standards Board (FASB) issued
FASB Statement No. 123 (revised 2004), "Share-Based Payment," which is a
revision of FASB Statement No. 123, "Accounting for Stock-Based Compensation."
Statement 123(R) supersedes APB Opinion No. 25, "Accounting for Stock Issued to
Employees," and amends FASB Statement No. 95, "Statement of Cash Flows."
Generally, the approach in Statement 123(R) is similar to the approach described
in Statement 123. However, Statement 123(R) requires all share-based payments to
employees, including grants of employee stock options, to be recognized in the
income statement based on their fair values. Pro forma disclosure is no longer
an alternative.
Statement 123(R) must be adopted no later than January 1, 2006. Early adoption
will be permitted in periods in which financial statements have not yet been
issued. The Company expects to adopt Statement 123(R) on the first interim
period beginning after January 1, 2006.
Statement 123(R) permits public companies to adopt its requirements using one of
two methods:
1. A "modified prospective" method in which compensation cost is recognized
beginning with the effective date (a) based on the requirements of Statement
123(R) for all share-based payments granted after the effective date and (b)
based on the requirements of Statement 123 for all awards granted to employees
prior to the effective date of Statement 123(R) that remain unvested on the
effective date.
2. A "modified retrospective" method which includes the requirements of the
modified prospective method described above, but also permits entities to
restate based on the amounts previously recognized under Statement 123 for
purposes of pro forma disclosures either (a) all prior periods presented or (b)
prior interim periods of the year of adoption.
The Company is still in the process of evaluating the method it will use.
As permitted by Statement 123, the Company currently accounts for share-based
payments to employees using Opinion 25's intrinsic value method and, as such,
generally recognizes no compensation cost for employee stock options.
Accordingly, the adoption of Statement 123(R)'s fair value method will have a
significant impact on our result of operations, although it will have no impact
on our overall financial position. The impact of adoption of Statement 123(R)
cannot be predicted at this time because it will depend on levels of share-based
payments granted in the future. However, had the Company adopted Statement
123(R) in prior periods, the impact of that standard would have approximated the
impact of Statement 123 as described in the disclosure of pro forma net income
and earnings per share in Note 2.c. above to the Company's consolidated
financial statements. Statement 123(R) also requires the benefits of tax
deductions in excess of recognized compensation cost to be reported as a
financing cash flow, rather than as an operating cash flow as required under
current literature.
13
AROTECH CORPORATION
In March 2005, the SEC staff issued Staff Accounting Bulletin No. 107 (SAB 107)
to give guidance on implementation of SFAS 123(R), which the Company plans to
consider in implementing SFAS 123(R).
NOTE 4: SEGMENT INFORMATION
a. General:
The Company and its subsidiaries operate primarily in three business segments
and follow the requirements of SFAS No. 131.
The Company's reportable operating segments have been determined in accordance
with the Company's internal management structure, which is organized based on
operating activities. The accounting policies of the operating segments are the
same as those used by the Company in the preparation of its annual financial
statement. The Company evaluates performance based upon two primary factors, one
is the segment's operating income and the other is the segment's contribution to
the Company's future strategic growth.
b. The following is information about reported segment revenues, income (losses)
and assets for the three months ended March 31, 2005 and 2004:
Simulation Battery and
and Security Power Systems Armor All Others Total
------------ ------------ ------------ ------------ ------------
Three months ended March 31, 2005
Revenues from outside customers $ 4,115,651 $ 3,006,138 $ 3,265,656 $ -- $ 10,387,445
Depreciation expenses and amortization (1) (402,660) (222,699) (491,548) (35,000) (1,151,907)
Direct expenses (2) (3,508,124) (2,756,990) (3,316,049) (1,641,897) (11,223,060)
------------ ------------ ------------ ------------ ------------
Segment income (loss) $ 204,867 $ 26,449 $ (541,941) $ (1,676,897) (1,987,522)
============ ============ ============ ============
Financial income (after deduction of
minority interest) (468,978)
------------
Loss from continuing operations $ (2,456,500)
============
Segment assets (3) 31,783,459 13,265,919 20,816,358 759,121 66,624,857
============ ============ ============ ============ ============
Three months ended March 31, 2004
Revenues from outside customers $ 3,212,083 $ 2,505,621 $ 1,464,550 $ -- $ 7,182,254
Depreciation expenses and amortization(1) (385,101) (282,870) (29,450) (35,000) (732,421)
Direct expenses (2) (3,167,491) (2,463,960) (1,328,452) (927,106) (7,887,009)
------------ ------------ ------------ ------------ ------------
Segment income (loss) $ (340,509) $ (241,209) $ 106,648 $ (962,106) (1,437,176)
============ ============ ============ ============
Financial expenses (after deduction of (1,080,713)
minority interest)
------------
Loss from continuing operations $ (2,517,889)
============
Segment assets(3) 18,795,589 12,629,305 3,360,366 439,646 35,224,906
============ ============ ============ ============ ============
- ----------
(1) Includes depreciation of property and equipment, amortization
expenses of intangible assets and other amortization expenses.
(2) Including sales and marketing, general and administrative and tax
expenses.
(3) Consisting of property and equipment, inventory and intangible
assets.
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AROTECH CORPORATION
NOTE 5: CONVERTIBLE DEBENTURES AND DETACHABLE WARRANTS
a. 8% Secured Convertible Debentures due September 30, 2006 and issued in
September 2003
Pursuant to the terms of a Securities Purchase Agreement dated September 30,
2003, the Company, in September 2003, issued and sold to a group of
institutional investors an aggregate principal amount of 8% secured convertible
debentures in the amount of $5.0 million due September 30, 2006. These
debentures are convertible at any time prior to September 30, 2006 at a
conversion price of $1.15 per share.
As part of the Securities Purchase Agreement dated September 30, 2003, the
Company issued to the purchasers of its 8% secured convertible debentures due
September 30, 2006, warrants to purchase an aggregate of 1,250,000 shares of
common stock at any time prior to September 30, 2006 at a price of $1.4375 per
share.
As of March 31, 2005, $150,000 remained outstanding under these debentures.
This transaction was accounted according to APB No. 14 "Accounting for
Convertible Debt and Debt Issued with Stock Purchase Warrants" and Emerging
Issue Task Force No. 00-27 "Application of Issue No. 98-5 to Certain Convertible
Instruments" ("EITF 00-27"). The fair value of these warrants was determined
using Black-Scholes pricing model, assuming a risk-free interest rate of 1.95%,
a volatility factor 98%, dividend yields of 0% and a contractual life of three
years.
In connection with these convertible debentures, the Company recognized
financial expenses of $2,963,043 with respect to the beneficial conversion
feature, which is being amortized from the date of issuance to the stated
redemption date - September 30, 2006 - as financial expenses.
During the three months ended March 31, 2005 the Company recorded an expense of
$7,299, which was attributable to amortization of debt discount and beneficial
conversion features related to the convertible debenture over its term. These
expenses were included in the financial expenses.
b. 8% Secured Convertible Debentures due September 30, 2006 and issued in
December 2003
Pursuant to the terms of a Securities Purchase Agreement dated September 30,
2003, the Company, in December 2003, issued and sold to a group of institutional
investors an aggregate principal amount of 8% secured convertible debentures in
the amount of $6.0 million due September 30, 2006. These debentures are
convertible at any time prior to September 30, 2006 at a conversion price of
$1.45 per share.
As of March 31, 2005, $4,387,500 remained outstanding under these debentures.
As a further part of the Securities Purchase Agreement dated September 30, 2003,
the Company issued to the purchasers of its 8% secured convertible debentures
due December 31, 2006, warrants to purchase an aggregate of 1,500,000 shares of
common stock at any time prior to December 31, 2006 at a price of $1.8125 per
share. Additionally, the Company issued to the investors supplemental warrants
to purchase an aggregate of 1,038,000 shares of common stock at any time prior
to June 18, 2009 at a price of $2.20 per share.
15
AROTECH CORPORATION
This transaction was accounted according to APB No. 14, "Accounting for
Convertible Debt and Debt Issued with Stock Purchase Warrants" and Emerging
Issue Task Force No. 00-27, "Application of Issue No. 98-5 to Certain
Convertible Instruments" ("EITF 00-27"). The fair value of the warrants granted
in respect of convertible debentures was determined using Black-Scholes pricing
model, assuming a risk-free interest rate of 2.45%, a volatility factor 98%,
dividend yields of 0% and a contractual life of three years.
In connection with these convertible debentures, the Company recognized
financial expenses of $6,000,000 with respect to the beneficial conversion
feature, which is being amortized from the date of issuance to the stated
redemption date - September 30, 2006 - as financial expenses.
During the three months ended March 31, 2005 the Company recorded an expense of
$385,244, which was attributable to amortization of the beneficial conversion
feature of the convertible debenture over its term. These expenses were included
in the financial expenses.
16
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
This report contains forward-looking statements made pursuant to the safe
harbor provisions of the Private Securities Litigation Reform Act of 1995. These
statements involve inherent risks and uncertainties. When used in this
discussion, the words "believes," "anticipated," "expects," "estimates" and
similar expressions are intended to identify such forward-looking statements.
Such statements are subject to certain risks and uncertainties that could cause
actual results to differ materially from those projected. Readers are cautioned
not to place undue reliance on these forward-looking statements, which speak
only as of the date hereof. We undertake no obligation to publicly release the
result of any revisions to these forward-looking statements that may be made to
reflect events or circumstances after the date hereof or to reflect the
occurrence of unanticipated events. Our actual results could differ materially
from those anticipated in these forward-looking statements as a result of
certain factors including, but not limited to, those set forth elsewhere in this
report. Please see "Risk Factors," below, and in our other filings with the
Securities and Exchange Commission.
Arotech(TM) is a trademark and Electric Fuel(R) is a registered trademark
of Arotech Corporation. All company and product names mentioned may be
trademarks or registered trademarks of their respective holders. Unless the
context requires otherwise, all references to us refer collectively to Arotech
Corporation and its subsidiaries.
We make available through our internet website free of charge our annual
report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form
8-K, amendments to such reports and other filings made by us with the SEC, as
soon as practicable after we electronically files such reports and filings with
the SEC. Our website address is www.arotech.com. The information contained in
this website is not incorporated by reference in this report.
The following discussion and analysis should be read in conjunction with
the interim financial statements and notes thereto appearing elsewhere in this
Quarterly Report. We have rounded amounts reported here to the nearest thousand,
unless such amounts are more than 1.0 million, in which event we have rounded
such amounts to the nearest hundred thousand.
Executive Summary
Divisions and Subsidiaries
We operate primarily as a holding company, through our various
subsidiaries, which we have organized into three divisions. Our divisions and
subsidiaries (all 100% owned, unless otherwise noted) are as follows:
>> Our Simulation and Security Division, consisting of:
o FAAC Incorporated, located in Ann Arbor, Michigan, which
provides simulators, systems engineering and software products
to the United States military, government and private industry
("FAAC"); and
17
AROTECH CORPORATION
o IES Interactive Training, Inc., located in Littleton,
Colorado, which provides specialized "use of force" training
for police, security personnel and the military ("IES").
>> Our Armor Division, consisting of:
o Armour of America, located in Los Angeles, California, which
manufacturers ballistic and fragmentation armor kits for
rotary and fixed wing aircraft, marine armor, personnel armor,
military vehicles and architectural applications, including
both the LEGUARD Tactical Leg Armor and the Armourfloat
Ballistic Floatation Device, which is a unique vest that is
certified by the U.S. Coast Guard ("AoA");
o MDT Protective Industries, Ltd., located in Lod, Israel, which
specializes in using state-of-the-art lightweight ceramic materials,
special ballistic glass and advanced engineering processes to fully
armor vans and SUVs, and is a leading supplier to the Israeli
military, Israeli special forces and special services ("MDT") (75.5%
owned); and
o MDT Armor Corporation, located in Auburn, Alabama, which
conducts MDT's United States activities ("MDT Armor") (88%
owned).
>> Our Battery and Power Systems Division, consisting of:
o Epsilor Electronic Industries, Ltd., located in Dimona, Israel (in
Israel's Negev desert area), which develops and sells rechargeable
and primary lithium batteries and smart chargers to the military and
to private industry in the Middle East, Europe and Asia ("Epsilor");
o Electric Fuel Battery Corporation, located in Auburn, Alabama, which
manufactures and sells Zinc-Air fuel sells, batteries and chargers
for the military, focusing on applications that demand high energy
and light weight ("EFB"); and
o Electric Fuel (E.F.L.) Ltd., located in Beit Shemesh, Israel,
which produces water-activated lifejacket lights for
commercial aviation and marine applications, and which
conducts our Electric Vehicle effort, focusing on obtaining
and implementing demonstration projects in the U.S. and
Europe, and on building broad industry partnerships that can
lead to eventual commercialization of our Zinc-Air energy
system for electric vehicles ("EFL").
Overview of Results of Operations
We incurred significant operating losses for the years ended December 31,
2003 and 2004 and for the first three months of 2005. While we expect to
continue to derive revenues from the sale of products that our subsidiaries
manufacture and the services that they provide, there can be no assurance that
we will be able to achieve or maintain profitability on a consistent basis.
18
AROTECH CORPORATION
Between 2002 and 2004, we substantially increased our revenues and reduced
our net loss, from $18.5 million in 2002 to $9.2 million in 2003 to $9.0 million
in 2004. This was achieved through a combination of cost-cutting measures and
increased revenues, particularly from the sale of Zinc-Air batteries to the
military and from sales of products manufactured by the subsidiaries we acquired
in 2002 and 2004.
We succeeded during 2004 in moving Arotech to a positive EBITDA situation,
for the first time in our history. We are focused on continuing this success in
2005 (although we had negative EBITDA during the first three months of 2005) and
beyond, and ultimately on achieving profitability. In this connection, we note
that most of our business lines historically have had weaker first halves than
second halves, and weaker first quarters than second quarters. We expect this to
be the case for 2005 as well.
A portion of our operating loss during the first three months of 2005
arose as a result of non-cash charges. These charges were primarily related to
our acquisitions made in the previous year and to our raising capital through
convertible debenture in the prior years. Because we anticipate continuing these
activities, we expect to continue to incur such non-cash charges in the future.
Non-cash charges related to acquisitions arise when the purchase price for
an acquired company exceeds the company's book value. In such a circumstance, a
portion of the excess of the purchase price is recorded as goodwill and a
portion as intangible assets. In the case of goodwill, the assets recorded as
goodwill are not amortized; instead, we are required to perform an annual
impairment review. If we determine, through the impairment review process, that
goodwill has been impaired, we must record the impairment charge in our
statement of operations. Intangible assets are amortized in accordance with
their useful life. Accordingly, for a period of time following an acquisition,
we incur a non-cash charge in the amount of a fraction (based on the useful life
of the intangible assets) of the amount recorded as intangible assets. Our
acquisitions of FAAC, Epsilor and AoA resulted in our incurring similar non-cash
charges during the first three months of 2005.
As a result of the application of the above accounting rule, we incurred
non-cash charges related to our acquisitions in the amount of $823,000 during
the first three months of 2005.
The non-cash charges that relate to our financings arise when we sell
convertible debentures and warrants. When we issue convertible debentures, we
record an expense for a beneficial conversion feature that is amortized ratably
over the life of the debenture. When a debenture is converted, however, the
entire remaining unamortized beneficial conversion feature expense is
immediately recognized in the quarter in which the debenture is converted.
Similarly, when we issue warrants in connection with convertible debentures, we
record an expense for financial expenses that is amortized ratably over the term
of the convertible debentures; when the convertible debentures are converted,
the entire remaining unamortized financial expense is immediately recognized in
the quarter in which the conversion occurs. As and to the extent that our
remaining convertible debentures are converted, we would incur similar non-cash
charges going forward.
19
AROTECH CORPORATION
As a result of the application of the above accounting rule, we incurred
non-cash charges related to our financings in the amount of $393,000 during the
first three months of 2005.
Additionally, in an effort to improve our cash situation and our
shareholders' equity, we have periodically induced holders of certain of our
warrants to exercise their warrants by lowering the exercise price of the
warrants in exchange for immediate exercise of such warrants, and by issuing to
such investors new warrants. Under such circumstances, we record a deemed
dividend in an amount determined based upon the fair value of the new warrants
(using a Black-Scholes pricing model). As and to the extent that we engage in
similar warrant repricings and issuances in the future, we would incur similar
non-cash charges.
As a result of the application of the above accounting rule we recorded a
deemed dividend related to warrants repricing in amount of $0 and $1.2 million
during the first three months of 2005 and 2004 respectively.
In addition, we incurred non-cash charges in the amount of $221,000 during
the first three months of 2005 in connection with options and shares granted to
employees.
Overview of Operating Performance and Backlog
We shut down our money-losing consumer battery operations and began
acquiring new businesses in the defense and security field in 2002. Since then,
we have concentrated on eliminating our operating deficit and moving Arotech to
cash-flow positive operations. In order to do this, we have focused on acquiring
businesses with strong revenues and profitable operations.
In our Simulation and Security Division, revenues grew from approximately
$3.2 million in the first three months of 2004 to $4.1 million in the first
three months of 2005. As of March 31, 2005, our backlog for our Simulation and
Security Division totaled $10.6 million, most of which was attributable to FAAC.
In our Battery and Power Systems Division, revenues grew from
approximately $2.5 million in the first three months of 2004 to approximately
$3.0 million in the first three months of 2005. As of March 31, 2005, our
backlog for our Battery and Power Systems Division totaled $2.8 million.
In our Armor Division, revenues grew from $1.5 million during the first
three months of 2004 to $3.3 million during the first three months of 2005, due
primarily to increased revenues of MDT Armor as a result of new orders in
connection with the war in Iraq and the inclusion of AoA in our results. As of
March 31, 2005, our backlog for our Armor Division totaled $8.3 million.
Functional Currency
We consider the United States dollar to be the currency of the primary
economic environment in which we and our Israeli subsidiary EFL operate and,
therefore, both we and EFL have adopted and are using the United States dollar
as our functional currency. Transactions and balances originally denominated in
U.S. dollars are presented at the original amounts. Gains and losses arising
from non-dollar transactions and balances are included in net income.
20
AROTECH CORPORATION
The majority of financial transactions of our Israeli subsidiaries MDT and
Epsilor, is in New Israel Shekels ("NIS") and a substantial portion of MDT's and
Epsilor's costs is incurred in NIS. Management believes that the NIS is the
functional currency of MDT and Epsilor. Accordingly, the financial statements of
MDT and Epsilor have been translated into U.S. dollars. All balance sheet
accounts have been translated using the exchange rates in effect at the balance
sheet date. Statement of operations amounts have been translated using the
average exchange rate for the period. The resulting translation adjustments are
reported as a component of accumulated other comprehensive loss in shareholders'
equity.
Results of Operations
Preliminary Note
Results for the three months ended March 31, 2005 include the results of
AoA for such period as a result of our acquisition of AoA in August 2004. The
results of AoA were not included in our operating results for the three months
ended March 31, 2004. Accordingly, the following period-to-period comparisons
should not necessarily be relied upon as indications of future performance.
Three months ended March 31, 2005 compared to the three months ended March 31,
2004.
Revenues. During the three months ended March 31, 2005, we (through our
subsidiaries) recognized revenues as follows:
>> IES and FAAC recognized revenues from the sale of interactive
use-of-force training systems and from the provision of maintenance
services in connection with such systems;
>> MDT, MDT Armor and AoA recognized revenues from payments under
vehicle armoring contracts, for service and repair of armored
vehicles, and on sale of armoring products;
>> EFB and Epsilor recognized revenues from the sale of batteries,
chargers and adapters to the military, and under certain development
contracts with the U.S. Army; and
>> EFL recognized revenues from the sale of lifejacket lights and
from subcontracting fees received in connection with Phase IV
of the United States Department of Transportation (DOT)
electric bus program.
Revenues for the three months ended March 31, 2005 totaled $10.4 million,
compared to $7.2 million in the comparable period in 2004, an increase of $3.2
million, or 45%. This increase was primarily attributable to the following
factors:
21
AROTECH CORPORATION
>> Increased revenues from our Armor Division, particularly MDT Armor
and revenues generated by AoA ($726,000) in the first quarter of
2005 that were not present in the corresponding period of 2004.
>> Increased revenues from our Simulation and Security division,
particularly FAAC.
These revenues were offset to some extent by
>> Decreased U.S. Army Communications Electronics Command (CECOM) revenues
from our EFB subsidiary.
In the first quarter of 2005, revenues were $4.1 million for the
Simulation and Security Division (compared to $3.2 million in the first quarter
of 2004, an increase of $904,000, or 28.1%, due primarily to increased sales of
FAAC); $3.0 million for the Battery and Power Systems Division (compared to $2.5
million in the first quarter of 2004, an increase of $501,000, or 20.0%, due
primarily to increased sales of Epsilor, offset to some extent by decreased
CECOM revenues from our EFB subsidiary); and $3.3 million for the Armor Division
(compared to $1.5 million in the first quarter of 2004, an increase of $1.8
million, or 123.0%, due primarily to increased revenues from MDT Armor and to
the added revenues of AoA).
Cost of revenues and gross profit. Cost of revenues totaled $6.4 million
during the first quarter of 2005, compared to $4.6 million in the first quarter
of 2004, an increase of $1.8 million, or 39.8%, due primarily to increased sales
in all divisions.
Direct expenses for our three divisions during the first quarter of 2005
were $3.5 million for the Simulation and Security Division (compared to $3.2
million in the first quarter of 2004, an increase of $341,000, or 10.8%, due
primarily to increased sales of FAAC); $2.8 million for the Battery and Power
Systems Division (compared to $2.5 million in the first quarter of 2004, an
increase of $293,000, or 11.9%, due primarily to increased sales of Epsilor,
offset to some extent by decreased CECOM revenues from our EFB subsidiary; and
$3.3 million for the Armor Division (compared to $1.3 million in the first
quarter of 2004, an increase of $2.0 million, or 149.6%, due primarily to
increased revenues from MDT Armor and to the added revenues of AoA)
Gross profit was $4.0 million during the first quarter of 2005, compared
to $2.6 million during the first quarter of 2004, an increase of $1.4 million,
or 53.0%. This increase was the direct result of all factors presented above,
most notably the presence of AoA in our results and the increase in vehicle
armoring revenues.
Research and development expenses. Research and development expenses for
the first quarter of 2005 were $415,000, compared to $464,000 during the first
quarter of 2004, a decrease of $49,000, or 10.5%.
Sales and marketing expenses. Sales and marketing expenses for the first
quarter of 2005 were $1.2 million, compared to $1.0 million the first quarter of
2004, an increase of $138,000, or 13.5%. This increase was primarily
attributable to the inclusion of the sales and marketing expenses of AoA in our
results for 2004.
22
AROTECH CORPORATION
General and administrative expenses. General and administrative expenses
for the first quarter of 2005 were $3.4 million compared to $2.1 million in the
first quarter of 2004, an increase of $1.3 million, or 60.7%. This increase was
primarily attributable to the following factors:
>> The inclusion of the general and administrative expenses of AoA in
our results for 2004; and
>> Increases in other general and administrative expenses in comparison
to 2004, such as employees salaries, travel expenses and audit fees.
>> Increase in expenses in connection with grant of options and shares
to employees.
Financial expenses, net. Financial income, net of financial expenses and
exchange differentials, totaled approximately $469,000 in the first quarter of
2005 compared to $1.1 million in the first quarter of 2004. The difference was
due primarily to decrease in amortization of debt discount related to the
issuance of convertible debenture.
Income taxes. We and certain of our subsidiaries incurred accumulated net
operating losses during the three months ended March 31, 2005 and, accordingly,
we were not required to make any provision for income taxes. With respect to
some of our subsidiaries that operated at a net profit during 2005, we were able
to offset federal taxes against our accumulated loss carry forward. We recorded
a total of $217,000 in tax expenses in the first quarter of 2005, with respect
to certain of our subsidiaries that operated at a net profit during 2005 and we
are not able to offset their taxes against our loss carry forward. We recorded a
total of $5,000 in tax income in the first quarter of 2004, on account of
deferred tax assets with respect to certain of our subsidiaries.
Amortization of intangible assets. Amortization of intangible assets
totaled $823,000 in the first quarter of 2005, compared to $496,000 the first
quarter of 2004, an increase of $327,000, or 65.9%, due primarily to
amortization of intangible assets related to our subsidiary, AoA, that we
acquired in August 2004.
Net loss before deemed dividend to certain stockholders of common stock.
Due to the factors cited above, we reported a net loss of $2.5 million in the
first quarter of 2005, compared to a net loss of $2.5 million the first quarter
of 2004, a decrease of $61,000, or 2.4%.
Net loss attributable to common stockholders. Due to the factors cited
above and the deemed dividend recorded during the first three months of 2004,
Net loss attributable to common stockholders decreased from $3.7 million to $2.5
million, a decrease of $1.2 million , or 33.3%.
Liquidity and Capital Resources
As of March 31, 2005, we had $2.7 million in cash, $7.0 million in
restricted collateral securities and cash deposits due within one year, $4.0
million in long-term restricted securities and deposits, and $135,000 in
marketable securities, as compared to at December 31, 2004, when we had $6.7
million in cash, $7.0 million in restricted collateral securities and restricted
held-to-maturity securities due within one year, $4.0 million in long-term
restricted deposits, and $136,000 in available-for-sale marketable securities.
The decrease in cash was primarily the result of working capital needed in all
of our segments.
23
AROTECH CORPORATION
We used available funds in the first quarter of 2005 primarily for sales
and marketing, continued research and development expenditures, and other
working capital needs. We increased our investment in fixed assets during the
three months ended March 31, 2005 by $342,000 over the investment as at December
31, 2004, primarily in the Battery and Power Systems Division and in the
Simulation and Security Division. Our net fixed assets amounted to $4.5 million
at quarter end.
Net cash used in operating activities from continuing operations for the
three months ended March 31, 2005 and 2004 was $3.5 million and $1.4 million,
respectively, an increase of $2.0 million. This increase was primarily the
result of increase in inventories and decrease in trade payables and other
account payables.
Net cash used in investing activities for the three months ended March 31,
2005 and 2004 was $505,000 and $28.1 million, a decrease of $27.6 million. This
decrease was primarily the result of our investment in the acquisition of FAAC
and Epsilor in the first quarter of 2004.
Net cash provided by (used in) financing activities for the three months
ended March 31, 2005 and 2004 was $(106,000) and $20.7 million, respectively.
This decrease was primarily the result of lower amounts of funds raised through
sales of our securities in 2005 compared to 2004.
As of March 31, 2005, we had (based on the contractual amount of the debt
and not on the accounting valuation of the debt) approximately $5.5 million in
long term bank and certificated debt outstanding, of which $4.5 million was
convertible debt, and approximately $13.6 million in short-term debt (which
including short-term bank credit, current portion of long-term loan and
liabilities due to subsidiaries acquisitions, in the amount of $13.5 million).
Our current debt agreements grant to our investors a right of first
refusal on any future financings, except for underwritten public offerings in
excess of $30 million, and contain certain other affirmative and negative
covenants. We do not believe that these covenants will materially limit our
ability to undertake future financings.
Based on our internal forecasts, we believe that our present cash position
and anticipated cash flows from operations should be sufficient to satisfy our
current estimated cash requirements through the next twelve months. This belief
is based on certain assumptions that our management and our subsidiaries
managers believes to be reasonable, some of which are subject to the risk
factors detailed below. In this connection, we note that from time to time our
working capital needs are partially dependent on our subsidiaries' lines of
credit. In the event that we are unable to continue to make use of our
subsidiaries' lines of credit for working capital on economically feasible
terms, our business, operating results and financial condition could be
adversely affected.
24
AROTECH CORPORATION
Over the long term, we will need to become profitable, at least on a
cash-flow basis, and maintain that profitability in order to avoid future
capital requirements. Additionally, we would need to raise additional capital in
order to fund any future acquisitions.
RISK FACTORS
The following factors, among others, could cause actual results to differ
materially from those contained in forward-looking statements made in this
Report and presented elsewhere by management from time to time.
Business-Related Risks
We have had a history of losses and may incur future losses.
We were incorporated in 1990 and began our operations in 1991. We have
funded our operations principally from funds raised in each of the initial
public offering of our common stock in February 1994; through subsequent public
and private offerings of our common stock and equity and debt securities
convertible or exercisable into shares of our common stock; research contracts
and supply contracts; funds received under research and development grants from
the Government of Israel; and sales of products that we and our subsidiaries
manufacture. We have incurred significant net losses since our inception.
Additionally, as of March 31, 2005, we had an accumulated deficit of
approximately $121.4 million. There can be no assurance that we will ever be
able to achieve or maintain profitability consistently or that our business will
continue to exist.
Our existing indebtedness may adversely affect our ability to obtain
additional funds and may increase our vulnerability to economic or business
downturns.
Our bank and certificated indebtedness (short and long term) aggregated
approximately $19.1 million as of March 31, 2005 (not including trade payables,
other account payables and accrued severance pay). Accordingly, we are subject
to the risks associated with indebtedness, including:
o we must dedicate a portion of our cash flows from operations to pay
debt service costs and, as a result, we have less funds available
for operations, future acquisitions of consumer receivable
portfolios, and other purposes;
o it may be more difficult and expensive to obtain additional funds
through financings, if available at all;
o we are more vulnerable to economic downturns and fluctuations in
interest rates, less able to withstand competitive pressures and
less flexible in reacting to changes in our industry and general
economic conditions; and
o if we default under any of our existing debt instruments or if our
creditors demand payment of a portion or all of our indebtedness, we
may not have sufficient funds to make such payments.
The occurrence of any of these events could materially adversely affect our
results of operations and financial condition and adversely affect our stock
price.
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AROTECH CORPORATION
The agreements governing the terms of our debentures contain numerous
affirmative and negative covenants that limit the discretion of our management
with respect to certain business matters and place restrictions on us, including
obligations on our part to preserve and maintain our assets and restrictions on
our ability to incur or guarantee debt, to merge with or sell our assets to
another company, and to make significant capital expenditures without the
consent of the debenture holders. Our ability to comply with these and other
provisions of such agreements may be affected by changes in economic or business
conditions or other events beyond our control.
Failure to comply with the terms of our debentures could result in a default
that could have material adverse consequences for us.
A failure to comply with the obligations contained in our debenture
agreements could result in an event of default under such agreements which could
result in an acceleration of the debentures and the acceleration of debt under
other instruments evidencing indebtedness that may contain cross-acceleration or
cross-default provisions. If the indebtedness under the debentures or other
indebtedness were to be accelerated, there can be no assurance that our future
cash flow or assets would be sufficient to repay in full such indebtedness.
Failure to comply with the earnout provisions of our acquisition agreements
could have material adverse consequences for us.
A failure to comply with the obligations contained in our acquisition
agreements to make the earnout payments required under such agreements could
result in actions for damages, a possible right of rescission on the part of the
sellers, and the acceleration of debt under instruments evidencing indebtedness
that may contain cross-acceleration or cross-default provisions. If we are
unable to raise capital in order to pay the earnout provisions of our
acquisition agreements, there can be no assurance that our future cash flow or
assets would be sufficient to pay such obligations.
We have pledged a substantial portion of our assets to secure our borrowings.
Our debentures are secured by a substantial portion of our assets. If we
default under the indebtedness secured by our assets, those assets would be
available to the secured creditors to satisfy our obligations to the secured
creditors, which could materially adversely affect our results of operations and
financial condition and adversely affect our stock price.
We need significant amounts of capital to operate and grow our business.
We require substantial funds to market our products and develop and market
new products. To the extent that we are unable to fully fund our operations
through profitable sales of our products and services, we may continue to seek
additional funding, including through the issuance of equity or debt securities.
However, there can be no assurance that we will obtain any such additional
financing in a timely manner, on acceptable terms, or at all. If additional
funds are raised by issuing equity securities, stockholders may incur further
dilution. If additional funding is not secured, we will have to modify, reduce,
defer or eliminate parts of our anticipated future commitments and/or programs.
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AROTECH CORPORATION
Any inability to continue to make use from time to time of our subsidiaries'
current working capital lines of credit could have an adverse effect on our
ability to do business.
From time to time our working capital needs are partially dependent on our
subsidiaries' lines of credit. In the event that we are unable to continue to
make use of our subsidiaries' lines of credit for working capital on
economically feasible terms, our business, operating results and financial
condition could be adversely affected.
We may not be successful in operating new businesses.
Prior to the acquisitions of IES and MDT in 2002 and the acquisitions of
FAAC and Epsilor in January 2004 and AoA in August 2004, our primary business
was the marketing and sale of products based on primary and refuelable Zinc-Air
fuel cell technology and advancements in battery technology for defense and
security products and other military applications, electric vehicles and
consumer electronics. As a result of our acquisitions, a substantial component
of our business is the marketing and sale of hi-tech multimedia and interactive
training solutions and sophisticated lightweight materials and advanced
engineering processes used to armor vehicles. These are relatively new
businesses for us and our management group has limited experience operating
these types of businesses. Although we have retained our acquired companies'
management personnel, we cannot assure that such personnel will continue to work
for us or that we will be successful in managing these new businesses. If we are
unable to successfully operate these new businesses, our business, financial
condition and results of operations could be materially impaired.
Our acquisition strategy involves various risks.
Part of our strategy is to grow through the acquisition of companies that
will complement our existing operations or provide us with an entry into markets
we do not currently serve. Growth through acquisitions involves substantial
risks, including the risk of improper valuation of the acquired business and the
risk of inadequate integration. There can be no assurance that suitable
acquisition candidates will be available, that we will be able to acquire or
manage profitably such additional companies or that future acquisitions will
produce returns that justify our investments therein. In addition, we may
compete for acquisition and expansion opportunities with companies that have
significantly greater resources than we do. Furthermore, acquisitions could
disrupt our ongoing business, distract the attention of our senior officers,
make it difficult to maintain our operational standards, controls and procedures
and subject us to contingent and latent risks that are different, in nature and
magnitude, than the risks we currently face.
We may finance future acquisitions with cash from operations or additional
debt or equity financings. There can be no assurance that we will be able to
generate internal cash or obtain financing from external sources or that, if
available, such financing will be on terms acceptable to us. The issuance of
additional common stock to finance acquisitions may result in substantial
dilution to our stockholders. Any debt financing may significantly increase our
leverage and may involve restrictive covenants which limit our operations.
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AROTECH CORPORATION
We may not successfully integrate our acquisitions.
In light of our acquisitions of IES, MDT, FAAC, Epsilor and AoA, our
success will depend in part on our ability to manage the combined operations of
these companies and to integrate the operations and personnel of these companies
along with our other subsidiaries and divisions into a single organizational
structure. There can be no assurance that we will be able to effectively
integrate the operations of our subsidiaries and divisions and our acquired
businesses into a single organizational structure. Integration of these
operations could also place additional pressures on our management as well as on
our key technical resources. The failure to successfully manage this integration
could have an adverse material effect on us.
If we are successful in acquiring additional businesses, we may experience
a period of rapid growth that could place significant additional demands on, and
require us to expand, our management, resources and management information
systems. Our failure to manage any such rapid growth effectively could have a
material adverse effect on our financial condition, results of operations and
cash flows.
If we are unable to manage our growth, our operating results will be
impaired.
As a result of our acquisitions, we are currently experiencing a period of
significant growth and development activity which could place a significant
strain on our personnel and resources. Our activity has resulted in increased
levels of responsibility for both existing and new management personnel. Many of
our management personnel have had limited or no experience in managing growing
companies. We have sought to manage our current and anticipated growth through
the recruitment of additional management and technical personnel and the
implementation of internal systems and controls. However, our failure to manage
growth effectively could adversely affect our results of operations.
A significant portion of our business is dependent on government contracts
and reduction or reallocation of defense or law enforcement spending could
reduce our revenues.
Many of the customers of IES, FAAC and AoA to date have been in the public
sector of the U.S., including the federal, state and local governments, and in
the public sectors of a number of other countries, and most of MDT's customers
have been in the public sector in Israel, in particular the Ministry of Defense.
Additionally, all of EFB's sales to date of battery products for the military
and defense sectors have been in the public sector in the United States. A
significant decrease in the overall level or allocation of defense or law
enforcement spending in the U.S. or other countries could reduce our revenues
and have a material adverse effect on our future results of operations and
financial condition. MDT has already experienced a slowdown in orders from the
Ministry of Defense due to budget constraints and a requirement of U.S. aid to
Israel that a substantial proportion of such aid be spent in the U.S., where MDT
has only recently opened a factory.
Sales to public sector customers are subject to a multiplicity of detailed
regulatory requirements and public policies as well as to changes in training
and purchasing priorities. Contracts with public sector customers may be
conditioned upon the continuing availability of public funds, which in turn
depends upon lengthy and complex budgetary procedures, and may be subject to
certain pricing constraints. Moreover, U.S. government contracts and those of
many international government customers may generally be terminated for a
variety of factors when it is in the best interests of the government and
contractors may be suspended or debarred for misconduct at the discretion of the
government. There can be no assurance that these factors or others unique to
government contracts or the loss or suspension of necessary regulatory licenses
will not reduce our revenues and have a material adverse effect on our future
results of operations and financial condition.
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AROTECH CORPORATION
Our U.S. government contracts may be terminated at any time and may contain
other unfavorable provisions.
The U.S. government typically can terminate or modify any of its contracts
with us either for its convenience or if we default by failing to perform under
the terms of the applicable contract. A termination arising out of our default
could expose us to liability and have a material adverse effect on our ability
to re-compete for future contracts and orders. Our U.S. government contracts
contain provisions that allow the U.S. government to unilaterally suspend us
from receiving new contracts pending resolution of alleged violations of
procurement laws or regulations, reduce the value of existing contracts, issue
modifications to a contract and control and potentially prohibit the export of
our products, services and associated materials.
A negative audit by the U.S. government could adversely affect our
business, and we might not be reimbursed by the government for costs that we
have expended on our contracts.
Government agencies routinely audit government contracts. These agencies
review a contractor's performance on its contract, pricing practices, cost
structure and compliance with applicable laws, regulations and standards. If we
are audited, we will not be reimbursed for any costs found to be improperly
allocated to a specific contract, while we would be required to refund any
improper costs for which we had already been reimbursed. Therefore, an audit
could result in a substantial adjustment to our revenues. If a government audit
uncovers improper or illegal activities, we may be subject to civil and criminal
penalties and administrative sanctions, including termination of contracts,
forfeitures of profits, suspension of payments, fines and suspension or
debarment from doing business with United States government agencies. We could
suffer serious reputational harm if allegations of impropriety were made against
us. A governmental determination of impropriety or illegality, or an allegation
of impropriety, could have a material adverse effect on our business, financial
condition or results of operations.
We may be liable for penalties under a variety of procurement rules and
regulations, and changes in government regulations could adversely impact our
revenues, operating expenses and profitability.
Our defense and commercial businesses must comply with and are affected by
various government regulations that impact our operating costs, profit margins
and our internal organization and operation of our businesses. Among the most
significant regulations are the following:
o the U.S. Federal Acquisition Regulations, which regulate the
formation, administration and performance of government contracts;
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AROTECH CORPORATION
o the U.S. Truth in Negotiations Act, which requires certification and
disclosure of all cost and pricing data in connection with contract
negotiations; and
o the U.S. Cost Accounting Standards, which impose accounting
requirements that govern our right to reimbursement under certain
cost-based government contracts.
These regulations affect how we and our customers do business and, in some
instances, impose added costs on our businesses. Any changes in applicable laws
could adversely affect the financial performance of the business affected by the
changed regulations. With respect to U.S. government contracts, any failure to
comply with applicable laws could result in contract termination, price or fee
reductions or suspension or debarment from contracting with the U.S. government.
Our operating margins may decline under our fixed-price contracts if we fail
to estimate accurately the time and resources necessary to satisfy our
obligations.
Some of our contracts are fixed-price contracts under which we bear the
risk of any cost overruns. Our profits are adversely affected if our costs under
these contracts exceed the assumptions that we used in bidding for the contract.
Often, we are required to fix the price for a contract before we finalize the
project specifications, which increases the risk that we will mis-price these
contracts. The complexity of many of our engagements makes accurately estimating
our time and resources more difficult.
If we are unable to retain our contracts with the U.S. government and
subcontracts under U.S. government prime contracts in the competitive rebidding
process, our revenues may suffer.
Upon expiration of a U.S. government contract or subcontract under a U.S.
government prime contract, if the government customer requires further services
of the type provided in the contract, there is frequently a competitive
rebidding process. We cannot guarantee that we, or if we are a subcontractor
that the prime contractor, will win any particular bid, or that we will be able
to replace business lost upon expiration or completion of a contract. Further,
all U.S. government contracts are subject to protest by competitors. The
termination of several of our significant contracts or nonrenewal of several of
our significant contracts, could result in significant revenue shortfalls.
The loss of, or a significant reduction in, U.S. military business would have
a material adverse effect on us.
U.S. military contracts account for a significant portion of our business.
The U.S. military funds these contracts in annual increments. These contracts
require subsequent authorization and appropriation that may not occur or that
may be greater than or less than the total amount of the contract. Changes in
the U.S. military's budget, spending allocations and the timing of such spending
could adversely affect our ability to receive future contracts. None of our
contracts with the U.S. military has a minimum purchase commitment, and the U.S.
military generally has the right to cancel its contracts unilaterally without
prior notice. We manufacture for the U.S. aircraft and land vehicle armor
systems, protective equipment for military personnel and other technologies used
to protect soldiers in a variety of life-threatening or catastrophic situations,
and batteries for communications devices. The loss of, or a significant
reduction in, U.S. military business for our aircraft and land vehicle armor
systems, other protective equipment, or batteries could have a material adverse
effect on our business, financial condition, results of operations and
liquidity.
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AROTECH CORPORATION
A reduction of U.S. force levels in Iraq may affect our results of
operations.
Since the invasion of Iraq by the U.S. and other forces in March 2003, we
have received steadily increasing orders from the U.S. military for armoring of
vehicles and military batteries. These orders are the result, in substantial
part, from the particular combat situations encountered by the U.S. military in
Iraq. We cannot be certain, therefore, to what degree the U.S. military would
continue placing orders for our products if the U.S. military were to reduce its
force levels or withdraw completely from Iraq. A significant reduction in orders
from the U.S. military could have a material adverse effect on our business,
financial condition, results of operations and liquidity.
There are limited sources for some of our raw materials, which may
significantly curtail our manufacturing operations.
The raw materials that we use in manufacturing our armor products include
Kevlar(R), a patented product of E.I. du Pont de Nemours Co., Inc. We purchase
Kevlar in the form of woven cloth from various independent weaving companies. In
the event Du Pont and/or these independent weaving companies were to cease, for
any reason, to produce or sell Kevlar to us, we might be unable to replace it
with a material of like weight and strength, or at all. Thus, if our supply of
Kevlar were materially reduced or cut off or if there were a material increase
in the price of Kevlar, our manufacturing operations could be adversely affected
and our costs increased, and our business, financial condition and results of
operations could be materially adversely affected.
Some of the components of our products pose potential safety risks which
could create potential liability exposure for us.
Some of the components of our products contain elements that are known to
pose potential safety risks. In addition to these risks, there can be no
assurance that accidents in our facilities will not occur. Any accident, whether
occasioned by the use of all or any part of our products or technology or by our
manufacturing operations, could adversely affect commercial acceptance of our
products and could result in significant production delays or claims for damages
resulting from injuries. Any of these occurrences would materially adversely
affect our operations and financial condition. In the event that our products,
including the products manufactured by MDT and AoA, fail to perform as
specified, users of these products may assert claims for substantial amounts.
These claims could have a materially adverse effect on our financial condition
and results of operations. There is no assurance that the amount of the general
product liability insurance that we maintain will be sufficient to cover
potential claims or that the present amount of insurance can be maintained at
the present level of cost, or at all.
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AROTECH CORPORATION
Our fields of business are highly competitive.
The competition to develop defense and security products and electric
vehicle battery systems, and to obtain funding for the development of these
products, is, and is expected to remain, intense.
Our defense and security products compete with other manufacturers of
specialized training systems, including Firearms Training Systems, Inc., a
producer of interactive simulation systems designed to provide training in the
handling and use of small and supporting arms. In addition, we compete with
manufacturers and developers of armor for cars and vans, including O'Gara-Hess &
Eisenhardt, a division of Armor Holdings, Inc.
Our battery technology competes with other battery technologies, as well
as other Zinc-Air technologies. The competition in this area of our business
consists of development stage companies, major international companies and
consortia of such companies, including battery manufacturers, automobile
manufacturers, energy production and transportation companies, consumer goods
companies and defense contractors.
Various battery technologies are being considered for use in electric
vehicles and defense and safety products by other manufacturers and developers,
including the following: lead-acid, nickel-cadmium, nickel-iron, nickel-zinc,
nickel-metal hydride, sodium-sulfur, sodium-nickel chloride, zinc-bromine,
lithium-ion, lithium-polymer, lithium-iron sulfide, primary lithium,
rechargeable alkaline and Zinc-Air.
Many of our competitors have financial, technical, marketing, sales,
manufacturing, distribution and other resources significantly greater than ours.
If we are unable to compete successfully in each of our operating areas,
especially in the defense and security products area of our business, our
business and results of operations could be materially adversely affected.
Our business is dependent on proprietary rights that may be difficult to
protect and could affect our ability to compete effectively.
Our ability to compete effectively will depend on our ability to maintain
the proprietary nature of our technology and manufacturing processes through a
combination of patent and trade secret protection, non-disclosure agreements and
licensing arrangements.
Litigation, or participation in administrative proceedings, may be
necessary to protect our proprietary rights. This type of litigation can be
costly and time consuming and could divert company resources and management
attention to defend our rights, and this could harm us even if we were to be
successful in the litigation. In the absence of patent protection, and despite
our reliance upon our proprietary confidential information, our competitors may
be able to use innovations similar to those used by us to design and manufacture
products directly competitive with our products. In addition, no assurance can
be given that others will not obtain patents that we will need to license or
design around. To the extent any of our products are covered by third-party
patents, we could need to acquire a license under such patents to develop and
market our products.
32
Despite our efforts to safeguard and maintain our proprietary rights, we
may not be successful in doing so. In addition, competition is intense, and
there can be no assurance that our competitors will not independently develop or
patent technologies that are substantially equivalent or superior to our
technology. In the event of patent litigation, we cannot assure you that a court
would determine that we were the first creator of inventions covered by our
issued patents or pending patent applications or that we were the first to file
patent applications for those inventions. If existing or future third-party
patents containing broad claims were upheld by the courts or if we were found to
infringe third-party patents, we may not be able to obtain the required licenses
from the holders of such patents on acceptable terms, if at all. Failure to
obtain these licenses could cause delays in the introduction of our products or
necessitate costly attempts to design around such patents, or could foreclose
the development, manufacture or sale of our products. We could also incur
substantial costs in defending ourselves in patent infringement suits brought by
others and in prosecuting patent infringement suits against infringers.
We also rely on trade secrets and proprietary know-how that we seek to
protect, in part, through non-disclosure and confidentiality agreements with our
customers, employees, consultants, and entities with which we maintain strategic
relationships. We cannot assure you that these agreements will not be breached,
that we would have adequate remedies for any breach or that our trade secrets
will not otherwise become known or be independently developed by competitors.
We are dependent on key personnel and our business would suffer if we fail to
retain them.
We are highly dependent on the presidents of our IES, FAAC and AoA
subsidiaries and the general managers of our MDT and Epsilor subsidiaries, and
the loss of the services of one or more of these persons could adversely affect
us. We are especially dependent on the services of our Chairman, President and
Chief Executive Officer, Robert S. Ehrlich. The loss of Mr. Ehrlich could have a
material adverse effect on us. We are party to an employment agreement with Mr.
Ehrlich, which agreement expires at the end of 2007. We do not have key-man life
insurance on Mr. Ehrlich.
There are risks involved with the international nature of our business.
A significant portion of our sales are made to customers located outside
the U.S., primarily in Europe and Asia. In 2004, 2003 and 2002, without taking
account of revenues derived from discontinued operations, 19%, 42% and 56%,
respectively, of our revenues, were derived from sales to customers located
outside the U.S. We expect that our international customers will continue to
account for a substantial portion of our revenues in the near future. Sales to
international customers may be subject to political and economic risks,
including political instability, currency controls, exchange rate fluctuations,
foreign taxes, longer payment cycles and changes in import/export regulations
and tariff rates. In addition, various forms of protectionist trade legislation
have been and in the future may be proposed in the U.S. and certain other
countries. Any resulting changes in current tariff structures or other trade and
monetary policies could adversely affect our sales to international customers.
33
Investors should not purchase our common stock with the expectation of
receiving cash dividends.
We currently intend to retain any future earnings for funding growth and,
as a result, do not expect to pay any cash dividends in the foreseeable future.
Market-Related Risks
The price of our common stock is volatile.
The market price of our common stock has been volatile in the past and may
change rapidly in the future. The following factors, among others, may cause
significant volatility in our stock price:
o Announcements by us, our competitors or our customers;
o The introduction of new or enhanced products and services by us or
our competitors;
o Changes in the perceived ability to commercialize our technology
compared to that of our competitors;
o Rumors relating to our competitors or us;
o Actual or anticipated fluctuations in our operating results;
o The issuance of our securities, including warrants, in connection
with financings and acquisitions; and
o General market or economic conditions.
If our shares were to be delisted, our stock price might decline further and
we might be unable to raise additional capital.
One of the continued listing standards for our stock on the Nasdaq
National Market is the maintenance of a $1.00 bid price. Our stock price has
traded below $1.00 in the past. If our bid price were to go and remain below
$1.00 for 30 consecutive business days, Nasdaq could notify us of our failure to
meet the continued listing standards, after which we would have 180 calendar
days to correct such failure or be delisted from the Nasdaq National Market.
Although we would have the opportunity to appeal any potential delisting,
there can be no assurances that this appeal would be resolved favorably. As a
result, there can be no assurance that our common stock will remain listed on
the Nasdaq National Market. If our common stock were to be delisted from the
Nasdaq National Market, we might apply to be listed on the Nasdaq SmallCap
market; however, there can be no assurance that we would be approved for listing
on the Nasdaq SmallCap market, which has the same $1.00 minimum bid and other
similar requirements as the Nasdaq National Market. If we were to move to the
Nasdaq SmallCap market, current Nasdaq regulations would give us the opportunity
to obtain an additional 180-day grace period and an additional 90-day grace
period after that if we meet certain net income, stockholders' equity or market
capitalization criteria. While our stock would continue to trade on the
over-the-counter bulletin board following any delisting from the Nasdaq, any
such delisting of our common stock could have an adverse effect on the market
price of, and the efficiency of the trading market for, our common stock. Also,
if in the future we were to determine that we need to seek additional equity
capital, it could have an adverse effect on our ability to raise capital in the
public equity markets.
34
In addition, if we fail to maintain Nasdaq listing for our securities, and
no other exclusion from the definition of a "penny stock" under the Securities
Exchange Act of 1934, as amended, is available, then any broker engaging in a
transaction in our securities would be required to provide any customer with a
risk disclosure document, disclosure of market quotations, if any, disclosure of
the compensation of the broker-dealer and its salesperson in the transaction and
monthly account statements showing the market values of our securities held in
the customer's account. The bid and offer quotation and compensation information
must be provided prior to effecting the transaction and must be contained on the
customer's confirmation. If brokers become subject to the "penny stock" rules
when engaging in transactions in our securities, they would become less willing
to engage in transactions, thereby making it more difficult for our stockholders
to dispose of their shares.
Our management has determined that we have material weaknesses in our
internal controls. If we fail to achieve and maintain effective internal
controls in accordance with Section 404 of the Sarbanes-Oxley Act, we may not be
able to accurately report our financial results.
We have, with our auditors' concurrence, identified significant
deficiencies that constitute material weaknesses under standards established by
the Public Company Accounting Oversight Board (PCAOB). A material weakness is a
condition in which the design or operation of one or more of the internal
control components does not reduce to a relatively low level the risk that
misstatements caused by error or fraud in amounts that would be material in
relation to the financial statements being audited may occur and not be detected
within a timely period by employees in the normal course of performing their
assigned functions. Our auditors have reported to us that at December 31, 2004,
we had material weaknesses for inadequate controls related to the financial
statement close process, convertible debentures and share capital processes as
it applies to non-routine and highly complex financial transactions. The
material weaknesses arise from insufficient staff with technical accounting
expertise to independently apply our accounting policies, as they relate to
non-routine and highly complex transactions, in accordance with U.S. generally
accepted accounting principles.
As a public company, we will have significant requirements for enhanced
financial reporting and internal controls. The process of designing and
implementing effective internal controls is a continuous effort that requires us
to anticipate and react to changes in our business and the economic and
regulatory environments and to expend significant resources to maintain a system
of internal controls that is adequate to satisfy our reporting obligations as a
public company. We cannot assure you that the measures we have taken or will
take to remediate any material weaknesses or that we will implement and maintain
adequate controls over our financial processes and reporting in the future as we
continue our rapid growth. If we are unable to establish appropriate internal
financial reporting controls and procedures, it could cause us to fail to meet
our reporting obligations, result in material misstatements in our financial
statements, harm our operating results, cause investors to lose confidence in
our reported financial information and have a negative effect on the market
price for shares of our common stock.
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AROTECH CORPORATION
A substantial number of our shares are available for sale in the public
market and sales of those shares could adversely affect our stock price.
Sales of a substantial number of shares of common stock into the public
market, or the perception that those sales could occur, could adversely affect
our stock price or could impair our ability to obtain capital through an
offering of equity securities. As of March 31, 2005, we had 80,103,668 shares of
common stock issued and outstanding. Of these shares, most are freely
transferable without restriction under the Securities Act of 1933, and a
substantial portion of the remaining shares may be sold subject to the volume
restrictions, manner-of-sale provisions and other conditions of Rule 144 under
the Securities Act of 1933.
Exercise of our warrants, options and convertible debt could adversely affect
our stock price and will be dilutive.
As of March 31, 2005, there were outstanding warrants to purchase a total
of 16,961,463 shares of our common stock at a weighted average exercise price of
$1.55 per share, options to purchase a total of 9,284,047 shares of our common
stock at a weighted average exercise price of $1.33 per share, of which
7,168,676 were vested, at a weighted average exercise price of $1.34 per share,
and outstanding debentures convertible into a total of 3,156,298 shares of our
common stock at a weighted average conversion price of $1.44 per share. Holders
of our options, warrants and convertible debt will probably exercise or convert
them only at a time when the price of our common stock is higher than their
respective exercise or conversion prices. Accordingly, we may be required to
issue shares of our common stock at a price substantially lower than the market
price of our stock. This could adversely affect our stock price. In addition, if
and when these shares are issued, the percentage of our common stock that
existing stockholders own will be diluted.
Our certificate of incorporation and bylaws and Delaware law contain
provisions that could discourage a takeover.
Provisions of our amended and restated certificate of incorporation may
have the effect of making it more difficult for a third party to acquire, or of
discouraging a third party from attempting to acquire, control of us. These
provisions could limit the price that certain investors might be willing to pay
in the future for shares of our common stock. These provisions:
o divide our board of directors into three classes serving staggered
three-year terms;
o only permit removal of directors by stockholders "for cause," and
require the affirmative vote of at least 85% of the outstanding
common stock to so remove; and
o allow us to issue preferred stock without any vote or further action
by the stockholders.
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AROTECH CORPORATION
The classification system of electing directors and the removal provision
may tend to discourage a third-party from making a tender offer or otherwise
attempting to obtain control of us and may maintain the incumbency of our board
of directors, as the classification of the board of directors increases the
difficulty of replacing a majority of the directors. These provisions may have
the effect of deferring hostile takeovers, delaying changes in our control or
management, or may make it more difficult for stockholders to take certain
corporate actions. The amendment of any of these provisions would require
approval by holders of at least 85% of the outstanding common stock.
Israel-Related Risks
A significant portion of our operations takes place in Israel, and we could
be adversely affected by the economic, political and military conditions in that
region.
The offices and facilities of three of our subsidiaries, EFL, MDT and
Epsilor, are located in Israel (in Beit Shemesh, Lod and Dimona, respectively,
all of which are within Israel's pre-1967 borders). Most of our senior
management is located at EFL's facilities. Although we expect that most of our
sales will be made to customers outside Israel, we are nonetheless directly
affected by economic, political and military conditions in that country.
Accordingly, any major hostilities involving Israel or the interruption or
curtailment of trade between Israel and its present trading partners could have
a material adverse effect on our operations. Since the establishment of the
State of Israel in 1948, a number of armed conflicts have taken place between
Israel and its Arab neighbors and a state of hostility, varying in degree and
intensity, has led to security and economic problems for Israel.
Historically, Arab states have boycotted any direct trade with Israel and
to varying degrees have imposed a secondary boycott on any company carrying on
trade with or doing business in Israel. Although in October 1994, the states
comprising the Gulf Cooperation Council (Saudi Arabia, the United Arab Emirates,
Kuwait, Dubai, Bahrain and Oman) announced that they would no longer adhere to
the secondary boycott against Israel, and Israel has entered into certain
agreements with Egypt, Jordan, the Palestine Liberation Organization and the
Palestinian Authority, Israel has not entered into any peace arrangement with
Syria or Lebanon. Moreover, since September 2000, there has been a significant
deterioration in Israel's relationship with the Palestinian Authority, and a
significant increase in terror and violence. Efforts to resolve the problem have
failed to result in an agreeable solution. Continued hostilities between the
Palestinian community and Israel and any failure to settle the conflict may have
a material adverse effect on our business and us. Moreover, the current
political and security situation in the region has already had an adverse effect
on the economy of Israel, which in turn may have an adverse effect on us.
Service of process and enforcement of civil liabilities on us and our
officers may be difficult to obtain.
We are organized under the laws of the State of Delaware and will be
subject to service of process in the United States. However, approximately 22%
of our assets are located outside the United States. In addition, two of our
directors and most of our executive officers are residents of Israel and a
portion of the assets of such directors and executive officers are located
outside the United States.
37
There is doubt as to the enforceability of civil liabilities under the
Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as
amended, in original actions instituted in Israel. As a result, it may not be
possible for investors to enforce or effect service of process upon these
directors and executive officers or to judgments of U.S. courts predicated upon
the civil liability provisions of U.S. laws against our assets, as well as the
assets of these directors and executive officers. In addition, awards of
punitive damages in actions brought in the U.S. or elsewhere may be
unenforceable in Israel.
Exchange rate fluctuations between the U.S. dollar and the Israeli NIS may
negatively affect our earnings.
Although a substantial majority of our revenues and a substantial portion
of our expenses are denominated in U.S. dollars, a portion of our costs,
including personnel and facilities-related expenses, is incurred in New Israeli
Shekels (NIS). Inflation in Israel will have the effect of increasing the dollar
cost of our operations in Israel, unless it is offset on a timely basis by a
devaluation of the NIS relative to the dollar. In 2004, the inflation adjusted
NIS appreciated against the dollar, which raised the dollar cost of our Israeli
operations.
Some of our agreements are governed by Israeli law.
Israeli law governs some of our agreements, such as our lease agreements
on our subsidiaries' premises in Israel, and the agreements pursuant to which we
purchased IES, MDT and Epsilor. While Israeli law differs in certain respects
from American law, we do not believe that these differences materially adversely
affect our rights or remedies under these agreements.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Interest Rate Risk
It is our policy not to enter into interest rate derivative financial
instruments, except for hedging of foreign currency exposures discussed below.
We do not currently have any significant interest rate exposure.
Foreign Currency Exchange Rate Risk
Since a significant part of our sales and expenses are denominated in U.S.
dollars, we have experienced only insignificant foreign exchange gains and
losses to date, and do not expect to incur significant gains and losses in 2005.
Certain of our research, development and production activities are carried out
by our Israeli subsidiary, EFL, at its facility in Beit Shemesh, and accordingly
we have sales and expenses in NIS. Additionally, our MDT and Epsilor
subsidiaries operate primarily in NIS. However, the majority of our sales are
made outside Israel in U.S. dollars, and a substantial portion of our costs are
incurred in U.S. dollars. Therefore, our functional currency is the U.S. dollar.
While we conduct our business primarily in U.S. dollars, some of our
agreements are denominated in foreign currencies, and we occasionally hedge part
of the risk of a devaluation of the U.S dollar, which could have an adverse
effect on the revenues that we incur in foreign currencies. We do not hold or
issue derivative financial instruments for trading or speculative purposes
38
AROTECH CORPORATION
ITEM 4. CONTROLS AND PROCEDURES.
Evaluation of Disclosure Controls and Procedures
As of March 31, 2005, our management, including the principal executive
officer and principal financial officer, evaluated our disclosure controls and
procedures related to the recording, processing, summarization, and reporting of
information in our periodic reports that we file with the SEC. These disclosure
controls and procedures are intended to ensure that material information
relating to us, including our subsidiaries, is made known to our management,
including these officers, by other of our employees, and that this information
is recorded, processed, summarized, evaluated, and reported, as applicable,
within the time periods specified in the SEC's rules and forms. Due to the
inherent limitations of control systems, not all misstatements may be detected.
These inherent limitations include the realities that judgments in
decision-making can be faulty and that breakdowns can occur because of simple
error or mistake. Any system of controls and procedures, no matter how well
designed and operated, can at best provide only reasonable assurance that the
objective of the system are met and management necessarily is required to apply
its judgment in evaluating the cost benefit relationship of possible controls
and procedures. Additionally, controls can be circumvented by the individual
acts of some persons, by collusion of two or more people, or by management
override of the control. Our controls and procedures are intended to provide
only reasonable, not absolute, assurance that the above objectives have been
met.
Based on their evaluation, our principal executive officer and principal
financial officer concluded that our controls and procedures (as defined in
Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) were
not effective as of March 31, 2005.
Our management has not completed implementation of the changes it believes
are required to remediate the previously reported material weaknesses for
inadequate controls related to the financial statement close process,
convertible debentures and share capital processes as it applies to non-routine
and highly complex financial transactions. The material weaknesses arise from
insufficient staff with technical accounting expertise to independently apply
our accounting policies, as they relate to non-routine and highly complex
transactions, in accordance with U.S. generally accepted accounting principles.
Management has identified that due to the reasons described above, we did not
consistently follow established internal control over financial reporting
procedures related to the analysis, documentation and review of selection of the
appropriate accounting treatment for non-routine and highly complex
transactions. Because of these material weaknesses, we have concluded that we
did not maintain effective internal control over financial reporting as of March
31, 2005, based on the criteria set forth by the Committee of Sponsoring
Organizations ("COSO") of the Treadway Commission in Internal Control -
Integrated Framework.
In light of the material weakness described above, our management
performed additional analyses and other post-closing procedures to ensure our
consolidated financial statements are prepared in accordance with generally
accepted accounting principles in the United States (U.S. GAAP). Accordingly,
management believes that the consolidated financial statements included in this
report fairly present in all material respects our financial position, results
of operations and cash flows for the periods presented.
39
AROTECH CORPORATION
Management's Response to the Material Weaknesses
In response to the material weaknesses described above, we have undertaken
to take the following initiatives with respect to our internal controls and
procedures that we believe are reasonably likely to improve and materially
affect our internal control over financial reporting. We anticipate that
remediation will be continuing throughout fiscal 2005, during which we expect to
continue pursuing appropriate corrective actions, including the following:
>> Preparing appropriate written documentation of our financial control
procedures;
>> Adding additional qualified staff to our finance department;
>> Scheduling training for accounting staff to heighten awareness of
generally accepted accounting principles applicable to complex
transactions;
>> Strengthening our internal review procedures in conjunction with our
ongoing work to enhance our internal controls so as to enable us to
identify and adjust items proactively;
>> Engaging an outside accounting firm to support our Sarbanes-Oxley
Section 404 compliance activities and to provide technical expertise
in the selection and application of generally accepted accounting
principles related to complex transactions to identify areas that
require control or process improvements and to consult with us on
the appropriate accounting treatment applicable to complex
transactions; and
>> Implementing the recommendations of our outside accounting
consultants.
Our management and Audit Committee will monitor closely the implementation
of our remediation plan. The effectiveness of the steps we intend to implement
is subject to continued management review, as well as Audit Committee oversight,
and we may make additional changes to our internal control over financial
reporting.
Changes in Internal Controls Over Financial Reporting
Except as noted above, there have been no changes in our internal control
over financial reporting that occurred during our last fiscal quarter to which
this Annual Report on Form 10-K relates that have materially affected, or are
reasonably likely to materially affect, our internal control over financial
reporting.
40
AROTECH CORPORATION
PART II
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.
Issuance of Restricted Stock to Certain Employees
In January 2005, we granted 10,000 shares of our common stock as a stock
bonus to an employee. Under the terms of this grant, the sale or other transfer
of these shares is restricted for a period of two years from the date of grant,
and such shares automatically return to us if the employee leaves our employ
during such two-year period under circumstances that would not entitle the
employee to statutory severance under Israeli law (generally, resignation
without good cause or dismissal with good cause).
We issued the above securities in reliance on the exemption from
registration provided by Section 4(2) of the Securities Act as transactions by
an issuer not involving a public offering. The issuance of these securities was
without the use of an underwriter, and the shares of common stock were issued
with restrictive legends permitting transfer thereof only upon registration or
an exemption under the Act.
ITEM 6. EXHIBITS.
The following documents are filed as exhibits to this report:
Exhibit Number Description
-------------- -----------
*10.1 .........Agreement signed on May 15, 2005 among Electric Fuel
(E.F.L.) Ltd., Arotech Corporation and Robert S. Ehrlich
*10.2 .........Agreement signed on May 15, 2005 between Electric Fuel
(E.F.L.) Ltd. and Steven Esses
31.1 ..........Certification of Chief Executive Officer pursuant to Section
302 of the Sarbanes-Oxley Act of 2002
31.2 ..........Certification of Chief Financial Officer pursuant to Section
302 of the Sarbanes-Oxley Act of 2002
32.1 ..........Certification of Chief Executive Officer pursuant to Section
906 of the Sarbanes-Oxley Act of 2002
32.2 ..........Certification of Chief Financial Officer pursuant to Section
906 of the Sarbanes-Oxley Act of 2002
- ---------
* Includes management contracts and compensation plans and
arrangements.
41
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.
Dated: May 16, 2005
AROTECH CORPORATION
By: /s/ Robert S. Ehrlich
-------------------------------------
Name: Robert S. Ehrlich
Title: Chairman, President and CEO
(Principal Executive Officer)
By: /s/ Avihai Shen
-------------------------------------
Name: Avihai Shen
Title: Vice President - Finance
(Principal Financial Officer)
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AROTECH CORPORATION
EXHIBIT INDEX
Exhibit Number Description
-------------- -----------
*10.1 .........Agreement signed on May 15, 2005 among Electric Fuel
(E.F.L.) Ltd., Arotech Corporation and Robert S. Ehrlich
*10.2 .........Agreement signed on May 15, 2005 between Electric Fuel
(E.F.L.) Ltd. and Steven Esses
31.1 ..........Certification of Chief Executive Officer pursuant to Section
302 of the Sarbanes-Oxley Act of 2002
31.2 ..........Certification of Chief Financial Officer pursuant to Section
302 of the Sarbanes-Oxley Act of 2002
32.1 ..........Certification of Chief Executive Officer pursuant to Section
906 of the Sarbanes-Oxley Act of 2002
32.2 ..........Certification of Chief Financial Officer pursuant to Section
906 of the Sarbanes-Oxley Act of 2002
- ---------
* Includes management contracts and compensation plans and
arrangements.