ASPEN AEROGELS INC - Quarter Report: 2018 September (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended September 30, 2018

OR

For the transition period from              to             

Commission file number: 001-36481

ASPEN AEROGELS, INC.

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code: (508) 691-1111

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  ☒    No  ☐

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).        Yes  ☒    No  ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☒

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ☐    No  ☒

As of November 6, 2018, the registrant had 23,970,487 shares of common stock outstanding.

ASPEN AEROGELS, INC.

INDEX TO FORM 10-Q

Trademarks, Trade Names and Service Marks

We own or have rights to use “Aspen Aerogels,” “Cryogel,” “Pyrogel,” “Spaceloft,” the Aspen Aerogels logo and other trademarks, service marks and trade names of Aspen Aerogels, Inc. appearing in this Quarterly Report on Form 10-Q. Solely for convenience, the trademarks, service marks and trade names referred to in this report are presented without the ® and TM symbols, but such references are not intended to indicate, in any way, that the owner thereof will not assert, to the fullest extent under applicable law, such owner’s rights to these trademarks, service marks and trade names. This report contains additional trademarks, service marks and trade names of other companies, which, to our knowledge, are the property of their respective owners.

PART I — FINANCIAL INFORMATION

ASPEN AEROGELS, INC.

Consolidated Balance Sheets

(Unaudited)

See accompanying notes to unaudited consolidated financial statements.

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ASPEN AEROGELS, INC.

Consolidated Statements of Operations

(Unaudited)

See accompanying notes to unaudited consolidated financial statements.

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ASPEN AEROGELS, INC.

Consolidated Statements of Cash Flows

(Unaudited)

See accompanying notes to unaudited consolidated financial statements.

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ASPEN AEROGELS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

(1) Description of Business and Basis of Presentation

Nature of Business

Aspen Aerogels, Inc. (the Company) is an aerogel technology company that designs, develops and manufactures innovative, high-performance aerogel insulation used primarily in the energy infrastructure and building materials markets. The Company also conducts research and development related to aerogel technology supported by funding from several agencies of the U.S. government and other institutions in the form of research and development contracts.

The Company maintains its corporate offices in Northborough, Massachusetts. The Company has three wholly owned subsidiaries: Aspen Aerogels Rhode Island, LLC, Aspen Aerogels Germany, GmbH and Aspen Aerogels Georgia, LLC.

Liquidity

In August 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2014‑15, Presentation of Financial Statements-Going Concern (Subtopic 205-40): Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern (ASU 2015-14). This ASU requires management to assess and evaluate whether conditions or events exist, considered in the aggregate, that raise substantial doubt about the entity's ability to continue as a going concern within one year after the financial statements issue date. The Company adopted this standard effective January 1, 2017.

At September 30, 2018, the Company had a cash and cash equivalents balance of $5.2 million and $5.2 million of outstanding borrowings under its revolving line of credit (see note 7). After giving effect to the outstanding borrowings and letters of credit, the additional amount available to the Company at September 30, 2018 under the revolving line of credit was $8.0 million. The existing revolving line of credit matures on April 28, 2019.

The Company is making investments to increase capacity at its existing manufacturing facility in East Providence, Rhode Island, to expand its sales and marketing efforts, and to develop new technologies and business opportunities. The Company expects its existing cash balance and the amount anticipated to be available under the existing revolving line of credit will be sufficient to fund a portion of these investments. The Company plans to manage capital expenditures and working capital balances to maintain the cash resources required to support current operating requirements and the initial phases of the capacity expansion plan.

The Company will need to supplement its cash balance and amounts available under its revolving line of credit with anticipated cash flows from operations, local government grants, debt financings, customer prepayments, technology licensing agreements or equity financings to provide the capital required to complete the expansion of the existing manufacturing facility and to fund its strategic business initiatives.

Unaudited Interim Financial Information

The accompanying unaudited interim consolidated financial statements include the accounts of the Company and have been prepared in accordance with accounting principles generally accepted in the United States of America (U.S. GAAP) and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Certain information and disclosures normally included in the consolidated financial statements prepared in accordance with U.S. GAAP have been condensed or omitted pursuant to such rules and regulations. As such, the information included in this Quarterly Report on Form 10-Q should be read in conjunction with the audited consolidated financial statements and accompanying notes in our Annual Report on Form 10-K for the year ended December 31, 2017 (the Annual Report), filed with the Securities and Exchange Commission on March 1, 2018.

In the opinion of the Company’s management, the unaudited interim consolidated financial statements have been prepared on the same basis as the audited consolidated financial statements and include all adjustments that are of a normal recurring nature and necessary for the fair statement of the Company’s financial position as of September 30, 2018 and the results of its operations for the nine months ended September 30, 2018 and 2017 and the cash flows for the nine month periods then ended. The Company has evaluated events through the date of this filing.

The results of operations for the three and nine months ended September 30, 2018 are not necessarily indicative of the results to be expected for the year ending December 31, 2018 or any other period.

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(2) Significant Accounting Policies

Principles of Consolidation

The accompanying consolidated financial statements, which have been prepared in accordance with U.S. GAAP, include the accounts of the Company and its wholly owned subsidiaries. All intercompany balances and transactions have been eliminated in consolidation.

Use of Estimates

The preparation of the consolidated financial statements requires the Company to make a number of estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Significant items subject to such estimates and assumptions include allowances for doubtful accounts, sales returns and allowances, product warranty costs, inventory valuation, the carrying amount of property and equipment, stock-based compensation and deferred income taxes. The Company evaluates its estimates and assumptions on an on-going basis using historical experience and other factors, including the current economic environment, which are believed to be reasonable under the circumstances. Management adjusts such estimates and assumptions when facts and circumstances warrant. Illiquid credit markets, volatile equity markets and declines in business investment increase the uncertainty inherent in such estimates and assumptions. As future events and their effects cannot be determined with precision, actual results could differ significantly from these estimates. Changes in these estimates resulting from continuing changes in the economic environment will be reflected in the financial statements in future periods.

Cash and Cash Equivalents

Cash equivalents include short-term, highly liquid instruments, which consist of money market accounts. All cash and cash equivalents are maintained with major financial institutions in North America. Deposits with these financial institutions may exceed the amount of insurance provided on such deposits; however, these deposits typically may be redeemed upon demand and, therefore, bear minimal risk.

Revenue Recognition

On January 1, 2018, the Company adopted Accounting Standards Codification 606, Revenue from Contracts with Customers (ASC 606). See note 3 for further details.

The Company recognizes revenue from the sale of products and performance of research and development services. Revenue is recognized when a customer obtains control of promised goods or services, in an amount that reflects the consideration which the Company expects to receive in exchange from those goods or services.

Sales returns are recorded based on historical sales and return information. Products that exhibit unusual sales return patterns due to quality or other manufacturing matters are specifically investigated and analyzed as part of the sales return accrual. The sales return accrual represents a reserve for products that may be returned due to quality concerns or authorized for destruction in the field. Sales return reserves are recorded at full original sales value. The Company rarely exchanges products from inventory for returned products. Sales return and other credit reserves were $0.2 million and $0.1 million at September 30, 2018 and December 31, 2017, respectively.

Stock-based Compensation

Stock-based compensation expense is measured at the grant date based on the fair value of the award. Expense is recognized on a straight-line basis over the requisite service period for all awards with service conditions. For performance-based awards, the grant date fair value is recognized as expense when the condition is probable of being achieved, and then on a graded basis over the requisite service period. The Company uses the Black-Scholes option-pricing model to determine the fair value of service-based option awards, which requires a number of complex and subjective assumptions including fair value of the underlying security, the expected volatility of the underlying security, a risk-free interest rate and the expected term of the option. The fair value of restricted stock and restricted stock unit grants is determined using the closing trading price of the Company’s common stock on the date of grant. The fair value of awards containing market conditions is determined using a Monte Carlo simulation model based upon the nature of the conditions, the expected volatility of the underlying security, and other relevant factors.

During the nine months ended September 30, 2018, the Company granted 58,062 shares of restricted common stock with a grant date fair value of $0.3 million and 81,102 non-qualified options (NSOs) to purchase shares of common stock with a grant date fair value of $0.4 million vesting over a period of one year to its non-employee directors under the 2014 Employee, Director and

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Consultant Equity Incentive Plan (the 2014 Equity Plan). During the nine months ended September 30, 2018, the Company also granted 497,910 restricted common stock units (RSUs) with a grant date fair value of $2.3 million and 493,154 NSOs to purchase shares of common stock with a grant date fair value of $1.1 million to employees under the 2014 Equity Plan. The RSUs and NSOs granted to employees vest over a three year period.

Stock-based compensation is included in cost of revenue or operating expenses, as applicable, and consists of the following:

Pursuant to the “evergreen” provisions of the 2014 Equity Plan, the number of shares of common stock authorized for issuance under the plan automatically increased by 472,863 shares to 7,009,460 shares effective January 1, 2018.

As of September 30, 2018, 3,826,217 shares of common stock were reserved for issuance upon the exercise or vesting of outstanding stock-based awards granted under the 2014 Equity Plan. In addition, as of September 30, 2018, 89,465 shares of common stock were reserved for issuance upon the exercise of outstanding stock options granted under the Company’s 2001 Equity Incentive Plan, as amended (the 2001 Equity Plan). Any cancellations or forfeitures of the options outstanding under the 2001 Equity Plan will result in the shares reserved for issuance upon exercise of such options becoming available for grant under the 2014 Equity Plan. As of September 30, 2018, there were 1,785,891 shares of common stock available for future grant under the 2014 Equity Plan.

Earnings per Share

The Company calculates net loss per common share based on the weighted-average number of common shares outstanding during each period. Potential common stock equivalents are determined using the treasury stock method. The weighted-average number of common shares included in the computation of diluted net loss gives effect to all potentially dilutive common equivalent shares, including outstanding stock options, RSUs and warrants. Common equivalent shares are excluded from the computation of diluted net loss per share if their effect is antidilutive.

Segments

Operating segments are identified as components of an enterprise about which separate, discrete financial information is available for evaluation by the chief operating decision maker in making decisions on how to allocate resources and assess performance. The Company’s chief operating decision maker is the Chief Executive Officer. The Company’s chief operating decision maker reviews consolidated operating results to make decisions about allocating resources and assessing performance for the entire Company. The Company views its operations and manages its business as one operating segment.

Information about the Company’s total revenues, based on shipment destination or services location, is presented in the following table:

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Warranty Costs

The Company provides warranties for its products and records the estimated cost within cost of revenue in the period that the related revenue is recorded. The Company’s standard warranty period extends to one year from the date of shipment. This standard warranty provides that the Company’s products will be free from defects in material and workmanship, and will, under normal use, conform to the specifications for the product.

The Company’s products may be utilized in systems that involve new technical demands and new configurations. Accordingly, the Company regularly reviews and assesses whether warranty reserves should be recorded in the period that the related revenue is recorded. For an initial shipment of product for use in a system with new technical demands or new configurations and where the Company is unsure of meeting the customer’s specifications, the Company will defer the recognition of product revenue and related costs until written customer acceptance is obtained.

The Company performs periodic testing of its aerogel blankets to ensure compliance with published performance specifications. From time to time, tests may indicate a product could potentially perform outside of these specifications. At that time, additional testing is initiated or the Company may conduct a root cause investigation. During the nine months ended September 30, 2018, a test result indicated that tested samples performed outside the published performance specifications for a specific attribute of a product and, as a result, the Company performed additional testing. The Company has determined that it is probable it has incurred a liability, however, a liability or range of liability is not estimable as of September 30, 2018. The Company will continue to assess the impact of the testing results on its customer base and, depending on the assessment, could be subject to material warranty charges in future periods.

The Company did not record any warranty expense during the nine months ended September 30, 2018. During the nine months ended September 30, 2017, the Company recorded warranty expense of $0.9 million. This specific warranty charge was related to product claims for a single product application issue. As of September 30, 2018, the Company had satisfied all outstanding warranty claims.

Recently Issued Accounting Standards

From time to time, new accounting pronouncements are issued by the FASB or other standard setting bodies. Recently issued standards typically do not require adoption until a future effective date. Prior to their effective date, the Company evaluates the pronouncements to determine the potential effects of adoption to its consolidated financial statements.

Standards Implemented Since December 31, 2017

In August 2015, the FASB issued a deferral of ASU 2014-09, Revenue from Contracts with Customers. The standard replaced the transaction- and industry-specific revenue recognition guidance under current U.S. GAAP with a principle based approach for determining revenue recognition. As a result of the deferral, public entities were required to apply the revised revenue recognition standard for the annual reporting period beginning on or after December 15, 2017, including interim periods within that annual reporting period. The Company adopted this standard using the modified retrospective method on January 1, 2018. The Company completed its analysis of the new revenue standard and determined that it would not materially impact the allocation and timing of recognition of previously reported revenues from the sale of products or performance of research and development services. In addition, the Company determined that there were no incremental contract costs or contract fulfillment costs to be recognized in connection with the adoption. Based on the Company’s analysis, no adjustment to retained earnings was required as of the January 1, 2018 adoption date. Accordingly, the Company’s application of the standard did not have a material impact on the Company’s consolidated balance sheet at January 1, 2018 and did not have a material impact to its statement of operations for the nine months ended September 30, 2018 and 2017 or the twelve months ended December 31, 2017.

In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments (ASU 2016-15). This amendment addresses eight classification issues related to the statement of cash flows. The amendments in ASU 2016-15 are effective for public business entities for annual and interim periods in fiscal years beginning after December 15, 2017. The Company adopted the provisions of the amendment on January 1, 2018. The adoption of the standard has not resulted in any material impact to the Company’s consolidated financial statements or other disclosures.

Standards to be Implemented

In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). FASB ASU 2016-02 modifies the accounting for leases and requires that all leases be recorded on the consolidated balance sheets as assets and liabilities. This standard is effective for fiscal years beginning after December 15, 2018. Early application is permitted. The Company expects to adopt the new standard on January

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1, 2019, to apply a modified retrospective transition approach and to use the effective date as the date of initial application. As a result, the Company will not update financial information and will not provide the disclosures required under the new standard for dates and periods before January 1, 2019. The Company expects to elect the package of practical expedients under the new standard, which permits the Company to not reassess prior conclusions about lease identification, lease classification, and initial direct costs. The Company expects that this standard will have a material effect on the Company’s consolidated financial statements. The most significant effects relate to the recognition of new right-of-use (ROU) assets and lease liabilities on the consolidated balance sheets and the provision of significant new disclosures about the Company’s leasing activities. The Company currently expects to elect the short-term lease recognition exemption for all leases that qualify. For leases that qualify for this exemption, the Company will not recognize ROU assets or lease liabilities. The Company also currently expects to elect the practical expedient to not separate lease and non-lease components for all of the Company’s leases.

The Company is in the process of updating its systems, controls and procedures for lease portfolio accounting to comply with the new standard. The Company does not expect a significant change in leasing activities prior to the expected adoption of the new standard on January 1, 2019.

(3) Revenue from Contracts with Customers

On January 1, 2018, the Company adopted Accounting Standards Codification 606, Revenue from Contracts with Customers (ASC 606) using the modified retrospective method for all contracts not completed as of the date of adoption. The adoption of ASC 606 did not have a material impact on the allocation and timing of the recognition of previously reported revenues from the sale of products, subsea projects or performance of research and development services. In addition, the Company determined that there are no incremental contract costs or contract fulfillment costs associated with the adoption. The reported results for 2018 reflect the application of ASC 606 guidance while the reported results for 2017 were prepared under the guidance of ASC 605. The adoption of ASC 606 represents a change in accounting principle that more closely aligns revenue recognition with the delivery of the Company's product or research services and will provide financial statement readers with enhanced disclosures.

Revenue Recognition

Revenue is recognized when a customer obtains control of promised goods or services, in an amount that reflects the consideration which the entity expects to receive in exchange from those goods or services. To determine revenue recognition for arrangements within the scope of ASC 606, the Company performs the following five steps: (i) identification of the contract with a customer; (ii) identification of the performance obligations in the contract; (iii) determination of the transaction price; (iv) allocation of the transaction price to the separate performance obligations in the contract; and (v) recognition of the revenue associated with performance obligation as they are satisfied. The Company applies the five-step model to contracts when it is probable that the Company will collect the consideration it is entitled to in exchange for the goods or services it transfers to the customer. At contract inception, once the contract is determined to be within the scope of ASC 606, the Company assesses the goods or services promised within each contract and determines those that are performance obligations, and assesses whether each promised good or service is distinct. If the contract contains a single performance obligation, the entire transaction price is allocated to the single performance obligation. Contracts that contain multiple performance obligations require an allocation of the transaction price based on the estimated relative standalone selling prices of the promised products or services underlying each performance obligation. The Company determines standalone selling prices based on the price at which the performance obligation is sold separately. If the standalone selling price is not observable through past transactions, the Company estimates the standalone selling price taking into account available information such as market conditions and internally approved pricing guidelines related to the performance obligations. The Company then recognizes as revenue the amount of the transaction price that is allocated to the respective performance obligation when (or as) the performance obligation is satisfied.

When determining the transaction price of a contract, an adjustment is made if payment from a customer occurs either significantly before or significantly after performance, resulting in a significant financing component. Applying the practical expedient in paragraph ASC 606-10-32-18, the Company does not assess whether a significant financing component exists if the period between when the Company performs its obligations under the contract and when the customer pays is one year or less. The Company did not have any contracts outstanding at January 1, 2018 and did not enter into any contracts during the nine months ended September 30, 2018 that contained a significant financing component.

The Company records deferred revenue for product sales when the Company has delivered products but other performance obligations have not been satisfied or control has not been transferred to the customer.

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Shipping and Handling Costs

Shipping and handling costs associated with outbound freight after control over a product has transferred to a customer are accounted for as fulfillment costs and are included in the cost of product revenue. The amount of revenue recognized reflects the consideration to which the Company expects to be entitled to receive in exchange for these products or research services.

Product Revenue

The Company generally enters into contracts containing one type of performance obligation. The Company recognizes product revenue when the performance obligation is satisfied, which is generally upon delivery according to contractual shipping terms within customer purchase orders.

The Company also enters into rebate agreements with certain customers. These agreements may be considered an additional performance obligation of the Company or variable consideration within a contract. Rebates are recorded as a reduction of revenue in the period the related product revenue is recognized. A corresponding liability is recorded as a component of deferred revenue on the consolidated balance sheets. These arrangements are primarily based on the customer attaining contractually specified sales volumes.

The Company estimates the amount of its product sales that may be returned by its customers and records this estimate as a reduction of revenue in the period the related product revenue is recognized. The Company currently estimates product return liabilities using historical rates of return, current quarter credit sales, and specific items of exposure on a contract by contract basis.

Subsea Projects

The Company manufactures and sells subsea products that are designed for pipe-in-pipe applications in offshore oil production and are typically customized to meet customer specifications. Subsea products typically have no alternative use and contain an enforceable right to payment. Customer invoicing terms for subsea products are typically based on certain milestones within the production and delivery schedule. Under the provisions of ASC 606, the Company recognizes revenue at a point in time when transfer of control of the products is passed to the customer, or over time utilizing the input/cost-to-cost method. The timing of revenue recognition is assessed on a contract by contract basis. During the nine months ended September 30, 2018, the Company recognized $2.4 million in connection with subsea projects.

Other Revenue

The Company is party to an amended and restated supply agreement with BASF Polyurethanes GmbH (BASF) (the Supply Agreement) and a joint development agreement with BASF SE (the JDA) (see note 7). Pursuant to the Supply Agreement, the Company will sell exclusively to BASF the Company’s Spaceloft A2 product at annual volumes to be specified by BASF, subject to certain volume limits. The Company has determined that the exclusivity component of the Supply Agreement represents a performance obligation to BASF that will be satisfied over time. The Company will calculate the value of the exclusivity component upon receipt of prepayments from BASF. Revenue associated with this performance obligation will be recognized over the term of the agreement which expires on December 31, 2027.

During the nine months ended September 30, 2018, BASF made two prepayments of $2.5 million each. At the time of the receipt of the prepayments, the Company calculated and accounted for the value associated with exclusivity component as deferred revenue. The value associated with the exclusivity component was approximately $0.5 million for each prepayment.

During the nine months ended September 30, 2018, the Company recognized less than $0.1 million in revenue associated with the exclusive right to sell Spaceloft A2 which is recorded as a component of product revenue in the Company’s consolidated statement of operations. At September 30, 2018, deferred revenue related to the exclusivity component of the Supply Agreement totaled $1.0 million. There was no deferred revenue related to the Supply Agreement at December 31, 2017.

Research Services

The Company performs research services under contracts with various government agencies and other institutions. These contracts generally have one type of performance obligation associated with the provision of research services including functional licenses to any resulting intellectual property. The Company records revenue using the percentage-of-completion method in two ways: (1) for firm-fixed-price contracts, the Company accrues that portion of the total contract price that is allocable on the basis of the Company’s estimates of costs incurred to date to total contract costs; and (2) for cost-plus-fixed-fee contracts, the Company records revenue that is equal to total payroll cost incurred times a stated factor plus reimbursable expenses, to a stated upper limit. The primary cost under the Company’s research service contacts is the labor effort expended in completing the research, and the only

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deliverable, other than the labor hours expended, is the reporting of research results to the customer. Because the input measure of labor hours expended is also reflective of the output measure, it is a reliable means to measure the extent of progress toward completion. Revisions in cost estimates and fees during the course of the contract are reflected in the accounting period in which the facts that require the revisions become known. Contract costs and rates used to allocate overhead to contracts are subject to audit by the respective contracting government agency. Adjustments to revenue as a result of audit are recorded within the period they become known. To date, adjustments to revenue as a result of contracting agency audits have been insignificant.

Disaggregation of Revenue

In the following table, revenue is disaggregated by primary geographical region and source of revenue:

Contract Balances

The following table presents changes in the Company’s contract assets and contract liabilities during the nine months ended September 30, 2018:

During the nine months ended September 30, 2018, the Company recognized $1.3 million of revenue that was included in deferred revenue at the beginning of the period.

A contract asset is recorded when the Company satisfies a performance obligation by transferring a promised good or service and has earned the right to consideration from its customer. These assets may represent a conditional or unconditional right to consideration and are included within accounts receivable on the consolidated balance sheets.

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A contract liability is recorded when consideration is received, or such consideration is unconditionally due, from a customer prior to transferring goods or services under the terms of the contract. Contract liabilities are recognized as revenue after control of the products or services is transferred to the customer and all revenue recognition criteria have been met. 

Transition Disclosures

The following tables summarize the impacts of adopting ASC 606 on certain components of the Company’s consolidated financial statements as of and for the three and nine months ended September 30, 2018:

Consolidated Balance Sheets

Total reported assets and liabilities were each approximately $0.5 million less than the pro forma consolidated balance sheet which assumes ASC 605 guidance remained in effect as of September 30, 2018. Reported inventories and deferred revenue reflect the impact of revenue recognized over time utilizing the input/cost-to-cost method for subsea projects during the nine months ended September 30, 2018.

Consolidated Statements of Operations

Total reported product revenue and product cost of revenue were each approximately $0.5 million greater than the pro forma consolidated statement of operations for the three and nine months ended September 30, 2018 under ASC 606. Reported revenue and cost of revenue reflect the impact of revenue recognized over time utilizing the input/cost-to-cost method for subsea projects during the nine months ended September 30, 2018. Under ASC 605 subsea projects revenue was recognized at a point in time when transfer of control of the product passed to the customer.

The impact of the adoption of ASC 606 on the consolidated statement of cash flows for the nine months ended September 30, 2018 was not material and had no impact on net cash used in operating activities.

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(4) Inventories

Inventories consist of the following:

(5) Property, Plant and Equipment, Net

Property, plant and equipment consist of the following:

Depreciation expense was $8.3 million and $8.0 million for the nine months ended September 30, 2018 and 2017, respectively.

Construction in progress included engineering designs and other pre-construction costs for the planned manufacturing facility in Statesboro, Georgia of $7.2 million at both September 30, 2018 and December 31, 2017. The Company has delayed the project to construct the Statesboro, Georgia manufacturing facility to better align the timing of this capacity expansion with the Company’s assessment of future demand. In addition, construction in progress included $2.3 million and less than $0.1 million at September 30, 2018 and December 31, 2017, respectively, related to projects associated with the Company’s plan to expand the capacity of the East Providence, Rhode Island facility.

(6) Accrued Expenses

Accrued expenses consist of the following:

(7) Commitments and Contingencies

Customer Supply Agreement

The Company is party to the Supply Agreement with BASF and the JDA with BASF SE. Pursuant to the Supply Agreement, the Company will sell exclusively to BASF the Company’s Spaceloft A2 product at annual volumes to be specified by BASF, subject to certain volume limits. The Supply Agreement will terminate on December 31, 2027. Upon expiration of the Supply Agreement, the Company will be subject to a post-termination supply commitment for an additional two years. The JDA is designed to facilitate the collaboration between the parties on the development and commercialization of new products.

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In addition, BASF, in its sole discretion, may make prepayments to the Company in the aggregate amount of up to $22.0 million during the term of the Supply Agreement. BASF agreed to make a prepayment in the amount of $5.0 million to the Company in two equal installments in 2018 (the 2018 Prepayment). The amounts and terms of additional prepayment installments, if any, are subject to negotiation between the Company and BASF.

After January 1, 2019, the Company will, at BASF’s instruction, credit up to 25.3% of any amounts invoiced by the Company for Spaceloft A2 product sold to BASF against the prepayment balance. However, BASF has no obligation to purchase products under the Supply Agreement. If any of the 2018 Prepayment remains uncredited as of December 31, 2021, BASF may request that the Company repay the uncredited amount to BASF. The prepayment obligation is secured by a security interest in real estate, plant and equipment at the Company’s Rhode Island facility and a license to certain intellectual property.

As of September 30, 2018, the Company had received $5.0 million of the 2018 Prepayment from BASF, which is recorded on the balance sheet as a prepayment liability, net of discount of $0.9 million. The discount will be amortized into interest expense through December 31, 2021, or until the prepayment liability is fully credited by purchases from BASF.

Prepayment liability consists of the following:

The deferred revenue associated with the prepayment liability represents a grant to BASF of the exclusive right to sell Spaceloft A2 over the term of the Supply Agreement. Deferred revenue will be amortized into revenue on a straight-line basis over the term of the Supply Agreement. At September 30, 2018, $1.0 million was recorded as deferred revenue of which $0.1 million was recorded as a component of short term deferred revenue. During the nine months ended September 30, 2018, the Company recognized less than $0.1 million in revenue associated with the grant to BASF of the exclusive right to sell Spaceloft A2, which is recorded as a component of product revenue in the consolidated statement of operations.

Deferred revenue consists of the following:

Revolving Line of Credit

The Company entered into an Amended and Restated Loan and Security Agreement (the Loan Agreement) with Silicon Valley Bank (the Bank), on August 31, 2014, which has been subsequently amended from time to time. On January 25, 2018, the Loan Agreement was amended to extend the maturity date of the facility to April 28, 2018. On April 25, 2018, the Loan Agreement was further amended to extend the maturity date of the facility to April 28, 2019. Under the Loan Agreement, the Company may borrow up to $20.0 million subject to compliance with certain covenants and borrowing base limitations. At the Company’s election, the interest rate applicable to borrowings may be based on the prime rate or LIBOR. Prime rate-based rates vary from prime rate plus 0.75% per annum to prime rate plus 2.00% per annum, while LIBOR-based rates vary from LIBOR plus 3.75% per annum to LIBOR plus 4.25% per annum. In addition, the Company is required to pay a monthly fee of 0.5% per annum of the average unused portion of the facility. Obligations under the Loan Agreement are secured by a security interest in all assets of the Company, including those at the East Providence facility, except for certain exclusions. The revolving credit facility matures on April 28, 2019.

At September 30, 2018 and December 31, 2017, the Company had $5.2 million and $3.8 million, respectively, drawn on the revolving credit facility. Under the Loan Agreement, the Company is required to comply with both non-financial and financial covenants, including minimum Adjusted EBITDA and minimum Adjusted Quick Ratio covenants, each as defined in the Loan Agreement. During 2018, the Company obtained a waiver on two occasions from the Bank with respect to compliance with the Adjusted Quick Ratio covenant. At September 30, 2018, the Company was in compliance with all such covenants. The Company has been required to provide letters of credit to secure obligations under certain commercial contracts. The Company had outstanding

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letters of credit backed by the revolving credit facility of $2.0 million and $2.3 million at September 30, 2018 and December 31, 2017, respectively, which reduce the funds otherwise available to the Company under the facility.

At September 30, 2018, the effective amount available to the Company under the revolving credit facility was $8.0 million after giving effect to the $5.2 million in outstanding borrowings and $2.0 million of outstanding letters of credit.

Litigation

The Company is, from time to time, a party to litigation that arises in the normal course of its business operations. See Part II, Item 1 “Legal Proceedings” of this Quarterly Report on Form 10-Q for a description of certain of the Company’s current legal proceedings. The Company is not presently a party to any litigation for which it believes a loss is probable requiring an amount to be accrued or a possible loss contingency requiring disclosure.

(8) Deferred Rent

The Company leases office and warehouse space in Northborough, Massachusetts and East Providence, Rhode Island.

For leases that contain fixed increases in the minimum annual lease payments during the term of the lease, the Company recognizes rental expense on a straight-line basis over the lease term, and records the difference between rent expense and the amount currently payable as deferred rent.

Deferred rent consists of the following:

(9) Net Loss Per Share

The computation of basic and diluted net loss per share consists of the following:

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Potentially dilutive common shares that were excluded from the computation of diluted net loss per share because they were anti-dilutive consist of the following:

In the table above, anti-dilutive shares consist of those common stock equivalents that have (i) an exercise price above the average stock price for the period or (ii) related average unrecognized stock compensation expense sufficient to buy back the entire amount of shares. The Company excludes the shares issued in connection with restricted stock awards from the calculation of basic weighted average common shares outstanding until the restrictions lapse.

(10) Income Taxes

The Company incurred net operating losses and recorded a full valuation allowance against net deferred tax assets for all periods presented. Accordingly, the Company has not recorded a provision for federal or state income taxes.

The Securities and Exchange Commission staff issued Staff Accounting Bulletin No. 118 (SAB 118) to address the tax reform legislation enacted in the United States in 2017. In accordance with SAB 118, the Company has recognized the provisional tax impacts, related to the re-measurement of its deferred income tax assets and liabilities associated with the one-time mandatory transition tax on deemed repatriation as of December 31, 2017. Although the Company does not believe there will be any material adjustments in subsequent reporting periods, the ultimate impact may differ from the provisional amounts, due to, among other things, the significant complexity of the 2017 Tax Cuts and Jobs Act and anticipated additional regulatory guidance that may be issued by the Internal Revenue Service, changes in analysis, interpretations and assumptions the Company has made and actions the Company may take as a result of the 2017 Tax Cuts and Jobs Act.

(11) Subsequent Events

The Company has evaluated subsequent events through November 7, 2018, the date of issuance of the consolidated financial statements for the three and nine months ended September 30, 2018.

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The following information should be read in conjunction with the unaudited financial information and the notes thereto included in this Quarterly Report on Form 10-Q and the audited financial information and the notes thereto included in the Annual Report on Form 10-K for the year ended December 31, 2017, filed with the Securities and Exchange Commission (“SEC”) on March 1, 2018, which we refer to as the Annual Report.

Certain matters discussed in this Quarterly Report on Form 10-Q may be deemed to be forward-looking statements that involve risks and uncertainties. We make such forward-looking statements pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 and other federal securities laws. In this Quarterly Report on Form 10-Q, words such as “may,” “will,” “anticipate,” “estimate,” “expects,” “projects,” “intends,” “plans,” “believes” and similar expressions (as well as other words or expressions referencing future events, conditions or circumstances) are intended to identify forward-looking statements.

Our actual results and the timing of certain events may differ materially from the results discussed, projected, anticipated, or indicated in any forward-looking statements. We caution you that forward-looking statements are not guarantees of future performance and that our actual results of operations, financial condition and liquidity, and the development of the industry in which we operate may differ materially from the forward-looking statements contained in this Quarterly Report on Form 10-Q. In addition, even if our results of operations, financial condition and liquidity, and the development of the industry in which we operate are consistent with the forward-looking statements contained in this Quarterly Report on Form 10-Q, they may not be predictive of results or developments in future periods.

The following information and any forward-looking statements should be considered in light of factors discussed elsewhere in this Quarterly Report on Form 10-Q and under “Risk Factors” in Item 1A of the Annual Report.

We caution readers not to place undue reliance on any forward-looking statements made by us, which speak only as of the date they are made. We disclaim any obligation, except as specifically required by law and the rules of the SEC, to publicly update or revise any such statements to reflect any change in our expectations or in events, conditions or circumstances on which any such statements may be based, or that may affect the likelihood that actual results will differ from those set forth in the forward-looking statements.

You should read the following discussion and analysis of financial condition and results of operations together with Part I Item 1 “Financial Statements,” which includes our financial statements and related notes, elsewhere in this Quarterly Report on Form 10-Q.

Overview

We design, develop and manufacture innovative, high-performance aerogel insulation used primarily in the energy infrastructure and building materials markets. We believe our aerogel blankets deliver the best thermal performance of any widely used insulation product available on the market today and provide a combination of performance attributes unmatched by traditional insulation materials. Our end-use customers select our products where thermal performance is critical and to save money, improve resource efficiency, enhance sustainability, preserve operating assets and protect workers.

Our insulation is used by oil producers and the owners and operators of refineries, petrochemical plants, liquefied natural gas facilities, power generating assets and other energy infrastructure. Our Pyrogel and Cryogel product lines have undergone rigorous technical validation by industry leading end-users and achieved significant market adoption. We also derive product revenue from the building materials and other end markets. Customers in these markets use our products for applications as diverse as wall systems, military and commercial aircraft, trains, buses, appliances, apparel, footwear and outdoor gear.

We generate product revenue through the sale of our line of aerogel blankets. We market and sell our products primarily through a sales force based in North America, Europe and Asia. The efforts of our sales force are supported by a small number of sales consultants with extensive knowledge of a particular market or region. Our sales force is responsible for establishing and maintaining customer and partner relationships, delivering highly technical information and ensuring high-quality customer service.

Our salespeople work directly with end-use customers and engineering firms to promote the qualification, specification and acceptance of our products. We also rely on an existing and well-established channel of qualified insulation distributors and contractors in more than 40 countries around the world to ensure rapid delivery of our products and strong end-user support. Our salespeople also work to educate insulation contractors about the technical and operating cost advantages of our aerogel blankets.

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We perform research services under contracts with various agencies of the U.S. government, including the Department of Defense and the Department of Energy, and other institutions. Research performed under contract with government agencies and other institutions enables us to develop and leverage technologies into broader commercial applications.

We manufacture our products using our proprietary technology at our facility in East Providence, Rhode Island. We have operated the East Providence facility since 2008 and have increased our annual nameplate capacity since that date to 50 million square feet of aerogel blankets. During 2018, we initiated a series of projects designed to increase this nameplate capacity to 60 million square feet of aerogel blankets by the end of 2020. We have also completed the design and engineering of a first line in a planned second manufacturing facility to be located in Statesboro, Georgia supported by a package of incentives from the State of Georgia and local governmental authorities. We have elected to delay construction of the Statesboro facility to better align the timing of this capacity expansion with our assessment of future demand. In the likely event that we do not commence construction of the Statesboro manufacturing facility by February 15, 2019, the governmental authorities may terminate the agreements that provide the package of incentives.

We have entered into a strategic partnership with BASF Polyurethanes GmbH (“BASF”) to develop and commercialize products for the building materials and other markets. The strategic partnership includes an amended and restated supply agreement (the “BASF Supply Agreement”) governing the sale of our Spaceloft A2 product to BASF and a joint development agreement targeting innovative products and technologies. Pursuant to the BASF Supply Agreement, BASF may, in its sole discretion, make a series of prepayments to us in the aggregate amount of up to $22.0 million in support of our capacity expansion plans, our process improvement initiatives and our new business development efforts. BASF has made prepayments to us in the aggregate amount of $5.0 million during the nine months ended September 30, 2018. These 2018 prepayments will be credited against amounts invoiced to BASF for Spaceloft A2 or repaid by us to BASF on or after December 31, 2021.

Our revenue for the nine months ended September 30, 2018 was $68.7 million, which represented a decrease of $6.6 million from the nine months ended September 30, 2017. Net loss for the nine months ended September 30, 2018 was $20.3 million and net loss per diluted share was $0.86. Net loss for the nine months ended September 30, 2017 was $17.6 million and net loss per diluted share was $0.76.

Key Metrics and Non-GAAP Financial Measures

We regularly review a number of metrics, including the following key metrics, to evaluate our business, measure our performance, identify trends affecting our business, formulate financial projections and make strategic decisions.

Square Foot Operating Metric

We price our product and measure our product shipments in square feet. We estimate our annual nameplate capacity was 50 million square feet of aerogel blankets at September 30, 2018. We believe the square foot operating metric allows us and our investors to measure our manufacturing capacity and product shipments on a uniform and consistent basis. The following chart sets forth product shipments associated with recognized revenue in square feet for the periods presented:

Adjusted EBITDA

We use Adjusted EBITDA, a non-GAAP financial measure, as a means to assess our operating performance. We define Adjusted EBITDA as net income (loss) before interest expense, taxes, depreciation, amortization, stock-based compensation expense and other items, which occur from time to time that we do not believe are indicative of our core operating performance. Adjusted EBITDA is a supplemental measure of our performance that is not presented in accordance with U.S. GAAP. Adjusted EBITDA should not be considered as an alternative to net income (loss) or any other measure of financial performance calculated and presented in accordance with U.S. GAAP. In addition, our definition and presentation of Adjusted EBITDA may not be comparable to similarly titled measures presented by other companies.

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We use Adjusted EBITDA:

We also believe that the presentation of Adjusted EBITDA provides useful information to investors with respect to our results of operations and in assessing the performance and value of our business. Various measures of EBITDA are widely used by investors to measure a company’s operating performance without regard to items that can vary substantially from company to company depending upon financing and accounting methods, book values of assets, capital structures and the methods by which assets were acquired.

Although measures similar to Adjusted EBITDA are frequently used by investors and securities analysts in their evaluation of companies, we understand that Adjusted EBITDA has limitations as an analytical tool, and you should not consider it in isolation or as a substitute for net income (loss), income (loss) from operations, net cash provided by (used in) operating activities or an analysis of our results of operations as reported under U.S. GAAP. Some of these limitations are:

Because of these limitations, our Adjusted EBITDA should not be considered as a measure of discretionary cash available to us to reinvest in the growth of our business or as a measure of cash available for us to meet our obligations.

To properly and prudently evaluate our business, we encourage you to review the U.S. GAAP financial statements included elsewhere in this Quarterly Report on Form 10-Q, and not to rely on any single financial measure to evaluate our business.

The following table presents a reconciliation of net loss, the most directly comparable U.S. GAAP measure, to Adjusted EBITDA for the periods presented:

⁽¹⁾ Represents non-cash stock-based compensation related to vesting and modifications of stock option grants, vesting of restricted stock units and vesting of restricted common stock.

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Our financial performance, including such measures as net income (loss), earnings per share and Adjusted EBITDA, are affected by a number of factors including volume and mix of aerogel products sold, average selling prices, our material and manufacturing costs, the costs associated with and timing of capacity expansions and start-up of additional production capacity, and the amount and timing of operating expenses, including patent enforcement costs. As we build out manufacturing capacity in our existing facility and in new facilities in the longer term, we expect increased manufacturing expenses will periodically have a negative impact on net income (loss), earnings per share and Adjusted EBITDA, but will set the framework for improved performance in the long term. Accordingly, we expect that our net income (loss), earnings per share and Adjusted EBITDA will vary from period to period, in particular as and when we expand our manufacturing capacity in existing or new facilities.

As a result of the conclusion of a multiyear petrochemical project with a major Asian energy company and a decline in the volume of subsea projects, which together comprised 19% of our product revenue during 2017, we are experiencing a decrease in revenue during 2018. In addition, we have increased our investment in new initiatives and personnel during 2018 with the objective of restoring long-term growth in our existing markets and developing new business opportunities. As a result of the decrease in revenue and the increase in expense associated with these new initiatives and personnel, we are experiencing an increase in net loss and net loss per share and a decrease in Adjusted EBITDA during 2018.

We expect to experience growth in total revenue and Adjusted EBITDA during 2019 due to expected volume growth in our petrochemical and refinery markets, and an anticipated increase in project-based demand in the subsea and LNG markets. We have also announced a price increase for 2019 which we expect will support the projected increase in revenue and improvement in Adjusted EBITDA during the year. As a result of these factors, we are projecting growth in total revenue versus 2018 in excess of 20%, a decrease in net loss and a return to positive Adjusted EBITDA for the year.

Emerging Growth Company Status

The JOBS Act permits us, as an “emerging growth company,” to take advantage of an extended transition period to comply with new or revised accounting standards applicable to public companies. We have opted out of this provision and, as a result, we comply with new or revised accounting standards as required when they are adopted. This decision to opt out of the extended transition period under the JOBS Act is irrevocable.

Components of Our Results of Operations

Revenue

We recognize product revenue from the sale of our line of aerogel products and research services revenue from the provision of services under contracts with various agencies of the U.S. government and other institutions. Product and research services revenue is recognized upon the satisfaction of contractual performance obligations.

We record deferred revenue for product sales when (i) we have delivered products but other revenue recognition criteria have not been satisfied or (ii) payments have been received in advance of products being delivered.

We have experienced a decrease in revenue during 2018 due to the conclusion of the multiyear petrochemical project with a major Asian energy company and a decrease in project related revenue in the subsea market, which together comprised 19% of our product revenue during 2017.

Cost of Revenue

Cost of product revenue consists primarily of materials and manufacturing expense. Cost of product revenue is recorded when the related product revenue is recognized.

Material is our most significant component of cost of product revenue and includes fibrous batting, silica materials and additives. Material costs as a percentage of product revenue vary from product to product due to differences in average selling prices, material requirements, product thicknesses and manufacturing yields. During the nine months ended September 30, 2018, we have experienced a significant increase in the costs of silica precursor materials, which constitute over 50% of our raw material costs. In addition, we provide warranties for our products and record the estimated cost within cost of revenue in the period that the related revenue is recorded or when we become aware that a potential warranty claim is probable and can be reasonably estimated. During the nine months ended September 30, 2018, a test result has indicated that tested samples performed outside the published performance specifications for a specific attribute of a product and, as a result, we have performed additional testing. We have determined that it is probable we have incurred a liability, however, the liability is not estimable as of September 30, 2018. We will continue to assess the impact of the test results on our customer base and, depending on the assessment, we could be subject to material warranty charges in

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future periods. As a result of these factors, material costs as a percentage of revenue will vary from period to period due to changes in the mix of aerogel products sold, the costs of our raw materials or the estimated cost of warranties. However, in general, we expect material costs to decline as a percentage of revenue as we seek to achieve higher selling prices, material sourcing improvements, quality improvements and manufacturing yield enhancements for our aerogel products.

Manufacturing expense is also a significant component of cost of revenue. Manufacturing expense includes labor, utilities, maintenance expense, and depreciation on manufacturing assets. Manufacturing expense also includes stock-based compensation of manufacturing employees and shipping costs. As we increase manufacturing capacity in our East Providence, Rhode Island facility through 2020 and, over time, through the anticipated construction, operation, and expansion of a second manufacturing facility, we expect manufacturing expense as a percentage of product revenue will increase following each such expansion but will decrease in the long-term due to improved manufacturing productivity and increased product revenue supported by the additional capacity.

Our cost of product revenue in absolute dollars has decreased during 2018 compared to 2017. The decrease in cost of product revenue in absolute dollars reflects the impact of a decrease in manufacturing output and a favorable mix of products sold, offset, in part, by an increase in the cost of our raw materials, and an increase in personnel and expense in support of our capacity expansion and growth initiatives. However, due to the impact of the decrease in product revenue during 2018, our cost of product revenue as a percentage of product revenue has increased during 2018 compared to 2017.

Cost of research services revenue consists of direct labor costs of research personnel engaged in the contract research, third-party consulting expense, and associated direct material costs. This cost of revenue also includes overhead expenses associated with project resources, development tools and supplies. Cost of research services revenue is recorded when the related research services revenue is recognized.

Gross Profit

Our gross profit as a percentage of revenue is affected by a number of factors, including the volume of aerogel products produced and sold, the mix of aerogel products sold, average selling prices, our material and manufacturing costs, realized capacity utilization and the costs associated with expansions and start-up of production capacity. Accordingly, we expect our gross profit in absolute dollars and as a percentage of revenue to vary significantly from period to period. As and when we build out our manufacturing capacity, we expect increased manufacturing expenses will periodically have a negative impact on gross profit in the periods following any such expansion.

Due to the conclusion of a multiyear petrochemical project with a major Asian energy company and a decrease in the volume of subsea projects, which together comprised 19% of our product revenue during 2017, we are experiencing a decrease in revenue and an associated decrease in gross profit in absolute dollars and as a percentage of revenue during 2018. During the nine months ended September 30, 2018, we have also experienced a significant increase in the costs of silica materials, which constitute over 50% or our raw material costs. In addition, we have increased investment in manufacturing personnel and expenses during 2018 in support of our objective to increase the capacity of our East Providence, Rhode Island manufacturing facility, operational improvement initiatives and our new business development efforts. As a result of these factors, we have experienced a decrease in gross profit during 2018.

However, in the longer term, we expect gross profit to improve in absolute dollars and as a percentage of revenue due to expected increases in total revenue, production volumes and manufacturing productivity. In addition, we expect the increases in revenue, volume and productivity will be supported by planned capacity expansions, and the realization of material purchasing efficiencies.

Operating Expenses

Operating expenses consist of research and development, sales and marketing, and general and administrative expenses. Operating expenses include personnel costs, legal fees, professional fees, service fees, insurance premiums, travel expense, facilities related costs and other costs and fees. The largest component of our operating expenses is personnel costs, consisting of salaries, benefits, incentive compensation and stock-based compensation. In any particular period, the timing and extent of personnel additions or reductions, legal activities, including patent enforcement actions, marketing programs, research efforts and a range of similar activities or actions could materially affect our operating expenses, both in absolute dollars and as a percentage of revenue.

We have increased our investment in new initiatives and personnel during 2018 with the objective of restoring long-term growth in our existing markets and to develop new business opportunities. However, we have decreased spending for patent enforcement actions during the year. As a result, we have experienced a decrease in operating expenses in absolute dollars during 2018. However, due to the impact of the decrease in revenue during 2018, our operating expenses as a percentage of revenue has increased during 2018 compared to 2017.

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Research and Development Expenses

Research and development expenses consist primarily of expenses for personnel engaged in the development of next generation aerogel compositions, form factors and manufacturing technologies. These expenses also include testing services, prototype expenses, consulting services, equipment depreciation, facilities costs and related overhead. We expense research and development costs as incurred. We expect to continue to devote substantial resources to the development of new aerogel technologies. We believe that these investments are necessary to maintain and improve our competitive position. We expect to continue to invest in research and engineering personnel and the infrastructure required in support of their efforts. While we expect that our research and development expenses will increase in absolute dollars but decrease as a percentage of revenue in the longer term, in the nearer term we expect such expenses will increase as a percentage of revenue.

Sales and Marketing Expenses

Sales and marketing expenses consist primarily of personnel costs, incentive compensation, marketing programs, travel and related costs, consulting expenses and facilities related costs. We are expanding our sales force and sales consultants globally to drive anticipated growth in customers and demand for our products. While we expect that sales and marketing expenses will increase in absolute dollars but decrease as a percentage of revenue in the longer-term, in the nearer term we expect such expenses will increase as a percentage of revenue.

General and Administrative Expenses

General and administrative expenses consist primarily of personnel costs, legal expenses, consulting and professional services, audit and tax consulting costs, and expenses for our executive, finance, legal, human resources and information technology organizations. General and administrative expenses have increased as we have incurred additional costs related to operating as a publicly-traded company, which include costs of compliance with securities, corporate governance and related laws and regulations, investor relations expenses, increased insurance premiums, including director and officer insurance, and increased audit and legal fees. In addition, we expect our general and administrative expenses to increase as we add general and administrative personnel to support the anticipated growth of our business and continued expansion of our manufacturing operations. We also expect that the patent enforcement actions, described in more detail under “Legal Proceedings” in Part II, Item 1 of this Quarterly Report on Form 10-Q, if protracted, could result in significant additional legal expense over the medium to long-term. During 2018, general and administrative expense have decreased both in absolute dollars and as a percentage of revenue due to a reduction in patent enforcement costs. In the longer term, however, we expect that general and administrative expenses will increase in absolute dollars but continue to decline as a percentage of revenue.

Interest Expense, Net

For the nine months ended September 30, 2018, interest expense, net consisted of fees and interest expense related to our revolving credit facility and $0.1 million of accretion of the prepayment liability discount associated with the BASF Supply Agreement. For the nine months ended September 30, 2017, interest expense, net consisted primarily of fees related to our revolving credit facility.

Provision for Income Taxes

We have incurred net losses since inception and have not recorded benefit provisions for U.S. federal income taxes or state income taxes since the tax benefits of our net losses have been offset by valuation allowances due to the uncertainty associated with the utilization of net operating loss carryforwards.

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Results of Operations

Three months ended September 30, 2018 compared to the three months ended September 30, 2017

The following tables set forth a comparison of the components of our results of operations for the periods presented:

Revenue

The following chart sets forth product shipments in square feet for the periods presented:

Total revenue decreased $3.3 million, or 12%, to $23.9 million for the three months ended September 30, 2018 from $27.2 million in the comparable period in 2017 primarily as a result of a decrease in product revenue.

Product revenue decreased by $3.5 million, or 13%, to $23.3 million for the three months ended September 30, 2018 from $26.8 million in the comparable period in 2017. This decrease was principally the result of a decline in project work in South America and in the subsea market, offset, in part, by growth in the petrochemical and refinery markets, particularly in Asia and North America.

Product revenue for the three months ended September 30, 2018 included $5.0 million to a North American distributor. Product revenue for the three months ended September 30, 2017 included $5.0 million to a subsea contractor, $4.0 million and $3.2 million to two North American distributors, respectively, and $3.0 million to a South American contractor.

The average selling price per square foot of our products decreased by $0.11, or 4%, to $2.99 per square foot for the three months ended September 30, 2018 from $3.10 per square foot for the three months ended September 30, 2017. The decrease in average selling price reflected a year-over-year decrease in the mix of high-priced subsea products, offset, in part, by the impact of price increases enacted in early 2018. This decrease in average selling price had the effect of decreasing product revenue by $0.8 million for the three months ended September 30, 2018 from the comparable period in 2017.

In volume terms, product shipments decreased by 0.8 million square feet, or 10%, to 7.8 million square feet of aerogel products for the three months ended September 30, 2018, as compared to 8.6 million square feet for the three months ended September 30, 2017. The decrease in product volume had the effect of decreasing product revenue by $2.7 million for the three months ended September 30, 2018 from the comparable period in 2017.

Research services revenue increased $0.2 million, or 54%, to $0.6 million for the three months ended September 30, 2018 from $0.4 million in the comparable period in 2017. The increase was primarily due to the timing and amount of funding available under existing research contracts during the three months ended September 30, 2018 versus the comparable period in 2017.

Product revenue was 98% of total revenue for the three months ended September 30, 2018 and 99% for the three months September 30, 2017. Research services revenue was 2% of total revenue for the three months ended September 30, 2018 and 1% of total revenue for the three months ended September 30, 2017.

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Cost of Revenue

Total cost of revenue increased $0.2 million, or 1%, to $22.4 million for the three months ended September 30, 2018 from $22.2 million in the comparable period in 2017. The increase in total cost of revenue was primarily the result of an increase in research services cost of revenue.

Product cost of revenue increased by less than $0.1 million, or less than 1%, to $22.2 million for the three months ended September 30, 2018 from $22.1 million in the comparable period in 2017. The less than $0.1 million increase was the result of a $0.6 million increase in material costs, offset, in part, by a $0.5 million decrease in manufacturing expense. The increase in material costs was driven by an increase in the cost of silica materials, which constitute over 50% of our raw material costs, and a decrease in manufacturing output, offset, in part, by the 0.8 million square foot, or 10%, decrease in product shipments period over period. The decrease in manufacturing expense was the result of decreases in utilities costs of $0.3 million, maintenance expense of $0.2 million, and depreciation expense of $0.1 million, offset, in part, by an increase in other expenses of $0.1 million.

Product cost of revenue as a percentage of product revenue increased to 95% during the three months ended September 30, 2018 from 82% during the three months ended September 30, 2017. This increase was the result of the high proportion of fixed manufacturing expenses that remained essentially unchanged despite a 13% decrease in product revenue and a decrease in manufacturing output for the three months ended September 30, 2018 from the comparable period in 2017.

Research services cost of revenue increased $0.1 million, or 88%, to $0.2 million for the three months ended September 30, 2018 from $0.1 million for the comparable period in 2017. Cost of research service revenue as a percentage of research services revenue increased to 43% during the three months ended September 30, 2018 from 35% in the comparable period in 2017 due to an increase in outside services utilized to support the contracted research.

Gross Profit