Soluna Holdings, Inc - Quarter Report: 2004 March (Form 10-Q)

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

Accumulated unrealized gains related to securities available for sale are as follows:

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The Company's effective income tax benefit rate from operations differed from the Federal statutory rate as follows:

Income tax benefit (expense) consists of the following:

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

The valuation allowance at March 31, 2004 and December 31, 2003 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.

7. Shareholders' Equity

Changes in common shares are as follows:

7. Shareholders' Equity (Continued)

Changes in treasury stock are as follows:

The Company has reserved common shares for future issuance as of March 31, 2004 as follows:

On January 29, 2004, we issued to Fletcher International, Ltd., or Fletcher, in a private placement (1) 1,418,842 shares of our common stock for an aggregate purchase price of $10 million, or $7.048 per share, and (2) rights to purchase up to an additional $26 million of our common stock and in certain instances up to 3,000,000 shares of Plug Power Inc. (NASDAQ:PLUG) common stock owned by us, which rights are referred to herein as the additional investment rights.

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the right, but not the obligation, to purchase, in a single purchase or multiple purchases, up to an additional $20 million of our common stock at any time prior to December 31, 2006 at a price per share equal to $6.34, which date may be extended in the event that we have not satisfied our contractual obligations with respect to the registration for resale of common stock issued or issuable to Fletcher.

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7. Shareholders' Equity (Continued)

At the time of the consummation of the private placement, we deposited into escrow 3,000,000 shares of common stock of Plug Power owned by us. Commencing immediately after the SEC declares effective the registration statement relating to shares of our common stock that Fletcher owns or may acquire, 250,000 of such shares would have been released from escrow to us, on a monthly basis, in the event that on any day during such month, the prevailing price of our common stock exceeded $6.343 (which price may have been adjusted to reflect stock splits, recombinations, stock dividends or the like). If Fletcher did not exercise its right to purchase the first additional $8 million of our common stock, all of such Plug Power shares would have been released from escrow to us. If, however, Fletcher did exercise such right, then at any time during the month of June 2005, Fletcher may have purchased from us a number of shares of Plug Power common stock equal to $10,000,000 divided by the prevailing price per share of Plug Power common stock, but only to the extent of the number of shares remaining in escrow.

period. Each of the above referenced per share exercise prices for the additional investment rights was subject to adjustment as described below under "Adjustment Provisions - Prior to Amendment."

As a result of this exercise price calculation, we may be required to sell shares of Plug Power at a discount to prices we would otherwise obtain in sales at market prices. The table below illustrates such potential discounts based on assumed decreases in our stock price from $6.00 (which, for the purposes of this illustration, serves as an approximation of the price of our common stock as of March 11, 2004, the date we filed Amendment No. 1 to our Registration Statement on Form S-3), and an assumed price of Plug Power common stock at the time of exercise. Note that Fletcher's right to purchase Plug Power shares was conditioned on the exercising of Fletcher's first $8 million of additional investment rights.

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7. Shareholders' Equity (Continued)

dividends or the like). If Fletcher does not exercise its right to purchase the first additional $8 million of our common stock, all of such Plug Power shares will be released from escrow to us. If, however, Fletcher does exercise such right, then at any time, on one or multiple occasions, from June 1, 2005 to December 31, 2006, Fletcher may exercise its right to purchase from us a number of shares of Plug Power common stock totaling $10,000,000 divided by the prevailing price per share of Plug Power common stock, but only to the extent of the number of shares remaining in escrow.

As a result of this exercise price calculation, we may be required to sell shares of Plug Power at a discount to prices we would otherwise obtain in sales at market prices. The table below illustrates such potential discounts based on assumed decreases in our stock price from $6.00 (which, for the purposes of this illustration, serves as an approximation of the price of our common stock as of March 11, 2004, the date we filed Amendment No. 1 to our Registration Statement on Form S-3), and an assumed price of Plug Power common stock at the time of exercise. Note that Fletcher's right to purchase Plug Power shares is conditioned on the exercising of Fletcher's first $8 million of additional investment rights.

- a restatement of our financial results,

- a change in control of our company,

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7. Shareholders' Equity (Continued)

Our amended agreement with Fletcher also provides that we may be required to issue additional shares to Fletcher, reduce the exercise prices described above for the additional investment rights and/or extend the investment term upon the occurrence of certain events (each as more fully described below) including:

- a change in control of our company,

- a future issuance of our capital stock at a price less than $7.048 as it relates to the initial $10 million investment and $6.34 as it relates to all additional investments, or

Restatement - Before and After Amendment

Change in Control - Before and After Amendment

Dilutive Issuances - Prior to Amendment

If on or prior to December 31, 2004 we had issued any equity securities at a price below $7.048, then we were required to issue to Fletcher a number of additional shares to reflect the number of shares Fletcher would have acquired if its purchase price was such lower price and adjust the exercise price for the additional investment rights to such lower price. In addition, if after December 31, 2004 and prior to January 1, 2006 we issued any equity securities at a price below $7.048, the exercise price for the additional investment rights would have been adjusted to provide Fletcher "weighted average" anti-dilution protection and we would have been required to issue to Fletcher a number of additional shares such that all prior investments would have been effectively made at such adjusted exercise price.

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7. Shareholders' Equity (Continued)

If on or prior to December 31, 2004 we issue any equity securities at a price below $7.048 as it relates to the initial $10 million investment and $6.34 as it relates to all additional investments, then we must issue to Fletcher a number of additional shares to reflect the number of shares it would have acquired if its purchase price was such lower price and adjust the exercise price for the additional investment rights to such lower price. In addition, if after December 31, 2004 and ending December 31, 2006 we issue any equity securities at a price below $7.048 as it relates to the initial $10 million investment and $6.34 as it relates to any additional investments which have been made, the exercise price for the additional investment rights shall be adjusted to provide Fletcher "weighted average" anti-dilution protection and we must issue to Fletcher a number of additional shares such that all prior investments will have been effectively made at such adjusted exercise price.

Registration Obligations - Before and After Amendment

In the event we fail to satisfy our contractual obligations to register for resale shares of common stock issued or issuable to Fletcher, then we must issue to Fletcher a number of additional shares to reflect the number of shares it would have acquired if its purchase price was based on the actual exercise price reduced by five percent for each month in which we fail to satisfy our obligations and adjust the exercise price for the additional investment rights to such lower price. In addition, such failure will result in an extension of the investment term for each day we fail to satisfy our registration obligations. These registration obligations include, among other things, maintaining the effectiveness of registration statements.

basis price), where "X" is the product of (1) the additional investment amount, divided by the additional investment exercise price, multiplied by (2) the amount by which the net basis price exceeds the additional investment exercise price.

The agreement also provides Fletcher certain other rights including, but not limited to, indemnification rights with respect to (1) breaches of representations, warranties and covenants contained in the agreements with Fletcher, and (2) misstatements in or omissions from the prospectus and the registration statement relating to shares of our common stock that Fletcher owns or may acquire.

In connection with the private placement, in February 2004 the Company paid placement fees of $600 thousand to Chicago Investment Group, L.L.C. and issued a warrant to purchase 28,377 shares of the Company's common stock at an exercise price of $10.572 per share. The warrant may not be exercised until February 5, 2005 and expires on February 5, 2006. In connection with the amendment of the private placement, the Company incurred advisory fees of $300 thousand to Citigroup Global Markets Inc.

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8. Loss Per Share

The following is the reconciliation of the numerators and denominators of the basic and diluted loss per share computations:

For the three months ended March 31, 2004, options to purchase 2,825,650 shares of common stock at exercise prices ranging from $0.54 to $20.92 per share, additional investment rights to purchase approximately 3,688,990 shares ($26,000,000 divided by $7.04 per share) of common stock with an exercise price of $7.048 per share and warrants to purchase 28,377 shares of common stock with an exercise price of $10.572 per share were outstanding but were not included in the computations of Loss per Share-assuming dilution because the Company incurred losses during this period and inclusion would be anti-dilutive.

For the three months ended March 31, 2003, options to purchase 3,317,275 shares of common stock at prices ranging from $0.54 to $21.92 per share and warrants to purchase 300,000 shares of common stock with an

exercise price of $12.56 per share were outstanding but were not included in the computations of Loss per Share-assuming dilution because inclusion would be anti-dilutive. Additionally, under SFAS No. 128, Earnings per Share, 50,000 shares of non-vested restricted common stock, which vest solely upon continued service, were excluded from the computation of basic loss per share and these shares of non-vested restricted common stock were further excluded from the computation of Loss per Share - assuming dilution because inclusion would be anti-dilutive.

The Company sold shares of the following securities and recognized gains (losses) and proceeds as follows:

10. Cash Flows - Supplemental Information

The Company operates in two business segments, New Energy and Test and Measurement Instrumentation. The New Energy segment is focused on commercializing direct methanol micro fuel cells ("DMFCs"). The Test and Measurement Instrumentation segment designs, manufactures, markets and services computer-based balancing systems for aircraft engines, high-performance test and measurement instruments and systems, and wafer characterization tools for the semiconductor industry. The Company's principal operations are located in North America.

The accounting policies of the New Energy and Test and Measurement Instrumentation segments are the same as those described in the summary of significant accounting policies in the Company's consolidated financial statements for the year ended December 31, 2003. 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 "Reconciling Items" column includes minority interests in a consolidated subsidiary. In addition, segments' noncash items include any depreciation and amortization in reported profit or loss. The New Energy segment figures include the Company's micro fuel cell operations, equity securities of Plug Power and SatCon and gains (losses) on the sale of these securities.

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11. Segment Information (Continued)

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

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12. Related Party Transactions

As of March 31, 2004, amounts receivable from employees' stock option exercises totaled approximately $22 thousand and are included in the balance sheet caption "Other receivables - related parties."

13. Effect of Recent Accounting Pronouncements

None.

14. Commitments and Contingencies

Lawrence

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 ("FAC"), Mechanical Technology Incorporated, Dale Church, Edward Dohring, Beno Sternlicht, Alan Goldberg and George McNamee (former Directors of the Company), Marty Mastroianni (former President and Chief Operating Officer of the Company), and 33 other individuals ("Defendants") who purchased a total of 820,909 (2,462,727 shares post split) shares of the Company's common 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. In September 2003, the Bankruptcy Court issued an order permitting Plaintiffs to conduct limited discovery concerning how First Albany formed an opinion about the Company's stock up until the date the Stock Purchase Agreement was executed.

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.

Ling Electronics, Inc.

On July 8, 2003, Donald R. Gilillard, Sharon Gilillard, Vernon Dunham and Jean Dunham, owners of 4890 E. La Palma Avenue, Anaheim, CA 92870 ("Plaintiffs"), the former location of Ling Electronics, Inc. ("Ling"), filed suit in the Superior Court of California for Orange County against SatCon Power Systems, Inc., a subsidiary of SatCon Technology Corporation, and a former subsidiary of the Company. In September 2003, SatCon and the Company filed a joint answer to the complaint.

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14. Commitments and Contingencies (Continued)

The complaint alleges breach of the lease and, among other things, Ling's failure to maintain and repair the premises. Ling was a subsidiary of the Company until it was sold to SatCon Technology Corporation in 1999. The Plaintiffs allege that the correction and repair of the various breaches by SatCon and the Company of their obligations under the lease will exceed $400,000. The building was leased from 1983 through lease expiration in 2003. The Company remained as a guarantor on the lease after the sale of Ling to SatCon.

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 an increase 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.

Future minimum rental payments required under non-cancelable operating leases are (dollars in thousands): $411 remaining in 2004; $561 in 2005, $441 in 2006, $316 in 2007, $316 in 2008, and $289 thereafter.

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

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14. Commitments and Contingencies (Continued)

In connection with the Strategic Alliance Agreement between MTI Micro and The Gillette Company ("Gillette"), the Company guaranteed additional investments in its subsidiary, MTI Micro, of up to $20 million before September 19, 2005, if other sources of funding are not available. Immediately prior to the Gillette transaction closing, the Company invested $11 million ($7.4 million in cash and $3.6 million through the conversion of a loan receivable to equity) of its $20 million commitment in MTI Micro common stock. In October 2003, Jeong Kim, a related party, invested $1 million in MTI Micro common stock. The Company's remaining investment guaranty was $8 million as of March 31, 2004. As of April 7, 2004, the Company invested $15 million into MTI Micro fulfilling its remaining guaranty obligation.

The Company's securities available for sale constitute investment securities under the Investment Company Act of 1940 (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 were 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 the Company's 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 may not be available.

On December 3, 2001, the Company made an application to the SEC requesting that it 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. The Company amended this application on October 20, 2003. 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 the Company was 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 the Company to sell its interest in Plug Power until the value of its securities available for sale are reduced below 40% of total assets. This could result in sales of securities in quantities of shares at depressed prices and the Company may never realize anticipated benefits from, or may incur losses on, these sales. Also, in connection with the Strategic Alliance Agreement with Gillette, the Company has agreed to indemnify Gillette against any losses arising out of or related to the

Company's noncompliance with the Investment Company Act or any regulations thereunder.

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

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On April 7, 2004, MTI Micro sold approximately 3,218,885 and 215,000 shares of MTI Micro common stock to the Company and a group of private investors, respectively, at a price of $4.66 per share for approximately $15 million and $1 million, respectively. As a result of the Company's investment, it has fully satisfied its remaining investment guaranty under the Gillette Agreement.

On April 27, 2004, MTI Micro announced that it received a contract to supply DMFC systems to the Army Research Laboratory ("ARL"). The $200,000 contract includes the sale of units scheduled for delivery in the second quarter of 2004. Some of the units will be delivered in the form factor of the BA5590, a high volume, disposable, primary battery for the military. These units will each produce approximately 5 watts of continuous power, and 35 watts of peak power. Some compact units will also be delivered each targeting approximately 750 milliwatts of continuous power, and 3 watts of peak power.

On May 5, 2004, the Company agreed to amendments to the private placement agreement between the Company and Fletcher. The agreement, as amended, includes a change in the exercise price for the rights to purchase additional shares of MTI common stock to a fixed price of $6.34 per share from, in the original agreement, $7.048 per share until December 31, 2005 and the lesser of $7.048 per share or a variable price in 2006. The change to a fixed price substantially reduces the potential for shareholder dilution if shares had been purchased at a variable price in 2006. The price remains subject to adjustment upon the occurrence of certain limited events. The agreement, as amended, also includes:

• an increase in the rights to purchase additional shares of MTI common stock to $28 million from $26 million;
• a reduction in Fletcher's right to purchase Plug Power Inc. common stock escrowed by the Company to a maximum of 2,700,000 shares from a maximum of 3,000,000 shares;
• an extension of the exercise period for the right to purchase Plug Power Inc. common stock to one or more purchases between June 1, 2005 and December 31, 2006 from a one-time purchase in June of 2005;
• an extension of MTI's ability to withdraw Plug Power Inc. common stock from escrow through December 31, 2006 instead of through June 30, 2005; and
• an extension of the exercise period for the right to invest the first $8 million in MTI's common stock to any time prior to December 31, 2004 from any time prior to ninety business days after the effective date of MTI's registration statement.

This private placement amendment is more fully described in Note 7 - Shareholders' Equity.

On May 5, 2004 MTI Micro announced that it had received an award from the United States Department of Energy (DOE) Office of Hydrogen, Fuel Cells, and Infrastructure Technologies for a three year, cost-shared development contract through a merit-reviewed, competitive process, involving academia, industry and DOE national laboratories. The Company expects to receive $3 million in funding from the DOE which will be matched by MTI Micro, for a total program of $6 million.

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The Company is primarily engaged in the development and commercialization of DMFCs through its majority-owned subsidiary MTI Micro and the design, manufacture and sale of high-performance test and measurement instruments and systems through its wholly-owned subsidiary MTI Instruments. The Company also co-founded and retains an interest in Plug Power (NASDAQ: PLUG), a designer and developer of on-site energy systems based on proton exchange membrane fuel cells.

MTI Micro designs and develops DMFCs for portable power applications. A micro fuel cell is a portable power source that converts chemical energy into useable electrical energy. MTI Micro is developing a micro fuel cell that uses methanol, a common alcohol, as its fuel. We believe DMFC systems could potentially have an energy density of five to ten times that of Lithium-Ion batteries. The advantage of DMFC systems is that, when commercialized, they should be able to power a wireless electronic device for longer periods of time than Li-Ion batteries between recharging/refueling. In addition, DMFCs may be instantly refueled without the need for a power outlet or a lengthy recharge.

MTI Micro's fuel cell technology platform can be customized to provide portable power for a number of applications depending on the power level, required run time and size requirements. MTI Micro's initial product will be a power source for Intermec Technologies Corporation ("Intermec") RFID tag readers. The first DMFC power sources for Intermec products are scheduled for delivery by the end of 2004.

MTI Micro has also developed prototype DMFC systems for military customers, including the RF Communications Division of Harris Corporation ("Harris"), a supplier of military communication devices.

Pursuant to the initial Harris agreement, MTI Micro delivered prototypes during the first and second quarters of 2003.

MTI Instruments has three product groups: aviation, general gaging and semiconductor. These product groups provide: portable balancing systems for aircraft engines; electronic, computerized general gaging instruments for position, displacement and vibration applications; and semiconductor products for wafer characterization of semi-insulating and semi-conducting wafers. MTI Instruments' strategy is to continue to enhance and expand its product offerings with the goal of increasing market share and profitability. MTI Instruments' largest customers include the U.S. Air Force and industry leaders in the computer, electronic, semiconductor, automotive, aerospace, aircraft and bioengineering fields.

From inception through March 31, 2004, the Company has incurred net losses of $62.7 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, gains on sales of securities available for sale, the operating results of MTI Instruments and MTI Micro and the number of prototypes produced.

The Company's discussion and analysis of its financial condition and results of 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 America. Note 1 to the consolidated financial statements includes a summary of the Company's most significant accounting policies. The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of assets and liabilities. On an on-going basis, the Company evaluates its estimates, including those related to revenue recognition, inventories, securities available for sale and income taxes. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

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The following critical accounting policy has been newly identified for the quarter ended March 31, 2004:

The Company has held or issued certain derivative instruments and embedded derivative instruments and records these derivatives and embedded derivative instruments separated from the host contract in accordance with Statement of Financial Accounting Standards ("SFAS") No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended by SFAS No. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities. These standards require the Company to recognize all derivative instruments as either assets or liabilities on the statement of financial position and measure these instruments at fair value. Fair value is estimated using option pricing models including the Binomial and Black Scholes Option-Pricing Models.

Three Months Ended March 31, 2004 Compared to Three Months Ended March 31, 2003

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, 2004 compared to the three months ended March 31, 2003.

Product Revenue. Product revenue in the Test and Measurement Instrumentation segment for the three months ended March 31, 2004 increased by $.296 million or 23.1% to $1.579 million. The three-month increase is primarily the result of increases in sales to aviation customers of $.238 million, reflecting increases related to the fulfillment of orders under two Air Force contracts for the purchase of new PBS units and for the maintenance and upgrades of current PBS units already in service, an increase in semiconductor product sales of $.130 million due to six units being sold this quarter (including a semi-automated tool for a customer in Israel) as compared to two units being sold last year. These gains have been partially offset by a decrease in sales to general gaging customers of $.072 million due to decreased activity from Original Equipment Manufacturer customers.

The Air Force contracts were finalized during the third and fourth quarters of 2002. Information regarding these contracts is as follows:

(Dollars in thousands, except contract values)

* This contract may be extended by the Air Force at its discretion.

Funded Research and Development Revenue. Funded research and development revenue in the New Energy segment for the three months ended March 31, 2004 decreased $134 thousand to $388 thousand, a 25.7% decrease. The three month decrease is primarily the result of the New York State Energy Research and Development Authority ("NYSERDA") government contracts contributing revenues in 2003 and no NYSERDA revenues contributed in 2004.

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Information regarding government contracts included in funded research and development revenue is as follows:

(Dollars in thousands, except contract values)