Soluna Holdings, Inc - Quarter Report: 2000 December (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 December 31, 2000

/ / Transition report pursuant to Section 13 or 15 (d) of the Securities

Exchange Act of 1934

For the period from to

Commission File Number 0-6890

(Exact name of registrant as specified in its charter)

(Address of principal executive offices) (Zip Code)

Registrant's telephone number, including area code

(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No___

The accompanying notes are an integral part of the consolidated financial statements.

The accompanying notes are an integral part of the consolidated financial statements.

(Dollars in thousands)

The accompanying notes are an integral part of the consolidated financial statements.

1. In the opinion of management the accompanying unaudited consolidated financial statements contain all adjustments, consisting of only normal, recurring adjustments, necessary for a fair presentation of results for such periods. The results for any interim period are not necessarily indicative of results for the full year. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been omitted. These consolidated financial statements should be read in conjunction with the financial statements and notes thereto for the fiscal year ended September 30, 2000.

2. Reclassification

Certain fiscal 2000 amounts have been reclassified to conform with the fiscal 2001 presentation.

At December 31, 2000, the principal components of the Company's holdings accounted for under the equity method of accounting are the following:

4. Investments, at equity (Continued)

The following is a roll forward of the Company's accounting for holdings in Plug Power:

There is no difference between the carrying value of the Company's holdings in Plug Power and its interest in the underlying equity at December 31, 2000 or September 30, 2000.

The following is a roll forward of the Company's accounting for holdings in SatCon:

4. Investments, at equity (Continued)

The difference between the carrying value of the Company's holdings in SatCon and its interest in the underlying equity consists of the following:

5. Securities available for sale

Securities available for sale are classified as current assets. Accumulated net unrealized gains (losses) are charged to Other Comprehensive Income.

As of December 31, 2000, securities available for sale consist of Beacon Power common stock and includes the following:

On November 17, 2000, the date of the Beacon Power IPO, Beacon Power converted Beacon Preferred Stock to common stock and completed a 2-for-1 stock split immediately prior to the IPO. Immediately after Beacon Power's IPO, the Company owned 2,881,142 shares, approximately 7.5%, of Beacon Power common stock.

In connection with the Company's May 23, 2000 purchase of Beacon Power Class F Preferred Stock, the Company received warrants to purchase shares of common stock, the exercise date, number of shares and exercise price of which would be determined upon either the sale of Beacon Power or the consummation of an underwritten public offering of Beacon Power common stock. When Beacon Power completed its IPO, the warrant terms were set for the purchase of 1,333,333 shares of common stock at an exercise price of $2.25 per share exercisable as of November 17, 2000. The warrants expire on May 23, 2005.

The Company exercised the 1,333,333 warrants on a cash-less basis, on December 20, 2000, and received 985,507 shares of Beacon Power common stock. After the exercise of the warrants, the Company owns 3,866,649 shares, approximately 9.2%, of Beacon Power common stock.

6. Debt

At December 31, 2000, the Company has a $30 million Credit Agreement, as amended, with an outstanding balance of $25.2 million at the Prime Rate (9.5% at December 31, 2000). Additional borrowings are available when the Plug Power stock price is above $20 per share. This liability is classified as short-term.

The Company has pledged 8 million shares of Plug Power common stock as collateral. In addition, the Company entered into a Put and Call with First Albany Companies Inc. ("FAC") to provide independent credit support for repayment of its $25.2 million indebtedness to KeyBank, N.A. ("FAC Credit Enhancement"). The FAC Credit Enhancement provides FAC with the option, if the price of Plug Power stock falls to $4 per share, to either purchase 6.3 million Plug Power shares pledged as collateral on the loan or take an assignment of KeyBank, N.A.'s rights under the Credit Agreement, as amended. The FAC Credit Enhancement may be triggered in the event of a default and expires on April 27, 2001 and may be renewed by the Company and FAC on a monthly basis upon mutually agreeable terms. If the FAC Credit Enhancement expires, and is not replaced, prior to November 3, 2001, the loan is immediately due and payable. After November 3, 2001, upon expiration of the FAC Credit Enhancement, if Plug Power stock is trading below $20 per share, the loan is immediately due and payable. Mandatory repayments on any outstanding balance in excess of $25.2 million will be required if the Plug Power stock price declines below $16 per share while the FAC Credit Enhancement is in place. After the FAC Credit Enhancement expires, mandatory repayments on any outstanding balance will be required if the Plug Power stock price is below $20 per share. If the FAC Credit Enhancement, which expires on April 27, 2001, is not renewed, the Company may need to sell assets to fund the repayment of the outstanding balance on the credit line. The Company is obligated to make interest-only payments through March 15, 2002, and upon exercise of a term loan option at the end of the line of credit term, to repay the principal in 8 equal quarterly installments beginning March 31, 2002. Interest is payable monthly at either the Prime Rate or if certain performance standards are achieved, based on both the trading volume and market price of Plug Power common stock, at LIBOR based rates.

As of December 31, 2000, the $30 million Credit Agreement, as amended, requires the Company to meet certain covenants, including maintenance of a debt service reserve account (equal to 6 months of interest payments on outstanding debt, amounting to $1.067 million at December 31, 2000), a collateral coverage ratio, the FAC Credit Enhancement and a minimum Plug Power share price. The Company was in compliance with these covenants as of December 31, 2000.

On December 27, 2000, the Company entered into two bridge loan agreements with FAC. The first loan was for $945 thousand and was used to pay the purchase price for the FAC Credit Enhancement. The Company has pledged 200,000 shares of Plug Power common stock as collateral. The second loan is for $5 million, $3 million of which was used to make

6. Debt (Continued)

a December 27, 2000 principal loan repayment to KeyBank, N.A. and the remaining $2 million is available for working capital. The Company

pledged 1 million shares of Plug Power common stock as collateral. Both loans bear interest at the Prime Rate (9.5% at December 31, 2000) and both interest and principal are due on January 3, 2002. Upon mutual agreement of FAC and the Company, the loans may be converted to equity prior to maturity.

6. Change in Accounting for Derivative Financial Instruments

Effective October 1, 2000, the Company adopted SFAS No. 133 ("SFAS No. 133"), "Accounting for Derivative Instruments and Hedging Activities." SFAS No. 133 established a new model for accounting for derivatives and hedging activities. It requires an entity to recognize all derivatives as either assets or liabilities in the statement of financial position and measure these instruments at fair value regardless of purpose or intent for holding them. Changes in the fair value of derivative financial instruments are either recognized periodically in income or shareholders' equity (as a component of comprehensive income), depending on whether the derivative is being used to hedge changes in fair value or cash flows. Upon adoption of SFAS No. 133, the Company recorded an unrealized gain of $9.986 million. The deferred tax expense on this unrealized gain at December 31, 2000 was $3.876 million, resulting in a net unrealized gain of $6.110 million, reported in the Company's results of operations as a cumulative effect of a change in accounting.

Derivative financial instruments do not have quoted market prices; therefore fair value is based on estimates using valuation techniques.

The Company held the following derivative financial instruments:

The Company operates in two business segments, New Energy and Test and Measurement Instrumentation. The New Energy segment develops new energy technologies and companies. The Test and Measurement Instrumentation segment develops, manufactures, markets and services sensing instruments and computer-based balancing systems for aircraft engines.

The Company evaluates performance based on profit or loss from operations before income taxes, accounting changes, non-recurring items

During fiscal 2001, First Albany Companies Inc. provided a credit enhancement for which the Company paid a fee of $945 thousand.

The following is management's discussion and analysis of certain significant factors, which have affected the Company's earnings during the periods included in the accompanying, consolidated statements of income.

Sales for the quarter ended December 31, 2000 totaled $1.638 million compared to $1.360 million for the prior year, an increase of $.278 million, a 20.4% increase. This increase in sales is primarily the result of MTI Instruments' marketing efforts for its new wafer thickness gauge product line.

Gross profit increased to 56.3% of sales in the first quarter of fiscal 2001 from 40.7% of sales for the same period in the prior year. Gross profits increased in the fiscal 2001 quarter due to the sale of Ling in October 1999 (Ling had lower margin sales) and sales of higher margin products in fiscal 2001.

Selling, general and administrative expenses increased $.731 million to $1.521 million for the three months ended December 31, 2000 as compared to $.790 million for the three months ended December 31, 1999, a 92.5% increase. This increase is primarily the result of an increase in personnel costs related to the operations of the new energy technology segment.

Product development and research costs for the three months ended December 31, 2000 were 27.2% of sales, compared to 23.3% for the same period in the prior year. Development costs increased $.129 million from the three months ended December 31, 1999 to the same period in 2000, reflecting the Company's commitment to developing its micro fuel cell initiative.

Operating loss increased $.490 million to an operating loss of $1.044 million for the three months ended December 31, 2000 as compared to $.554 million for the three months ended December 31, 1999, an 88.4% increase. This increase is the result of increased expenditures for research and product development and activities in the new energy technology segment.

The Company recorded a $6.110 million unrealized gain, net of tax, from the adoption of SFAS No.133 "Accounting for Derivative Instruments and Hedging Activities," as of October 1, 2000. During the three months ended December 31, 2000, the Company also recorded a net $.729 million loss on derivative accounting. Changes in derivative fair values are recorded on a quarterly basis.

Results during the three months ended December 31, 2000 were reduced by higher interest expense of $.717 million compared to $.322 million in the same period last year. This increase results primarily from increased debt used to fund purchases of Plug Power, Beacon Power and

Continuing Operations (Continued)

SatCon stock as well as working capital requirements. Prior year

results included a $1.262 million gain from the sale of Ling.

The Company recorded a $4.872 million loss, net of tax, from the recognition of the Company's proportionate share of losses in equity investees compared to a $2.115 million loss, net of tax, in the same period last year.

Equity in investee losses result from the Company's minority ownership in certain companies which are accounted for under the equity method of accounting. Under the equity method of accounting, the Company's proportionate share of each company's operating losses and amortization of the Company's net excess investment over its equity in each company's net assets is included in equity in investee losses. Equity in investee losses for the three months ended December 31, 2000 includes the results from the Company's minority ownership in Plug Power and SatCon. Equity in investee losses for the three months ended December 31, 1999 included the results from the Company's minority ownership in Plug Power. The Company expects these companies to continue to invest in development of their products and services, and to recognize operating losses, which will result in future charges recorded by the Company to reflect its proportionate share of such losses.

Equity in investee losses includes a loss, before taxes, from Plug Power of $6.982 million for the three months ended December 31, 2000 compared to $2.991 million for the three months ended December 31, 1999. This $3.991 million increase in losses is primarily the result of Plug Power expanding its operations including costs to develop and prototype residential fuel cell units. Equity in investee losses for the three months ended December 31, 2000 also includes our proportionate share of losses from SatCon of $.291 million and embedded difference (the difference between the carrying value of the Company's investment and its interest in the underlying equity) amortization of $.689 million. SatCon is accounted for on a one-quarter lag and includes results of SatCon through September 30, 2000. The Company acquired its stock holdings in SatCon during fiscal 2000.

The tax rate for the three months ended December 31, 2000 is (38.8%) compared to (29.3%) in the first quarter of 1999. These tax rates are due to losses generated by operations and changes in deferred tax liabilities associated with the accounting for holdings in and recognition of the Company's proportionate share of losses from Plug Power and SatCon and its investment in derivatives and marketable securities. Further, as a result of ownership changes in 1996, the availability of net operating loss carryforwards to offset future taxable income will be significantly limited pursuant to the Internal Revenue Code.

Inventory and accounts receivable turnover ratios and their changes for the three months ended December 31 are as follows:

The change in the accounts receivable and inventory turnover ratios are the result of increasing sales levels.

Inventories at December 31, 2000 of $1.410 million reflect inventory levels for MTI Instruments required to support expected increased sales levels in fiscal 2001.

Working capital of $16.553 million at December 31, 2000 reflects a $40.846 million increase from September 30, 2000. This increase reflects the $24.116 million increase in fair value for the Beacon Power investment, coupled with $8.5 million for additional shares purchased through the cash-less exercise of warrants and the reclass of $6 million of investments at cost to securities available for sale.

At December 31, 2000, cash and cash equivalents were $.972 million versus $1.552 million at September 30, 2000. Net cash used by operating activities for the first three months of fiscal 2001 amounted to $1.633 million, as compared to a source of $.063 million in the prior year. Accounts receivable increased due to an increase in sales. Accounts receivable totaled $.933 million as of December 31, 2000 as compared to $.693 million as of September 30, 2000, or a 34.6% increase.

At December 31, 2000, the Company has a $30 million Credit Agreement, as amended with an outstanding balance of $25.2 million at Prime (9.5% at December 31, 2000). Additional borrowings above the $25.2 million balance are available when the Plug Power stock price is above $20 per share. This liability is classified as short-term.

The Company has pledged 8 million shares of Plug Power common stock as collateral. In addition, the Company entered into a Put and Call with First Albany Companies Inc. ("FAC") to provide independent credit support for repayment of its $25.2 million indebtedness to KeyBank, N.A. ("FAC Credit Enhancement"). The FAC Credit Enhancement provides FAC with the option, if the price of Plug Power stock falls to $4 per share, to either purchase 6.3 million Plug Power shares pledged as collateral on the loan or take an assignment of KeyBank N.A.'s rights under the Credit Agreement, as amended. The FAC Credit Enhancement may be triggered in the event of a default and expires on April 27, 2001 and may be renewed by the Company and FAC on a monthly basis upon mutually

Financial Condition (Continued)

agreeable terms. If the FAC Credit Enhancement expires, and is not replaced, prior to November 3, 2001, the loan is immediately due and payable. After November 3, 2001, upon expiration of the FAC Credit Enhancement, if Plug Power stock is trading below $20 per share, the loan is immediately due and payable. Mandatory repayments on any outstanding balance in excess of $25.2 million will be required if the Plug Power stock price declines below $16 per share while the FAC Credit Enhancement is in place. After the FAC Credit Enhancement expires, mandatory repayments on any outstanding balance will be required if the Plug Power stock price is below $20 per share. If the FAC Credit Enhancement, which expires on April 27, 2001, is not renewed, the Company may need to sell assets to fund the repayment of the outstanding balance on the credit line. The Company is obligated to make interest-only payments through March 15, 2002, and upon exercise of a term loan option at the end of the line of credit term, to repay the principal in 8 equal quarterly installments beginning March 31, 2002. Interest is payable monthly at either the Prime Rate or if certain performance standards are achieved, based on both the trading volume and market price of Plug Power common stock, at LIBOR based rates.

As of December 31, 2000, the $30 million Credit Agreement, as amended, requires the Company to meet certain covenants, including maintenance of a debt service reserve account (equal to 6 months of interest payments on outstanding debt, amounting to $1.067 million at December 31, 2000), a collateral coverage ratio, the FAC Credit Enhancement and a minimum Plug Power share price. The Company was in compliance with these covenants as of December 31, 2000.

On December 27, 2000, the Company entered into two bridge loan agreements with FAC. The first loan was for $945 thousand and was used to pay the purchase price for the FAC Credit Enhancement. The Company has pledged 200,000 shares of Plug Power common stock as collateral. The second loan is for $5 million, $3 million of which was used to make a December 27, 2000 principal loan repayment to KeyBank, N.A. and the remaining $2 million is available for working capital. The Company pledged 1 million shares of Plug Power common stock as collateral. Both loans bear interest at the Prime Rate (9.5% at December 31, 2000) and both interest and principal are due on January 3, 2002. Upon mutual agreement of FAC and the Company, the loans may be converted to equity prior to maturity.

Capital spending during the first three-months of fiscal 2001 was $.034 million, a decrease from the comparable period in fiscal 2000 where capital spending totaled $.118 million. Capital spending during fiscal 2001 included computers, software, manufacturing and laboratory equipment. Total additional capital spending during fiscal 2001 is expected to be approximately $1.8 million for computer, facilities fit-up, laboratory and manufacturing equipment.

Financial Condition (Continued)

The Company anticipates that it will be able to meet the liquidity needs of its continuing operations, including the repayment of its line of credit in April 2001 if the FAC Credit Enhancement is not extended, for the next year from current cash resources, borrowings under its bridge loan from FAC, equity financings, and sale of assets. However, there can be no assurance that the Company will not require additional financing within this time frame or that any additional financing will be available to the Company on terms acceptable to the Company, if at all.

As of December 31, 2000, the Company owns shares of common stock in the following companies:

These securities are currently traded on the Nasdaq National Market; therefore these securities are subject to stock market conditions and in Beacon Power's case, an underwriter's lockup prohibiting the sale of securities until May 17, 2001. When acquired, each of these securities was unregistered. In February 2000, SatCon registered the securities acquired by the Company on a Form S-3. The stock in Plug Power and Beacon Power are considered "restricted securities" as defined in Rule 144 and may be sold in the future without registration under the Securities Act subject to compliance with the provisions of Rule 144. Generally, restricted securities that have been owned for at least one year may be sold immediately after the completion of an IPO subject to the volume limitations of Rule 144. However, because of our ownership position and our appointment of directors to both Plug Power's and Beacon Power's Board of Directors, we are considered an "affiliate" of those companies and therefore are subject to the volume limitation of Rule 144, even if we have held the securities for two years.

The Rule 144 limitations, as currently in effect, limit our sales of either Plug Power or Beacon Power stock within any three-month period

to a number of shares that does not exceed the greater of 1% of the then outstanding shares of common stock of the Company, or the average weekly trading volume of the common stock during the four calendar weeks preceding the date on which notice of such sale is filed, subject to certain restrictions.

As disclosed in Plug Power's most recent Form 10-Q filed for the period ended September 30, 2000:

Plug Power's cash requirements depend on numerous factors, including completion of its product development activities, ability to commercialize residential fuel cell systems, market acceptance of its

Financial Condition (Continued)

systems and other factors. Plug Power expects to devote substantial capital resources to continue its development programs directed at

commercializing its fuel cell systems for worldwide residential use, to hire and train its production staff, develop and expand its manufacturing capacity, begin production activities and expand research and development activities. Plug Power will pursue the expansion of its operations through internal growth and strategic acquisitions and expect such activities will be funded from its existing cash and cash equivalents, issuance of additional equity or debt securities, or additional borrowings subject to market and other conditions. There can be no assurance that such additional financing will be available on

terms acceptable to Plug Power or at all. Failure to raise the funds necessary to finance future cash requirements or consummate future acquisitions could adversely affect Plug Power's ability to pursue its strategy and could negatively affect operations in future periods. Plug Power anticipates incurring substantial additional losses over at least the next several years and believes its current cash balances will provide it with sufficient capital to fund operations for at least the next twelve months.

As disclosed in SatCon's most recent Form 10-K filed for the year ended September 30, 2000:

Since inception, SatCon has financed its operations and met its capital expenditure requirements primarily through the sale of private equity securities, public security offerings, and borrowings on its line of credit and capital equipment leases.

SatCon anticipates that the existing $8.8 million in cash and cash equivalents will be sufficient to fund operations for at least the next twelve months. However, there can be no assurance that SatCon will not require additional financings within this time frame or that any additional financing, if needed, will be available to SatCon on terms acceptable to it, if at all.

Market risk represents the risk of changes in value of a financial instrument, caused by fluctuations in interest rates and equity prices.

At December 31, 2000, the Company had variable rate debt totaling $29.145 million. Interest rate changes generally do not affect the fair market value but do impact future earnings and cash flows. The earnings and cash flow impact for the next year resulting from a one-percentage point increase in interest rates would be approximately $.291 million, holding other variables (debt level) constant.

Market Risk (Continued)

The Company has performed a sensitivity analysis on its holdings of Plug Power, SatCon and Beacon Power common stock and its derivative financial instruments (warrants to purchase SatCon common stock). The sensitivity analysis presents the hypothetical change in fair value of our new energy holdings held by the Company at December 31, 2000, which are sensitive to changes in interest rates. Market risk is estimated as the potential change in fair value resulting from an immediate hypothetical one-percentage point parallel shift in the yield curve. The fair values of the Company's holdings in marketable securities have been based on quoted market prices and its derivative financial instruments based on estimates using valuation techniques.

The Company's interests in Plug Power and SatCon are accounted for on the equity method, Beacon Power is accounted for at fair value, and the derivative financial instruments are accounted for at estimated values. The fair market and estimated values, at December 31, 2000, of the Company's interests in these companies and the derivative financial instruments and the effects on fair value are as follows, if the market price on these interests decreased by ten percent:

This Form 10-Q contains and incorporates forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities and Exchange Act of 1934. You can identify forward-looking statements through our use of the words "expect," "anticipate," "believe," "should," "could," "may," "will," and other similar words, whether in the negative or the affirmative. Statements containing these, or similar words, are our predictions, expectations, plans and intentions of what may occur in the future. All statements that are not historical fact should be deemed to be forward-looking statements. We believe it is important to communicate our future expectations to our investors, however, our actual results may be very different from the predictions, expectations, plans and intentions we have shared with our investors. Such forward-looking statements involve known and unknown risks that may cause our actual results to differ materially from those stated and implied by our forward-looking statements. Such risks include, among others, our need to raise additional financing, difficulties in developing and acquiring new

Statement Concerning Forward Looking Statements (Continued)

energy companies and technologies, risks related to developing Direct Methanol Fuel Cells, market acceptance of new energy technologies, our dependence on the success of our portfolio companies, our history of losses, the historical volatility of our stock price, the risk we may become an inadvertent investment company, conflicts of interest between us, First Albany Companies Inc. and our portfolio companies and general market conditions. These and other risks are set forth in greater detail in the "Risk Factors" section of our Annual Report on Form 10-K, which is incorporated herein by reference. We do not intend to update any information in any forward-looking statements we make.

(b) One report on Form 8-K was filed during the quarter ended

December 31, 2000.

The Company filed a Form 8-K Report, dated December 22, 2000, reporting under Items 2 and 7 thereof its sale of Ling Electronics and acquisition of SatCon shares as of October 21, 1999 and the associated pro-forma financial statements and financial statements of SatCon for the year ended September 30, 1999.

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.

Mechanical Technology Incorporated