Soluna Holdings, Inc - Quarter Report: 2003 March (Form 10-Q)

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Exchange Act of 1934

For the quarterly period ended March 31, 2003

/ / 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___

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes ___ No X

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.

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

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

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(Dollars in thousands)

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

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1. Basis of Presentation

In the opinion of management the accompanying unaudited consolidated financial statements have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission and 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 accounting principles generally accepted in the United States of America have been omitted. These consolidated financial statements should be read in conjunction with the financial statements and notes thereto for the year ended December 31, 2002.

2. Significant Accounting Policies

The Company recognizes revenue from product sales in accordance with Staff Accounting Bulletin (SAB) No. 101, Revenue Recognition. Product revenue is recognized when there is persuasive evidence of an arrangement, delivery of the product to the customer or distributor has occurred, at which time title generally is passed to the customer or distributor, and the Company has determined that collection of a fixed fee is probable, all of which occur upon shipment of the product. If the product requires installation to be performed by the Company, all revenue related to the product is deferred and recognized upon the completion of the installation.

The Company performs funded research and development for government agencies and companies under cost reimbursement contracts, which generally require the Company to absorb up to 50% of the total costs incurred. Cost reimbursement contracts provide for the reimbursement of allowable costs. Revenues are generally recognized in proportion to the reimbursable costs incurred. When government agencies are providing funding they do not expect the government to be the only significant end user of the resulting products. These contracts do not require delivery of products that meet defined performance specifications, but are best efforts arrangements to achieve overall research and development objectives. Included in accounts receivable are billed and unbilled work-in-progress on cost reimbursed contracts.

While the Company's accounting for these contract costs are subject to audit by the sponsoring entity, in the opinion of management, no material adjustments are expected as a result of such audits. Cost of product revenue includes material, labor and overhead. Costs incurred in connection with funded research and development arrangements are included in funded research and product development expenses.

2. Significant Account Policies (Continued)

Deferred revenue consists of payments received from customers in advance of services performed, products shipped or installation completed.

The Company records a warranty reserve at the time product revenue is recorded based on a historical rate. The reserve is reviewed during the year and is adjusted, if appropriate, to reflect new product offerings or changes in experience. Actual warranty claims are tracked by product.

At March 31, 2003, the Company has two stock-based employee compensation plans, which are described more fully in Note 15 of the financial statements and notes thereto for the year ended December 31, 2002. SFAS No. 123, Accounting for Stock-Based Compensation, requires the measurement of the fair value of stock options or warrants granted to employees to be included in the statement of operations or, alternatively, disclosed in the notes to consolidated financial statements. The Company accounts for stock-based compensation of employees under the intrinsic value method of Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations and has elected the disclosure-only alternative under SFAS No. 123. The Company records the fair market value of stock options and warrants granted to non-employees in exchange for services in accordance with Emerging Issues Task Force (EITF) No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services, in the Consolidated Statement of Operations. The Company does not intend to adopt the transition provisions of SFAS No. 148, Accounting for Stock-Based Compensation- Transition and Disclosure.

The following table illustrates the effect on net loss and earnings per share as if the Company had applied the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation.

2. Significant Accounting Policies (Continued)

The Company accounts for taxes in accordance with Financial Accounting

Standard No. 109, Accounting for Income Taxes, which requires the use

of the asset and liability method of accounting for income taxes. Under the asset and liability method, deferred income taxes are recognized for the tax consequences of "temporary differences" by applying enacted statutory tax rates applicable for future years to differences between financial statement and tax bases of existing assets and liabilities. Under FAS No. 109, the effect of tax rate changes on deferred taxes is recognized in the income tax provision in the period that includes the enactment date. The provision for taxes is reduced by investment and other tax credits in the years such credits become available.

3. Contracts Receivable
   Included in accounts receivable are the following at:

The balances billed but not paid by customers pursuant to retainage provisions in contracts are due upon completion of the contracts and acceptance by the customer. Based on the Company's experience, most retainage amounts are expected to be collected within the ensuing year.

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4. Inventories

Inventories consist of the following at:

5. Securities Available for Sale

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

The principal components of the Company's securities available for sale consist of the following:

(Dollars in thousands, except stock price and share data)

The book basis roll forward of Plug Power and SatCon securities is as follows:

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5. Securities Available for Sale (Continued)

6. Impairment Losses

The slowing economy has had a negative impact on the equity value of companies in the new energy sector. In light of these circumstances

and based on the results of the reviews described above, the Company recorded other than temporary impairment charges with respect to its holdings in publicly traded companies. Pre-tax impairment losses were recorded as follows:

The Company's effective income tax rate from operations, including equity in holdings' losses differed from the Federal statutory rate as follows:

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7. Income Taxes (Continued)

Income tax (benefit) expense consists of the following:

The deferred tax assets and liabilities consist of the following tax effects relating to temporary differences and carryforwards:

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7. Income Taxes (Continued)

The valuation allowance at March 31, 2003 and December 31, 2002 was $1.836 million. The valuation allowance reflects the estimate that it was more likely than not that certain net operating losses may be unavailable to offset future taxable income.

8. Debt

As of March 31, 2003, the Company had a $10 million Credit Agreement with KeyBank, N.A. dated as of August 10, 2001 ("the $10 million Credit Agreement"). As of March 31, 2003, the Company had no outstanding debt and no availability under this line of credit because the market value of Plug Power common stock was $5.06 per share, which reduced the availability under this facility to zero.

9. Earnings Per Share

The amounts used in computing earnings per share ("EPS") and the effect on income and the weighted average number of shares of potentially dilutive securities are as follows:

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9. Earnings Per Share (Continued)

For the three months ended March 31, 2003, options to purchase 3,317,275 shares of common stock at prices ranging from $.54 to $21.92 per share and warrants to purchase 300,000 shares of common stock at $12.56 per share were outstanding but were not included in the computations of EPS-assuming dilution because the Company incurred losses during these periods and inclusion would be anti-dilutive. Additionally, under SFAS No. 128, Earnings per Share, 50,000 shares of non-vested restricted common stock, which vests solely upon continued service, were excluded from the computation of basic earnings per share.

For the three months ended March 31, 2002, options to purchase 3,175,050 shares of common stock at prices ranging from $.54 to $21.92 per share and warrants to purchase 300,000 shares of common stock at $12.56 per share were outstanding but were not included in the computations of EPS-assuming dilution because the Company incurred losses during these periods and inclusion would be anti-dilutive.

14. Segment Information

The Company operates in two business segments, New Energy and Test and Measurement Instrumentation. The New Energy segment develops new energy technologies and companies and is currently focused on commercializing direct methanol micro fuel cells. The Test and Measurement Instrumentation segment designs, manufactures, markets and services high-performance test and measurement instruments and systems and computer-based balancing systems for aircraft engines.

The Company evaluates performance based on profit or loss from operations before income taxes, accounting changes, items management does not deem relevant to segment performance, and interest income and expense. Inter-segment sales are not significant.

Summarized financial information concerning the Company's reportable segments is shown in the following table. The "Other" column

includes corporate related items and items like income taxes or unusual items, which are not allocated to reportable segments. The

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14. Segment Information (Continued)

"Reconciling Items" column includes minority interests in a consolidated subsidiary and income tax allocation to equity in holdings' losses. In addition, segments' noncash items include any depreciation and amortization in reported profit or loss. The New Energy segment figures include the Company's activities related to evaluating new energy technologies, companies and growth opportunities, micro fuel cell operations, the Company's holdings in Plug Power, SatCon and Beacon Power and the results of the Company's equity method of accounting for certain holdings. The results for Plug Power and SatCon were derived from their published quarterly and annual financial statements.

The Company's holdings in SatCon were accounted for on a one-quarter lag (through SatCon's quarter ended June 29, 2002) until accounting for the holding was changed on July 1, 2002 to fair value from the equity method. The sale of SatCon stock was affected as of the date

of sale. The accounting for the Company's holdings in Plug Power was changed on December 20, 2002 to fair value from the equity method.

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14. Segment Information (Continued)

The following table presents the details of "Other" segment (loss) profit:

15. Related Party Transactions

In connection with NIST billings, as of March 31, 2003, the Company has a liability to Dupont (a minority shareholder in MTI Micro) for approximately $55 thousand. This liability is included in the financial statement line "Accrued liabilities - related parties."

16. Effect of Recent Accounting Pronouncements

In June 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 143, Accounting for Asset Retirement Obligation. SFAS No. 143 requires entities to record the fair value of a liability for an asset retirement obligation in the period in which it is incurred. When the liability is initially recorded, an entity capitalizes a cost by increasing the carrying amount of the long-lived asset. Over time, the liability is accreted to its present value each period and the

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16. Effect of Recent Accounting Pronouncements (Continued)

In July 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. SFAS No. 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force (EITF) Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring). This statement is effective for exit and disposal activities initiated after December 31, 2002. The adoption of this Statement did not have a material impact on its consolidated financial statements.

In November 2002, FASB issued FASB Interpretation No. 45, Guarantor's Accounting and Disclosure Requirements for Guarantees, Including

Indirect Guarantees of Indebtedness of Others, an interpretation of

FASB Statement No. 5, 57, and 107 and Rescission of FASB Interpretation No. 34 ("FIN 45"). FIN 45 clarifies the requirements

of SFAS No. 5, Accounting for Contingencies, relating to the

guarantor's accounting for, and disclosure of, the issuance of certain types of guarantees. FIN 45 requires that upon issuance of a guarantee, the guarantor must recognize a liability for the fair value of the obligation it assumes under that guarantee. FIN 45 covers guarantee contracts that have any of the following four characteristics: (a) contracts that contingently require the guarantor to make payments to the guaranteed party based on changes in an underlying that is related to an asset, a liability, or an equity security of the guaranteed party (e.g., financial and market

value guarantees), (b) contracts that contingently require the guarantor to make payments to the guaranteed party based on another entity's failure to perform under an obligating agreement (performance guarantees), (c) indemnification agreements that contingently require the indemnifying party (guarantor) to make

payments to the indemnified party (guaranteed party) based on changes in an underlying that is related to an asset, a liability, or an equity security of the indemnified party, such as an adverse judgment in a lawsuit or the imposition of additional taxes due to either a change in the tax law or an adverse interpretation of the tax law, and (d) indirect guarantees of the indebtedness of others. FIN 45 specifically excludes certain guarantee contracts from its scope. Additionally, certain guarantees are not subject to FIN 45's provisions for initial recognition and measurement but

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16. Effect of Recent Accounting Pronouncements (Continued)

are subject to its disclosure requirements. The initial recognition and measurement provisions are effective for guarantees issued or modified after December 31, 2002. The adoption of the Standard had no impact on the Company's consolidated financial statements and the Company began making required disclosures in its consolidated financial statements beginning December 31, 2002. The Company has made appropriate disclosures regarding warranties and future guarantees issued or modified will be recognized in the Company's consolidated financial statements.

In December 2002, the FASB issued SFAS No. 148, Accounting for Stock Based Compensation-Transition and Disclosure, an amendment to FASB Statement No. 123. This Statement amends SFAS No. 123, Accounting for Stock-Based Compensation, to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, this Statement amends the disclosure requirements of Statement No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. Finally, SFAS No. 148 amends APB Opinion No. 28, Interim Financial

Reporting, to require disclosure about those effects in interim financial reporting. For entities that voluntarily change to the fair

value based method of accounting for stock-based employee compensation, the transition provisions are effective for fiscal

years ending after December 15, 2002. For all other companies, the disclosure provisions and the amendment to APB No. 28 are effective for interim periods beginning after December 15, 2002. The Company does not intend to adopt the transition provisions of the Statement and began making all required disclosures as of December 31, 2002.

In January 2003, FASB issued FASB Interpretation No. 46, Consolidation of Variable Interest Entities ("FIN 46"). FIN 46 requires a variable interest entity to be consolidated by a company if that company is subject to a majority of the risk of loss from the

variable interest entity's activities or entitled to receive a majority of the entity's residual returns or both. FIN 46 also requires disclosures about variable interest entities that a company is not required to consolidate but in which it has a significant variable interest. The consolidation requirements of FIN 46 apply

immediately to variable interest entities created after January 31, 2003. The consolidation requirements apply to existing entities in the first fiscal year or interim period beginning after June 15, 2003. Certain of the disclosure requirements apply in all financial statements issued after January 31, 2003, regardless of when the variable interest entity was established. The adoption of the Standard, effective January 1, 2003, had no impact on the Company's

consolidated financial statements and related disclosures.

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17. Contingencies

Our securities available for sale constitute investment securities under the Investment Company Act. In general, a company may be deemed to be an investment company if it owns investment securities with a value exceeding 40% of its total assets, subject to certain exclusions and exemptions. Investment companies are subject to registration under, and compliance with, the Investment Company Act unless a particular exemption or safe harbor provision applies. If the Company was to be deemed an investment company, the Company would become subject to the requirements of the Investment Company Act. As a consequence, the Company would be prohibited from engaging in certain businesses or issuing certain securities, certain of our contracts might be voidable, and the Company might be subject to civil and criminal penalties for noncompliance.

Until fiscal 2001, the Company qualified for a safe harbor exemption under the Investment Company Act based upon the level of ownership of

shares of Plug Power and influence over its management or policies.

However, since the Company sold some of its shares of Plug Power during fiscal 2001, this safe harbor exemption is no longer available.

On December 3, 2001, the Company made an application to the Securities and Exchange Commission ("SEC") requesting that they either declare that the Company is not an investment company because it is primarily engaged in another business or exempt it from the provisions of the Investment Company Act for a period of time. This application is pending. If the Company's application is not granted, the Company will have to find another safe harbor or exemption that it can qualify for, which may include a one-year safe harbor granted by the Investment Company Act, or become an investment company

subject to the regulations of the Investment Company Act.

If we were deemed to be an investment company and could not find another safe harbor or exemption and failed to register as an investment company, the SEC could require us to sell our interests in

Plug Power and SatCon, until the value of our holdings is reduced

below 40% of total assets. This could result in sales of our

holdings in quantities of shares at depressed prices and we may never realize anticipated benefits from, or may incur losses on, these sales.

Further, we may be unable to sell some holdings due to contractual or legal restrictions or the inability to locate a suitable buyer. Moreover, we may incur tax liabilities when selling assets.

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17. Contingencies (Continued)

On September 9, 1998, Barbara Lawrence, the Lawrence Group, Inc.

("Lawrence"), and certain other Lawrence-related entities ("Plaintiffs") initially filed suit in the Bankruptcy Court and the United States District Court for the Northern District of New York which were subsequently consolidated in the District Court, against First Albany Corporation, Mechanical Technology, Dale Church, Edward Dohring, Alan Goldberg, George McNamee, Beno Sternlicht, Marty Mastroianni (former President and Chief Operating Officer of the Company), and 33 other individuals ("Defendants") who purchased a total of 820,909 shares of the Company's stock from the Plaintiffs. The case concerns the Defendants' 1997 purchase of Mechanical Technology shares from the Plaintiffs at the price of $2.25 per share ($0.75 per share post split). FAC acted as Placement Agent for the Defendants in the negotiation and sale of the shares and in proceedings before the Bankruptcy Court for the Northern District of New York, which approved the sale in September 1997.

Plaintiffs claim that the Defendants failed to disclose material inside information concerning Plug Power, LLC to the Plaintiffs and therefore the $2.25 per share ($0.75 per share post split) purchase price was unfair. Plaintiffs are seeking damages of $5 million plus punitive damages and costs. In April 1999, Defendants filed a motion to dismiss the amended complaint, which was denied by the Bankruptcy Court. On appeal in October 2000, Plaintiffs' cause of action was dismissed by the United States District Court for the Northern District of New York. In November 2000, Plaintiffs filed an appeal of that dismissal with the United States Court of Appeals for the Second Circuit. In June 2002, the Second Circuit Court of Appeals reversed the District Court decision and remanded the case for further consideration of the Plaintiff's claims as motions to modify the Bankruptcy Court sale order. The Plaintiff's claims have now been referred back to Bankruptcy Court for such consideration. The

Company believes the claims have no merit and intends to defend them vigorously. The Company cannot predict the outcome of the claims nor reasonably estimate a range of possible loss given the current status of the litigation. Accordingly, no amounts have been reserved for this matter.

The Company and its subsidiaries lease certain manufacturing, laboratory and office facilities. The leases generally provide for the Company to pay either increases over a base year level for taxes, maintenance, insurance and other costs of the leased properties or the Company's allocated share of insurance, taxes, maintenance and other costs of leased properties. The leases contain renewal provisions.

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17. Contingencies (Continued)

Future minimum rental payments required under noncancelable operating leases are (dollars in thousands): $418 remaining in 2003; $607 in 2004, $547 in 2005, $429 in 2006, $316 in 2007 and $605 thereafter.

A reconciliation of changes in product warranty liabilities is as follows:

The Company has employment agreements with certain employees that

provide severance payments and accelerated vesting of certain options upon termination of employment under certain circumstances, as

defined. As of March 31, 2003, the Company's potential minimum

obligation to these employees was approximately $971 thousand.

18. Subsequent Events

From April 1 through May 14, 2003, the Company sold securities available for sale as follows:

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The Company is primarily engaged in the development and commercialization of direct methanol micro fuel cells ("DMFCs") through its subsidiary MTI MicroFuel Cells Inc. ("MTI Micro") and the development and sales of precision instruments through its subsidiary MTI Instruments, Inc. ("MTI Instruments"). The Company also co-founded and retains an interest in Plug Power Inc. ("Plug Power") (NASDAQ: PLUG), a leading manufacturer of fuel cells. The Company also has an interest in SatCon Technology Corporation ("SatCon") (NASDAQ: SATC), which develops power electronics and energy management products.

MTI Micro is commercializing its micro fuel cell power systems as future power sources for portable electronics in commercial and military markets, with an initial product planned for 2004.

A micro fuel cell is a portable power source for electronic devices that creates useable electrical energy through a chemical reaction with a catalyst. MTI Micro's proprietary micro fuel cell power systems use methanol, a common alcohol with a high energy density, which allows its systems to be lightweight and provide power for longer periods of time between refueling. MTI Micro's systems can be instantly refueled without the need for a power outlet or a lengthy recharge and do not contain the heavy toxic metals found in many batteries.

MTI Micro has built a number of system prototypes that demonstrate size reductions, performance improvements, the ability to operate in any orientation, operation at a range of voltages and, most recently, the use of 100 percent methanol fuel - eliminating the need to carry water in the fuel cartridge, thereby achieving greater energy density.

MTI Instruments specializes in the design, manufacture and sale of high-performance test and measurement instruments and systems. MTI Instruments' three product groups provide: electronic, computerized general gaging instruments for position, displacement and vibration applications; semiconductor products for wafer characterization of semi-insulating and semiconducting wafers; and portable balancing systems for aircraft engines. MTI Instruments' largest customers include industry leaders in the computer, electronic, semiconductor, automotive, aerospace, aircraft and bioengineering fields.

From inception through March 31, 2003, the Company has incurred net losses of $61.9 million and expects to incur losses as it continues micro fuel cell product development and commercialization programs. The Company expects that losses will fluctuate from year to year and that such fluctuations may be substantial as a result of, among other factors, the number of prototypes produced, gains on sales of holdings and the operating results of MTI Instruments and MTI Micro.

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The Company's discussion and analysis of its financial condition and results of its operations are based upon the Company's consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of

Management believes that the following are the Company's most critical accounting policies affected by the estimates and assumptions the Company must make in the preparation of its consolidated financial statements and related disclosures:

Revenue Recognition. The Company recognizes revenue from product sales in accordance with Staff Accounting Bulletin (SAB) No. 101, Revenue Recognition. Product revenue is recognized when there is persuasive evidence of an arrangement, delivery of the product to the customer or distributor has occurred, at which time title generally is passed to the customer or distributor, and the Company has determined that collection of a fixed fee is probable, all of which occur upon shipment of the product. If the product requires installation to be performed by the Company, all revenue related to the product is deferred and recognized upon the completion of the installation.

The Company performs funded research and development for government agencies and companies under cost reimbursement contracts, which generally require the Company to absorb up to 50% of the total costs incurred.  Cost reimbursement contracts provide for the reimbursement of allowable costs.  Revenues are generally recognized in proportion to the reimbursable costs incurred. When government agencies are providing funding they do not expect the government to be the only significant end user of the resulting products.  These contracts do not require delivery of products that meet defined performance specifications, but are best efforts arrangements to achieve overall research and development objectives. Included in accounts receivable are billed and unbilled work-in-progress on cost reimbursed contracts.

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Impairment of Holdings and Securities Available for Sale. The Company holds minority interests in companies having operations or technology in areas within its strategic focus, all of which are publicly traded and have highly volatile share prices. The Company records an impairment charge when it believes a holding or security available for sale has experienced a decline in value that is other than temporary. If the Company determines that the decline in value is temporary, unrealized losses, net of income taxes, would be reported as a separate component of shareholders' equity.

Future adverse changes in market conditions or poor operating results of underlying holdings or securities available for sale could result in significant losses and an inability to recover the carrying value of the asset, thereby possibly requiring an impairment charge in the future.

Income Taxes. As part of the process of preparing our consolidated financial statements, the Company is required to estimate its income taxes in each of the jurisdictions in which it operates. This process involves the estimation of our actual current tax exposure together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. Included in this assessment is the determination of net operating loss carryforwards. These differences result in a net deferred tax asset. The Company must assess the likelihood that its deferred tax assets will be recovered from future taxable income and, to the extent that the Company believes that recovery is not likely; it must establish a valuation allowance.

Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets. We have recorded a valuation allowance due to uncertainties related to our ability to utilize certain net deferred tax assets, primarily consisting of net operating losses being carried forward. The valuation allowance is based on estimates of the recoverability of certain net operating losses. In the event that actual results differ from these estimates or we adjust these estimates in future periods, we may need to adjust the recorded valuation allowance, which could materially impact our financial position and results of operations. The Company has recorded a $1.836 million valuation allowance against its net deferred tax assets of $4.732 million as of March 31, 2003, due to uncertainties related to its ability to utilize certain of these assets.

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The following is management's discussion and analysis of certain significant factors, which have affected the Company's results of operations for the three-months ended March 31, 2003 compared to the three-months ended March 31, 2002.

Product Revenue. Product revenue in the Test and Measurement Segment for the three months ended March 31, 2003 totaled $1.283 million compared to $.590 million for the same period in the prior year, an increase of $.693 million, or 117.5%. This increase is primarily the result of increased sales to Aviation and General Gaging customers of $.469 and $.127 million, respectively, and other product line net increases of $.097 million.

Funded Research and Development Revenue. Funded research and development revenue in the New Energy Segment for the three months ended March 31, 2003 totaled $.522 million compared to $.172 million for the same period in the prior year, an increase of $.350 million, or 203.5%. These amounts reflect billings and amounts to be billed under government contracts for the research and development of micro fuel cells for use in portable electronics. This increase is the direct result of the NIST and NYSERDA contracts being fully underway compared to the prior year where the NIST contract was just starting.

Cost of Product Revenue. Cost of product revenue in Test and Measurement for the three months ended March 31, 2003 increased by $.143 million or 34.7% from $.412 million for the same period in the prior year to $.555 million. The increase was primarily due to increased sales.

Gross profit as a percentage of product revenue increased to 56.7% for the three months ended March 31, 2003 from 30.2% in the prior year. The gross profit percentage increased for the three months ended March 31, 2003 due to a change in the product mix at MTI Instruments and a reduction in overhead as compared to the same period in 2002 where overhead absorption was higher on lower overall sales levels.

Funded Research and Product Development Expenses. Funded research and product development expenses in New Energy increased by $.475 million or 137.7% to $.820 million for the three months ended March 31, 2003 from $.345 million for the same period in the prior year. The increased costs are attributable to increased development costs related to MTI Micro moving toward commercialization.

Unfunded Research and Product Development Expenses. Unfunded research and product development expenses decreased by $.072 million or 7.0% to

$.951 million for the three months ended March 31, 2003 from $1.023 million for the same period in the prior year. This decrease reflects a $.038 million reduction in product development costs for Test and Measurement due to reduced spending on development. The development of MTI Instrument's newest product, the Microtrak II, was completed

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and introduced during the third quarter of 2002. This decrease also includes a $.034 million decrease at New Energy as more costs are allocated to funded programs in 2003 than in 2002.

Selling, General and Administrative Expenses. Selling, general and administrative expenses decreased $.215 million to $1.420 million for the three months ended March 31, 2003 as compared to $1.635 million for the same period in the prior year, a 13.1% decrease. This decrease is primarily the result of a reduction in staffing levels at MTI Instruments and an increase in recovery of costs related to government contracts at MTI Micro.

Operating Loss. Operating loss decreased $.712 million to an operating loss of $1.941 million for the three months ended

March 31, 2003 as compared to $2.653 million for the same period in the prior year, a 26.8% decrease. This decrease in loss results primarily from increases in gross profits from product revenues, reduced staffing levels at MTI Instruments and an increase in funded research and development revenue at MTI Micro.

Loss on Derivatives. The Company recorded net losses of $6 thousand and $167 thousand on derivative accounting for the three months ended March 31, 2003 and 2002, respectively. Changes in derivative fair values, calculated using the Black-Scholes pricing model, are recorded on a quarterly basis.

Gain on Sale of Holdings, Net. Results in the prior year for the three months ended March 31, 2002 include a $2.241 million gain on the sale of holdings. The average selling price per share of Plug Power and SatCon was $9.67 and $6.04, respectively, in 2002.

Gain on Sale of Securities Available for Sale, Net. Results for the three months ended March 31, 2003 include a $1.720 million gain on the sale of securities available for sale. The average selling price per share of Plug Power and SatCon was $5.26 and $1.28, respectively, in 2003.

Impairment Losses. Impairment losses were not recorded during the three months ended March 31, 2003. For the three months ended March 31, 2002, the Company recorded a $5.282 million charge for impairment losses for other than temporary decline in the value of certain available-for-sale securities ($3.484 million) and equity method investments ($1.798 million).

Interest Expense. Results during the three months ended March 31, 2003 and 2002 were affected by interest expense of $3 and $12 thousand, respectively. The decrease in expense results from decreases in the amount of debt outstanding and prime interest rate.

Equity in Holdings' Losses, Net of Tax. In the three months ended March 31, 2002, the Company recorded a $1.866 million loss, net of tax, respectively, from the recognition of the Company's proportionate share of losses in equity holdings. Equity in

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holdings' losses results 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 is included in equity in holdings' losses. Equity in holdings' losses for the three months ended March 31, 2002 includes the results from the Company's minority ownership in Plug Power and SatCon. Effective July 1, 2002, the Company's holdings in SatCon and as of December 20, 2002, the Company's holdings in Plug Power are accounted for using the fair value method as set forth in SFAS No. 115, Accounting for Certain Debt and Equity Securities. The Company is no longer required to record its share of any losses from SatCon or Plug Power and the holdings are carried at fair value, designated as available for sale, and any unrealized holding gains and losses are included in stockholders' equity as a component of accumulated other comprehensive income (loss).

Equity in holdings' losses includes a loss, before taxes, from Plug Power of $2.691 million for the three months ended March 31, 2002. Equity in holdings' losses, before taxes, for the three months ended March 31, 2002 also includes our proportionate share of losses from SatCon of $.424 million. SatCon was accounted for on a one-quarter lag until the accounting was changed to fair value from the equity method on July 1, 2002. Plug Power was accounted for under the equity method until the accounting was changed on December 20, 2002 to fair value.

Income Tax Benefit. The income tax benefit rate for the three months ended March 31, 2003 is 33.21% compared to the rate for the three months ended March 31, 2002 of 40.11%. These tax rates are primarily due to losses generated by operations. The valuation allowance at March 31, 2003 and December 31, 2002 was $1.836 million. The Company determined that it was more likely than not that the ultimate recognition of certain deferred tax assets would not be realized.

Further, as a result of ownership changes in 1996, the availability of $1.467 million of net operating loss carryforwards to offset future taxable income will be limited pursuant to the Internal Revenue Code.

The Company has incurred significant losses as it continues micro fuel cell product development and commercialization programs. The Company expects that losses will fluctuate from year to year and that such fluctuations may be substantial as a result of, among other factors, the number of prototypes produced, gains on sales of holdings and the operating results of MTI Instruments and MTI Micro. As of March 31, 2003, the Company had an accumulated deficit of $61.937 million. During the three months ended March 31, 2003, the Company incurred a loss of $63 thousand and used cash in operating activities totaling $1.797 million. This cash use in 2003 was funded by proceeds from sale of holdings totaling $2.776 million. The Company expects to continue to incur losses as it develops and

29

commercializes micro fuel cells and it expects to continue funding its operations from the sales of holdings unless other sources of funding can be found.

The Company anticipates that it will be able to meet the liquidity needs of its continuing operations for the next year from current cash resources, cash flow generated by operations, sale of assets (securities available for sale) and equity financings, if deemed appropriate. 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. Cash used in operations is expected to total approximately $10.8 million for 2003. Further, cash used for capital expenditures is expected to total approximately $2.3 million in 2003. Based on current cash flow and revenue projections, and assuming current market values, the sale of available for sale securities and current cash and cash equivalents should be adequate to fund operations for another two to three years. The Company will also seek to provide additional resources through equity offerings and additional government revenues.

Proceeds from the sale of assets are subject to fluctuations in the market value of Plug Power and SatCon as well as limitations on the ability to sell shares arising under securities laws and other agreements detailed below.

On December 17, 2001 the Company entered into a plan under Rule 10b5-1 (the "Plan") pursuant to which the Company will sell shares of Plug Power. The Plan provides for the sale of, and the Company intends to sell, up to 2 million shares of Plug Power during calendar 2003. Under the terms of the Plan, the Company may terminate the Plan at any time.

The future sale of holdings in Plug Power and SatCon will generate taxable income or loss which is different from book income or loss due to the tax bases in these assets being significantly different from their book bases. Book and tax bases as of March 31, 2003 are as follows:

As of March 31, 2003, the Company has holdings in Plug Power and SatCon securities. Each of these securities is currently traded on the Nasdaq National Market and is therefore subject to stock market conditions. 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 is 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,

30

restricted securities that have been owned for a period of at least one year may be sold immediately after an IPO, subject to the volume limitations of Rule 144. However, because of our ownership position, we are considered an "affiliate" of Plug Power and therefore are subject to the volume limitation of Rule 144, even if we have held the securities for two years or more.

The Rule 144 limitations, as currently in effect, limit our sales of Plug 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.

Working capital was $37.83 million at March 31, 2003, a $1.15 million increase from $36.68 million at December 31, 2002. This increase is primarily the result of $1.5 million of fair value adjustments for securities available for sale and a $.8 million increase in cash primarily resulting from the sale of securities available for sale during the period offset by a $1.1 million increase in current deferred tax liabilities.

At March 31, 2003, the Company's order backlog was $.547 million, compared to $.446 million at December 31, 2002.

Inventory and accounts receivable (from product revenues) turnover ratios and their changes for the three months ended March 31 are as follows:

The changes in the inventory and accounts receivable turnover ratios are the result of increases in sales over the comparable prior year period.

Inventories at March 31, 2003 of $1.3 million reflect inventory levels for MTI Instruments required to support expected second quarter sales. Additionally, accounts receivable decreased by $.106 million in 2003 primarily due to lower monthly sales volume in March 2003 compared to December 2002.

Cash flow used by operating activities for the three months ended March 31, 2003 was $1.8 million compared with $2.5 million in the prior year.

Capital expenditures during the first three months of 2003 were $.150 million, an increase from the comparable period in 2002 where spending totaled $.070 million. Capital expenditures in 2003 included furniture, computer equipment, facilities fit-up, software, and manufacturing and laboratory equipment. Remaining capital expenditures

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in 2003 are expected to approximate $2.1 million, consisting of expenditures for facility expansion, computer, manufacturing and laboratory equipment. The Company expects to finance these expenditures with cash from operations and other sources.

Future minimum rental, license and royalty payments to LANL, as of March 31, 2003, under agreements with non-cancelable terms are as follows:

(A) Once products are sold under this agreement, royalties will be based on 2% of the first $50 million of net sales, 1% on net sales in excess of $50 million but less than $100 million and .5% on net sales in excess of $100 million. License payments made in any year can be applied against royalties due and total annual fees in any year shall not exceed $1 million.

Cash and cash equivalents were $8.2 million at March 31, 2003 compared to $7.3 million at December 31, 2002.

As of March 31, 2003, the Company had a $10 million Credit Agreement with KeyBank, N.A. dated as of August 10, 2001 ("the $10 million Credit Agreement"). The Company has no debt outstanding and no availability under this line of credit since the March 31, 2003 market value of Plug Power common stock was $5.06. Under the terms of the $10 million Credit Agreement, the Company has the ability to borrow under the facility if the market value of Plug Power common stock rises above $7 per share.

The $10 million Credit Agreement expires July 31, 2003 and the Company plans to pursue a new working capital line of credit during 2003. The Company has pledged two million shares of Plug Power common stock as collateral for the $10 million Credit Agreement. Additional collateral consisting of 500,000 shares of SatCon common stock was pledged in August 2001, when the market value of Plug Power common stock fell below $10 per share. At the Company's request, KeyBank released the SatCon stock on April 19, 2003.

The $10 million Credit Agreement requires the Company to meet certain covenants, including maintenance of a debt service reserve account

32

(equal to 3 months of interest payments on outstanding debt), minimum Plug Power share price and pledge additional collateral and maintain an additional collateral value, if required, based on the Plug Power share price falling below $10 per share. The Company was in compliance with these covenants as of March 31, 2003.

In 2003, the Company recognized a $1.720 million net gain on the sale of its securities available for sale. This gain related to the Company's previously announced strategy to raise additional capital through equity offerings and the sale of its assets in order to fund its micro fuel cell operations.

As of March 31, 2003, the Company has sold .500 million shares of Plug Power common stock with proceeds totaling $2.661 million and gains totaling $1.773 million and .125 million shares of SatCon common stock with proceeds totaling $.115 million and losses totaling $53 thousand. Taxes on the net gains will be offset by the Company's operating losses. As of March 31, 2003, the Company estimates its remaining net operating loss carryforwards to be approximately $10.2 million.

From April 1 through May 14, 2003, the Company sold available for sale securities as follows:

The Company and its partners have begun the second year of a $4.6 million Advanced Technology Program ("ATP") of the National Institute of Standards and Technology ("NIST"). The award is to carry out a two-and-a-half-year, $9.3 million cost-shared program to research and develop a micro fuel cell for use in portable electronics. The

program began October 1, 2001 and, during 2003, the Company expects to receive approximately $1.6 million in NIST grant revenues.

In June 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Statement ("SFAS") No. 143, Accounting for Asset Retirement Obligation. SFAS No. 143 requires entities to record the fair value of a liability for an asset retirement obligation in the period in which it is incurred. When the liability is initially recorded, an entity capitalizes a cost by increasing the carrying amount of the long-lived asset. Over time, the liability is accreted to its present value each period and the capitalized cost is depreciated over the useful life of the related asset. Upon settlement of the liability, an entity either settles the obligation for its recorded amount or

33

In July 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. SFAS No. 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force (EITF) Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring). This statement is effective for exit and disposal activities initiated after December 31, 2002. The Company does not believe the adoption of this Statement will have a material impact on its consolidated financial statements.

In November 2002, the FASB issued FASB Interpretation No. 45, Guarantor's Accounting and Disclosure Requirements for Guarantees,

Including Indirect Guarantees of Indebtedness of Others, an interpretation of FASB Statement No. 5, 57, and 107 and Rescission of FASB Interpretation No. 34 ("FIN 45"). FIN 45 clarifies the requirements of SFAS No. 5, Accounting for Contingencies, relating to the guarantor's accounting for, and disclosure of, the issuance of certain types of guarantees. FIN 45 requires that upon issuance of a guarantee, the guarantor must recognize a liability for the fair value of the obligation it assumes under that guarantee. FIN 45 covers guarantee contracts that have any of the following four characteristics: (a) contracts that contingently require the guarantor to make payments to the guaranteed party based on changes in an underlying that is related to an asset, a liability, or an equity security of the guaranteed party (e.g., financial and market value guarantees), (b) contracts that contingently require the guarantor to make payments to the guaranteed party based on another entity's failure to perform under an obligating agreement (performance guarantees), (c) indemnification agreements that contingently require the indemnifying party (guarantor) to make payments to the indemnified party (guaranteed party) based on changes in an underlying that is related to an asset, a liability, or an equity security of the indemnified party, such as an adverse judgment in a lawsuit or the imposition of additional taxes due to either a change in the tax law or an adverse interpretation of the tax law, and (d) indirect guarantees of the indebtedness of others. FIN 45 specifically excludes certain guarantee contracts from its scope. Additionally, certain guarantees are not subject to FIN 45's provisions for initial recognition and measurement but are subject to its disclosure requirements. The initial recognition and measurement provisions are effective for guarantees issued or modified after December 31, 2002. The Company began making required disclosures in its consolidated financial statements beginning December 31, 2002. The Company has made appropriate disclosures regarding warranties and future quarters issued or modified will be recognized in the Company's consolidated financial statements.

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In December 2002, the FASB issued SFAS No. 148, Accounting for Stock Based Compensation-Transition and Disclosure, an amendment to FASB Statement No. 123. This Statement amends SFAS No. 123, Accounting for Stock-Based Compensation, to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, this Statement amends the disclosure requirements of Statement No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. Finally, SFAS No. 148 amends APB Opinion No. 28, Interim Financial

Reporting, to require disclosure about those effects in interim financial reporting. For entities that voluntarily change to the fair value based method of accounting for stock-based employee compensation, the transition provisions are effective for fiscal years ending after December 15, 2002. For all other companies, the disclosure provisions and the amendment to APB No. 28 are effective for interim periods beginning after December 15, 2002. The Company does not intend to adopt the transition provisions of the Statement and began making required disclosures in its consolidated financial statements beginning December 31, 2002.

In January 2003, the FASB issued FASB Interpretation No. 46, Consolidation of Variable Interest Entities ("FIN 46"). FIN 46 requires a variable interest entity to be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity's activities or entitled to receive a majority of the entity's residual returns or both. FIN 46 also requires disclosures about variable interest entities that a company is not required to consolidate but in which it has a significant variable interest. The consolidation requirements of FIN 46 apply immediately to variable interest entities created after January 31, 2003. The consolidation requirements apply to existing entities in the first fiscal year or interim period beginning after June 15, 2003. Certain of the disclosure requirements apply in all financial statements issued after January 31, 2003, regardless of when the variable interest entity was established. The Company is currently evaluating the impact of FIN 46 on its consolidated financial statements and related disclosures but does not expect that there will be any material impact.

Statement Concerning Forward Looking Statements

This Quarterly Report on Form 10-Q contains and incorporates forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities and Exchange Act of 1934, as amended. 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

35

We develop products in the United States and sell them worldwide. As a result, our financial results could be affected by factors such as changes in foreign exchange rates or weak economic conditions in foreign markets. Since our sales are currently priced in U.S. dollars and are translated to local currency amounts, a strengthening of the dollar could make our products less competitive in foreign markets. Interest income is sensitive to changes in the general level of U.S. interest rates, particularly since our investments are in short-term instruments. Based on the nature and current levels of our investments, however, we have concluded that there is no material market risk exposure.

(a) Evaluation of disclosure controls and procedures. Based on their evaluation of our disclosure controls and procedures (as defined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of 1934)as of a date within 90 days of the filing date of this Quarterly Report on Form 10-Q, our chief executive officer and chief financial officer have concluded that our disclosure controls and procedures are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms and are operating in an effective manner.

(b) Changes in internal controls. There were no significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the date of their most recent evaluation.

36

At any point in time, the Company and its subsidiaries may be involved in various lawsuits or other legal proceedings; these could arise from the sale of products or services or from other matters relating to its regular business activities, compliance with various governmental regulations and requirements, or other transactions or circumstances. The Company does not believe there are any such proceedings presently pending, which could have a material adverse effect on the Company's financial condition except for the matters described in Note 16 of the Notes to Interim Consolidated Financial Statements.

Not applicable.

Not applicable.

Not applicable.

Not applicable.

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Mechanical Technology Incorporated

38

1. I have reviewed this quarterly report on Form 10-Q of Mechanical Technology Incorporated;
   

2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;
   
3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;
   
4. The registrant's other certifying officers and I are responsible for
   establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to

the filing date of this quarterly report (the "Evaluation Date");

and

c) presented in this quarterly report our conclusions about the

effectiveness of the disclosure controls and procedures based

on our evaluation as of the Evaluation Date;

5. The registrant's other certifying officers and I have disclosed,

based on our most recent evaluation, to the registrant's auditors
and the audit committee of registrant's board of directors (or
persons performing the equivalent function):

a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the
registrant's ability to record, process, summarize and report
financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and

b) any fraud, whether or not material, that involves management
or other employees who have a significant role in the
registrant's internal controls; and

6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

May 15, 2003 /S/ DALE W. CHURCH
Dale W. Church

Chief Executive Officer

39

I, Cynthia A. Scheuer, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Mechanical Technology Incorporated;

2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;
   
3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;
   
4. The registrant's other certifying officers and I are responsible for
   establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to

the filing date of this quarterly report (the "Evaluation Date");

and

c) presented in this quarterly report our conclusions about the

effectiveness of the disclosure controls and procedures based

on our evaluation as of the Evaluation Date;

5. The registrant's other certifying officers and I have disclosed,

based on our most recent evaluation, to the registrant's auditors
and the audit committee of registrant's board of directors (or
persons performing the equivalent function):

a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the
registrant's ability to record, process, summarize and report
financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and

b) any fraud, whether or not material, that involves management
or other employees who have a significant role in the
registrant's internal controls; and

6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

May 15, 2003 /S/ CYNTHIA A. SCHEUER Dale W. Church

Cynthia A. Scheuer

Chief Financial Officer

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