****UNITED STATES****SECURITIES AND EXCHANGE COMMISSION**
Washington, DC 20549
**FORM 10-QSB**
(Mark One)[ **X**] Quarterly Report Pursuant to Section 13or 15(d) of the Securities Exchange Act of 1934 for the quarterly periodended June 30, 2001or[   ] Transition Report Pursuant to Section13 or 15(d) of the Securities Exchange Act of 1934 for the transition periodfrom ______ to ________Commission File Number 2-93124
***SGI International***(Exact name of small business issuer as specified inits charter)
                Utah                                                                                                                           33-0119035(State or other jurisdiction of                                                                                         (I.R.S. Employer incorporation or organization)                                                                                                                                  Identification No.)  
1200 Prospect Street, Suite 325, La Jolla, California92037(Address of principal executive offices)
(858) 551-1090(Issuer's telephone number) 
(Former name, former address and former fiscal year, ifchanged since last report)
Check whether the issuer (1) filed all reports requiredto be filed by Section 13 or 15(d) of the Exchange Act during the past12 months (or for such shorter period that the registrant was requiredto file such reports), and (2) has been subject to such filing requirementsfor the past 90 days.
[**X**] Yes [   ] No
The number of shares of common stock, no par value, outstandingas of July 26, 2001, was 90,599,608.
Transitional Small Business Disclosure Format (Check one):[  ] Yes [ **X** ] No  
 
**TABLE OF CONTENTS**
**FORM 10-QSB**
PART I.FINANCIAL INFORMATIONITEM 1. FINANCIAL STATEMENTSCondensedConsolidated Balance Sheets3CondensedConsolidated Statements of Operations4CondensedConsolidated Statement of Stockholders' Deficiency5CondensedConsolidated Statements of Cash Flows6Notesto Condensed Consolidated Financial Statements7ITEM2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF                FINANCIAL CONDITION AND RESULTS OF OPERATIONSIntroductoryNote12Resultsof Operations13Liquidityand Capital Resources14RecentAccounting Pronouncement16ITEM3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT                MARKET RISK17PARTII.OTHERINFORMATIONITEM1. LEGAL PROCEEDINGS17ITEM2. CHANGES IN SECURITIES17ITEM3. DEFAULTS UPON SENIOR DEBT SECURITIES18ITEM4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS18ITEM5. OTHER INFORMATION18ITEM6. EXHIBITS AND REPORTS ON FORM 8-K18PARTIII.SIGNATURES19 
  **SGI INTERNATIONAL AND SUBSIDIARIES****CONDENSED CONSOLIDATED STATEMENTSOF OPERATIONS** **June 30,** December 31, **2001** 2000 **(Unaudited)** .ASSETS   Current assets:   Cash$ 146,252 $ 410,352Restricted cash deposit200,000 200,000Trade accounts receivable, lessallowance for doubtful accounts of $46,936   and $47,989338,754 1,048,996Inventories413,861 414,268Costs and estimated earnings inexcess of billings on contracts314,105 212,742Prepaid expenses and other currentassets51,405 78,826Total current assets1,464,377 2,365,184    LFC Royalty rights, net471,375 628,500LFC Process equipment, net167,394 230,225Investment in LFC Investees201,577 225,608LFC cogeneration project, net52,642 105,284LFC related notes receivable,net150,000 150,000Property, plant and equipment,net of accumulated depreciation and    amortization of $1,469,524 and $1,363,4522,335,771 2,415,823Goodwill, net of accumulated amortizationof $264,551 and $240,585215,693 239,659Interest receivable on notes fromstockholders56,365 37,680Other assets, net28,216 26,337 $ 5,143,410 $ 6,424,300LIABILITIES AND STOCKHOLDERS' DEFICIENCY   Current liabilities:   Accounts payable$ 1,141,633 $ 1,006,575Notes payable, net1,962,670 1,673,738Accrued salaries, benefits andrelated taxes1,541,386 1,271,155Billings in excess of costs andestimated earnings on contracts122,081 976,867Interest payable484,092 298,893Other accrued expenses574,977 284,470Current maturities of long-termdebt4,170,386 4,170,386Total current liabilities9,997,225 9,682,084Long-term debt, less current maturities2,360,544 2,259,204Total liabilities12,357,769 11,941,288COMMITMENTS AND CONTINGENCIES       Minority interest453,327 454,997    Stockholders' deficiency:   Convertible preferred stock605 605Common stock55,148,823 53,885,499Paid-in capital8,356,214 7,929,297Accumulated deficit(70,702,328) (67,316,386)Notes receivable from stockholders(471,000) (471,000)Total stockholders' deficiency(7,667,686) (5,971,985) $ 5,143,410 $ 6,424,300
*See notes to condensed consolidated financial statements.* **SGI INTERNATIONAL AND SUBSIDIARIES****CONDENSED CONSOLIDATED STATEMENTS OFOPERATIONS****(Unaudited)**Three monthsSix monthsended June 30,ended June 30,2001200020012000REVENUES:Contractrevenues**                   $ 1,130,024****$ 1,325,691****$ 2,384,616****$ 2,381,402**EXPENSES:Cost ofsales**843,173****1,002,463****1,627,341****1,812,178**Researchand development**359,366****385,157****823,253****753,887**Selling,general and administrative**864,834****992,122****1,723,023****1,827,706**Loss onLFC Investees**12,821****3,226****24,031****22,079**Legaland accounting**118,637****85,482****216,640****182,957**Depreciationand amortization**201,621****218,320****403,440****444,429**Total expenses**2,400,452****2,686,770****4,817,728****5,043,236**Loss fromoperations**(1,270,428)****(1,361,079)****(2,433,112)****(2,661,834)**NON-OPERATINGINCOME (EXPENSES):Interestexpense**(537,171)****(203,489)****(1,060,589)****(413,716)**Otherincome**13,757****22,449****106,089****41,472**Loss before minority interest in consolidatedsubsidiary**(1,793,842)****(1,542,119)****(3,387,612)****(3,034,078)**Minorityinterest in loss of consolidated subsidiary**593****4,074****1,670****9,238**Net loss**$(1,793,249)****$ (1,538,045)****$ (3,385,942)****$ (3,024,840)**Net lossper common share basic**$ (0.02)****$ (0.02)****$ (0.04)****$ (0.05)**Weightedaverage common shares outstanding**                    85,492,748****                                                                  63,494,131****                       82,747,724****                                                                     60,069,264**
*See notes to condensed consolidated financial statements*.   **SGI INTERNATIONAL AND SUBSIDIARIES****CONDENSED CONSOLIDATED STATEMENT OFSTOCKHOLDERS' DEFICIENCY****(Unaudited)**   Convertible         Total  Preferred Stock Common Stock Paid-In Accumulated Notes Stockholders'  SharesAmount Shares Amount Capital Deficit Receivable Deficiency                 Balances at December 31, 2000 60,518 $ 605 77,049,377 $ 53,885,499 $ 7,929,297 $ (67,316,386) $ (471,000) $ (5,971,985)  Issuance of common stockfor services and operating activities     824,783 141,556       141,556  Issuance of common stockfor cash, net     7,529,275 724,410 (31,132)     693,278  Issuance of common stockfor notes payable and interest            2,484,747             397,358                    397,358  Imputed beneficial conversionfeature related to convertible debt         458,049     458,049  Net loss           (3,385,942)   (3,385,942)Balances at June 30, 2001 60,518 $ 605 87,888,182 $ 55,148,823 $ 8,356,214 $ (70,702,328) $ (471,000) $ (7,667,686)
*See notes to condensed consolidated financial statements*.  
**SGI INTERNATIONAL AND SUBSIDIARIES****CONDENSED AND CONSOLIDATED STATEMENTS OFCASH FLOWS****(Unaudited)**
**Six months ended June 30,** **2001** 2000Operating activities:    Net loss **$ (3,385,942)** $ (3,024,840) Adjustments to reconcile net lossto net         cashused in operating activities:      Depreciation and amortization **403,440** 444,429  Common stock issued forservices and operating activities **78,237** 95,700  Common stock issued forinterest **2,569** -  Notes payable issued forservices **15,000** -  Non-employee compensationexpense on issuance of warrants **-** 11,412  Amortization of beneficialconversion feature on debt **603,833** -  Accrued long-term interestexpense **94,506** 94,063  Accrued interest income **(18,685)** (18,788)  Minority interest in lossof consolidated subsidiary **(1,670)** (9,238)  Equity in net loss of LFCInvestees **24,031** 22,080  Changes in operating assetsand liabilities:        Restrictedcash deposit **-** 402,500    Trade accountsreceivable **608,879** (220,771)    Inventories **407** 1,044    Prepaid expensesand other current assets **27,421** (55,799)    Accounts payable **135,058** 76,469    Accrued salaries,benefits and related taxes                **270,231**                    188,252    Billings inexcess of costs and estimated         earnings on contracts **(854,786)** 127,437    Interest payable **203,070** 43,798    Other accruedexpenses **353,826** (27,254)Net cash used in operating activities **(1,440,575)** (1,849,506)Investing activities:      Additions to LFC Processequipment **-** (233,562)  Purchase of property andequipment **(26,020)** (28,236)  Other assets **(2,683)** -Net cash used in investing activities **(28,703)** (261,798)Financing activities:      Payments of notes payable **-** (4,750)  Payments on line-of-credit **-** (400,000)  Proceeds from issuanceof debt **511,900** 500,705  Proceeds from issuanceof common stock **693,278** 2,045,695Net cash provided by financing activities **1,205,178** 2,141,650Net increase (decrease) in cash **(264,100)** 30,346Cash at beginning of period **410,352** 278,391Cash at end of period **$ 146,252** $ 308,737Supplemental disclosure of cashflow information:      Interest paid **$ 147,495** $ 261,873 Supplemental disclosure of non-cashactivities:      Conversion of preferredstock **-** 38,313  Common stock issued foraccrued liabilities **63,319** -  Common stock issued fordebt and interest payable **394,789** 401,172  Imputed beneficial conversionfeature related to convertible debt **409,099** - *See notes to condensed consolidated financial statements.*     
**SGI INTERNATIONAL AND SUBSIDIARIES****NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS****(Unaudited)**
**(1) BUSINESS**
SGI International, a Utah corporation, (together withits subsidiaries, hereinafter referred to as the "Company"), has its principaloffice in La Jolla, California. The Company is primarily in the businessof developing and marketing energy-related technologies, which at the presentinclude the Liquids From Coal ("LFC") Process and, the Opti-Crude EnhancementTechnology ("OCET") Process. The LFC Process is designed to convert andupgrade low-rank coal into a higher Btu more efficient fuel and simultaneouslyproduce a low temperature coal tar, which contains valuable chemicals.The OCET Process is designed to increase the efficiency of oil refineriesby deasphalting crude oil as well as residual oil bottoms ("resid"), whichis produced in oil refining. Through Assembly Manufacturing Systems, Inc.("AMS"), a wholly owned subsidiary, the Company is in the business of designingand manufacturing custom precision automated assembly equipment. The Companyis also attempting to develop the Level Sensor ("LS") and Asphaltenes ProcessingTechnology. The LS technology is designed to overcome a number of limitationspresented by existing "off-the-shelf" equipment and sensors. The Company'ssensor is characterized by a high degree of sensitivity, electrical stabilityand its small size. The Asphaltenes Processing Technology is intended toconvert the unwanted asphaltene by-products of the OCET Process, as wellas the existing solvent deasphalting processes, into a coal-like fuel.
**(2) BASIS OF PRESENTATION**
The accompanying condensed consolidated financial statementsof SGI International and subsidiaries for the three and six month periodsended June 30, 2001, and 2000, are unaudited and in the opinion of managementhave been prepared in accordance with accounting principles generally acceptedin the United States of America for interim financial information and theinstructions to Form 10-QSB. Accordingly, they do not include all informationand notes required by accounting principles generally accepted in the UnitedStates of America for complete financial statements. These financial statementsreflect all adjustments, consisting of only normal recurring adjustmentswhich, in the opinion of management, are necessary for a fair statementof the Company's consolidated financial position as of June 30, 2001, andits consolidated results of operations for the three and six months endedJune 30, 2001 and 2000, changes in stockholders' deficiency for the sixmonths ended June 30, 2001 and cash flows for the six months ended June30, 2001 and 2000. The results of operations for the three and six monthsended June 30, 2001, are not necessarily indicative of the results to beexpected for the year ending December 31, 2001. For more complete financialinformation, these financial statements, and the notes thereto, shouldbe read in conjunction with the consolidated audited financial statementsfor the year ended December 31, 2000, included in the Company's Form 10-KSBpreviously filed with the Securities and Exchange Commission.
The accompanying condensed consolidated financial statementsare prepared in conformity with accounting principles generally acceptedin the United States of America, which contemplates continuation of theCompany as a going concern and realization of assets and settlement ofliabilities and commitments in the normal course of business. The recoveryof amounts invested in the Company's principal assets, the LFC and OCETProcess assets are dependent upon the Company's ability to adequately fundits on-going development operations and any capital contributions thatmay be required for its joint venture "LFC Technologies, LLC" ("LFC Tech")with MLFC Corporation ("MLFC"), a wholly-owned subsidiary of MitsubishiCorp. Furthermore, the ability to successfully bring both LFC and OCETProcess technologies to commercialization will ultimately depend on theCompany's ability to attract sufficient additional equity, debt or otherthird-party financing.
Success in commercialization of the LFC Process and OCETProcess is dependent in large part upon the ability to enter into satisfactoryarrangements with other partners, financiers or customers and upon theability of these third parties to perform their responsibilities. The resourcesrequired to profitably develop, construct and operate a commercial LFCplant are likely to include hundreds of millions of dollars, and expertisein major plant development and operations. There can be no assurance anylicenses, joint venture agreements or other arrangements will be availableon acceptable terms, if at all; that any revenue will be derived from sucharrangements; or that, if revenue is generated, any of said arrangementswill be profitable to the Company. If the Company is unsuccessful in itsattempts to license the LFC Process or OCET Process, or if such third partiesare unsuccessful in profitably developing and operating LFC plants, theplanned business and operations of the Company will likely not succeedand the Company would not be able to recover the carrying value of thelong-lived assets related to either the LFC Process or OCET Process.
The Company had negative working capital of $8,533,000and an accumulated deficit of $70,702,000 at June 30, 2001. These factorsand the Company's recurring losses from continuing operations, among others,raise substantial doubt about the Company's ability to continue as a goingconcern. The Company is currently seeking additional financing throughpublic or private sales of its securities to fund working capital requirements.The Company will also seek funding through additional strategic partnerships,joint ventures or similar arrangements to commercialize the technologies.There can be no assurance that any collaborative financing arrangementsthrough a joint venture, and/or with strategic partners, will be availablewhen needed, or on terms acceptable to the Company. If adequate funds arenot available, the Company may be required to curtail or terminate oneor more of its operating activities. The Company is engaged in continuingnegotiations to secure additional capital and financing, and while managementbelieves funds can be raised, there is no assurance that their effortswill be successful. The consolidated financial statements do not includeany adjustments that might be necessary in the event the Company cannotcontinue in existence.
**(3) FINANCING TRANSACTIONS**
During the quarter ended March 31, 2001, the Company,upon maturity, exchanged three notes payable aggregating $226,192 in principaland interest for 1,585,939 shares of common stock.
In February 2001, the Board of Directors approved the2001 Non-Qualified Stock Option Plan (the "2001 Stock Plan") pursuant towhich a maximum aggregate of 4,000,000 shares was reserved for grant. Underthe 2001 Stock Plan, employees may be granted as an incentive or bonusan opportunity to purchase common stock in the Company, by way of non-qualified(a) stock options or warrants, (b) stock purchase rights, (c) stock appreciationrights and (d) long term performance awards. The terms and conditions ofeach award are at the discretion of the Board of Directors or any dulyauthorized committee. During the quarter ended March 31, 2001, in accordancewith the 2001 Stock Plan , the Company issued warrants at fair market valueto employees of the Company. The exercise price was not lower than theclosing bid price on the grant date. The warrants and incentive optionsare exercisable for a total of 1,215,000 shares of common stock at $0.26per share, the closing bid prices on the grant dates. The warrants areexercisable one year from the date of grant and expire on December 31,2006.
During the quarter ended March 31, 2001, the Company issuedapproximately 70,000 shares of restricted common stock valued at approximately$14,500. The shares were issued in full settlement of two contractual claimswhich arose in the ordinary course of business.
During the quarter ended June 30, 2001, in accordancewith the 2001 Stock Plan, the Company issued warrants at fair market valueto employees and directors of the Company. The warrants are exercisablefor a total of 430,000 shares of common stock at $0.14 per share, the closingbid price on the grant date. The warrants are exercisable one year fromthe date of grant and expire on December 31, 2006.
During the six months ended June 30, 2001, the Companyissued approximately 7,529,000 shares of restricted common stock to accreditedinvestors for approximately $724,000 in cash. In connection therewith,the Company paid $21,632 in cash and 98,572 shares of restricted stockvalued at $9,500 for services rendered.
During the six months ended June 30, 2001, the Company,as provided in their related consulting agreements, issued approximately607,000 restricted common shares to consultants for services rendered,valued at approximately $107,500.
During the quarter ended June 30, 2001, the Company, upondemand, exchanged $74,661 in principal of one 12% note payable for 439,254shares of common stock.
During the six month period ended June 30, 2001, the Companysold nine notes payable aggregating $253,400 for cash. The notes bear interestat 9% per annum, mature one year from the sale date and are unsecured.The notes and accrued interest are payable in cash or upon maturity, atthe Company's option, by issuing 3,419,699 shares of restricted commonstock. In conjunction with the sale of these notes the Company recordeda beneficial conversion feature of $250,599.
During the quarter ended June 30, 2001, the Company soldsix notes payable aggregating $158,500 for cash. The notes bear interestat 9% per annum, mature two years from the sale date and are unsecured.The notes and accrued interest are payable in cash or upon maturity, atthe Company's option, by issuing 2,737,543 shares of restricted commonstock. In conjunction with the sale of these notes the Company recordeda beneficial conversion feature of $158,500.
**(4)****COMPOSITION OF CERTAIN FINANCIAL STATEMENTCAPTIONS**
Inventories
Inventories are stated at the lower of cost or market,using the first-in, first-out cost method. Substantially, all inventoriesrepresent finished goods held for use in operations.
Property and Equipment June 30, December 31,20012000ENCOAL Demonstration Plant             $ 2,121,000                $ 2,121,000Laboratory equipment                1,036,000                   1,036,000Machinery and equipment                   206,000                      196,000Computer equipment                   269,000                      266,000Office furniture and fixtures                     73,000                        72,000Leasehold improvements                     54,000                        54,000Projects under construction                     47,000                        34,000                 3,806,000                 3 ,779,000 Less accumulated depreciation              (1,470,000)                 (1,363,000)     Net property and equipment             $ 2,336,000                $ 2,416,000Notes Payable
The Company from time to time issues various notes payablewhich contain a beneficial conversion feature. The Company in accordancewith accounting principles generally accepted in the United States of Americahas recognized this beneficial conversion feature by allocating a portionof the proceeds to additional paid-in capital and as an offset to the notespayable. During the three and six month periods ended June 30, 2001, theCompany amortized approximately $308,000 and $604,000, respectively, ofthe beneficial conversion feature. Short-term notes payable and bank linesof credit are shown below net of the unamortized portion of the beneficialconversion feature.  June 30,December 31,20012000Short-term notes payable                    $2,198,950                 $ 2,307,468Line of credit                         100,000                                   -Beneficial conversion feature                      (336,280)                     (633,730)     Notes payable,net                    $1,962,670                 $ 1,673,738
Long-Term Debt June 30,December 31,20012000Long-term debt                   $ 6,682,596                 $ 6,429,590Current maturities of long-termdebt                   (4,170,386)                   (4,170,386)Beneficial conversion feature                      (151,666)                                  -     Notes payable,net                   $2,360,544                 $ 2,259,204
**(5) SEGMENT REPORTING**
The Company in the past has managed its segments based on business unitsthat are in turn based along technological lines. These business unitsoffer products and services to different markets in accordance with theirunderlying technology. Accordingly, the Company's three business segmentswere centered on the operations associated with the LFC Process, the OCETProcess and the manufacturing of custom automated assembly systems.
During 2000, the Company's focus of its OCET lab and technical facilitiesslowly shifted from being primarily devoted to the OCET Process, to moreof a general research and development facility capable of assisting theCompany on its various research and development projects. These variousresearch and development projects include (a) enhancing the value of thevarious CDL by-products, (b) advancing the Level Sensor Technology, (c)further developing the Asphaltenes to Coal Process and (d) advancing thedevelopment of the OCET Process. In keeping with this changing focus theCompany effective February 28, 2001, combined the OCET lab and the SGITechnical Center ("SGITC") into one corporate wide research facility whichwill now be known solely as SGITC. Accordingly, all assets not solely devotedto the OCET Process and the OCET lab's lease have been transferred to SGITC,a division of SGI International. This combination will not result in anychange in business segment reporting as the Company will continue to reportthe operations of its technical facilities as one segment by combiningOCET's operations and those of SGITC.
The Company evaluates performance of each segment basedon profit or loss from operations before income taxes. The Company hasno significant intersegment sales and intersegment transfers are done atcost. Three months endedAutomatedLFCSGITCJune 30AssemblyProcessProcessCorporateTotal2001Revenues$ 1,130,000$ -                  $ -$ -$ 1,130,000Income (loss) beforeincome taxes75,000(615,000)(300,000)(953,000)(1,793,000)Equity in operationsof investee-(13,000)--(13,000)Depreciation and amortization31,000136,00030,0005,000202,000Research and development-145,000213,0001,000359,000Interest expense---537,000537,0002000Revenues$ 1,322,000$ -$ 4,000$ -$ 1,326,000Income (loss) beforeincome taxes122,000(676,000)(136,000)(848,000)(1,538,000) Equity in operationsof investee-(3,000)--(3,000)Depreciation and amortization32,000137,00046,0003,000218,000Research and development-242,000103,00040,000385,000Interest expense---203,000203,000 Six months endedAutomatedLFCSGITCJune 30AssemblyProcessProcessCorporateTotal2001Revenues$ 2,385,000$ -$ -$ -$ 2,385,000Income (loss) beforeincome taxes307,000(1,351,000)(336,000)(2,006,000)(3,386,000)Equity in operationsof investee-(24,000)--(24,000)Depreciation and amortization62,000273,00061,0007,000403,000Research and development-472,000295,00056,000823,000Interest expense---1,061,0001,061,0002000Revenues$ 2,376,000$ -$ 5,000$ -$ 2,381,000Income (loss) beforeincome taxes157,000(1,355,000)(308,000)(1,519,000)(3,025,000)Equity in operationsof investee-(22,000)--(22,000)Depreciation and amortization63,000275,00099,0007,000444,000Research and development-477,000237,00040,000754,000Interest expense1,000--413,000414,000 **Total Assets bySegment**June 30, 2001December 31, 2000Identifiable assets, net    Automated Assembly $ 1,216,000 $ 2,062,000LFC Process 3,561,000 3,844,000SGITC Process 98,000 153,000Corporate 268,000 365,000Total $ 5,143,000 $ 6,424,000
**(6) RELATED PARTY TRANSACTIONS**
During the quarter ended March 31, 2001, two outside directorsof the Company, upon maturity, exchanged their notes payable aggregating$96,506 in principal and interest for 459,554 shares of restricted commonstock. On the day of the exchange, the bid price of the Company's commonstock was $0.21.
On December 10, 2000, as a condition for obtaining a $100,000line-of-credit for AMS with a financial institution, an entity controlledby an outside director guaranteed the payment of the line-of-credit whichexpires on December 31, 2001. In return for this guarantee, the Companyduring the quarter ended March 31, 2001, paid this entity 50,000 sharesof restricted common stock valued at $10,000.
Effective March 23, 2001, the Company amended the termsof a $25,000 note payable to an outside director of the Company. Pursuantto the amendment, the note is now due five days after the Company receiveswritten notice of demand and may be paid by mutual consent in cash or restrictedstock.
**(7) RECENT ACCOUNTING PRONOUNCEMENT**
In June, 2001, the FASB issued SFAS No. 142, "Goodwilland Other Intangible Assets", which requires that goodwill and certainintangibles assets, including those recorded in past business combinations,no longer be amortized to earnings, but instead be tested for impairmentat least annually. SFAS No. 142 will become effective for fiscal yearsbeginning after December 15, 2001. The Company is required to adopt SFASNo. 142 on January 1, 2002 and has not determined the impact that thisstatement will have on its consolidated financial statements.
**ITEM 2. MANAGEMENT'S DISCUSSIONAND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS****INTRODUCTORY NOTE**
This Quarterly Report on Form 10-QSB contains statementsrelative to (i) projections, (ii) estimates, (iii) future research plansand expenditures, (iv) potential collaborative arrangements, (v) opinionsof management and (vi) the need for and availability of additional financingwhich may be considered "forward-looking statements."
The forward-looking statements included herein are basedon current expectations that involve a number of risks and uncertainties.These forward-looking statements are based on assumptions regarding theCompany's business and technology, which involve judgments with respectto, among other things, future scientific, economic and competitive conditions,and future business decisions, as well as risk factors detailed from timeto time in the Company's Securities and Exchange Commission reports (includingthis Form 10-QSB) and are difficult or impossible to predict accuratelyand many of which are beyond the control of the Company. Although the Companybelieves that the assumptions underlying the forward-looking statementsare reasonable, any of the assumptions could prove inaccurate and, therefore,there can be no assurance that the results contemplated will be realizedand actual results may differ materially.
Readers are urged to carefully review and consider thevarious disclosures made by the Company in this report and in the Company'sother reports filed with the Securities and Exchange Commission that attemptto advise interested parties of the risks and factors that may affect theCompany's business. Therefore, historical results and percentage relationshipswill not necessarily be indicative of the operating results of any futureperiod.
**RESULTS OF OPERATIONS**
***Net Loss per Common Share*.**Basic net loss per common share for the three and six month periods endedJune 30, 2001, remained the same and decreased $0.01 per share, respectively,over the same prior year periods. The net loss for the three and six monthperiods ended June 30, 2001, increased approximately 17% and 12%, respectively,over the same prior year periods. The decrease in basic net loss per share,for the six month period, is primarily attributable to an increase in theweighted average number of common shares outstanding.
***Revenues and Gross Margin***. Revenues andcost of sales are primarily attributable to Assembly and ManufacturingSystems, Inc. (AMS) and are recorded using the percentage of completionmethod. Revenues at AMS for the three and six month periods ended June30, 2001, increased 15% and remained relatively unchanged, respectively,over the same prior year periods. Gross margin as a percentage of salesfor the three month period ended June 30, 2001, was 25%, compared to 24%over the same prior year period which is a return to normal operating levels.Gross margin for the six month period ended June 30, 2001, was 32% comparedto 24% over the same prior year period. Gross margin is anticipated toremain at or below normal operating levels throughout the remainder ofthe fiscal year due to declining order activity. Gross margin may varyin any given period as a result of the variations in profitability of contractsfor large orders of automated production systems or specialty machines,as well as efficiencies related to the overall utilization of AMS' manufacturingresources.
The Company attributes the slight increase in revenuesfor the six months ended June 30, 2001, primarily from sales to the medicalindustry which continued from the prior year. Future sales to all sectorsfor the remainder of 2001 are anticipated to be below prior year levels.This projection is based on the slowing U. S. economy and order activity.
***Research and Development Expenses*.**Researchand development expenses for the three and six month periods ended June30, 2001, decreased 7% and increased 9%, respectively, over the same prioryear periods. Research and development expenses are primarily related tothe LFC Process as the Company has focused its efforts and limited resourceson commercializing the LFC Process. Research and development of the Company'sother technologies will resume at such time as more financial resourcesbecome available.
The decrease in research and development expenses for the three monthperiod ended June 30, 2001 is primarily attributable to a decrease in laborrelated costs at the Company's research facilities. The increase in researchand development expenses for the six months ended June 30, 2001, is primarilyattributable to the Company capitalizing certain engineering costs in theprior year related to the ENCOAL LFC plant. Research and development expensesare anticipated to remain relatively static over the remainder of the year.
***Selling, General and Administrative Expenses*.**Selling,general and administrative expenses for the three and six month periodsended June 30, 2001, decreased 13% and 6%, respectively, over the sameprior year periods. The decrease for both the three and six month periodsis primarily attributable to the shifting of costs associated with theannual meeting which has been moved from the second quarter of the yearto the third quarter.
Selling, general and administrative expenses for AMS for the three andsix month periods ended June 30, 2001, decreased 8% and remained relativelyunchanged, respectively, over the same prior year periods. The decreasefor the three month period ended June 30, 2001 is primarily the resultof decreased sales/order activity due to a slowing U.S. economy.
***Loss on Investment in LFC Investee*.**The Company's shareof the losses for its LFC joint venture (LFC Tech) for the three and sixmonths ended June 30, 2001, increased 297% and remained relatively unchanged,respectively, over the same prior year periods. The results of LFC Tech'soperations are largely influenced by the timing of legal and accountingexpenses associated with maintaining the various LFC Process patents. Allother costs associated with the licensing and marketing of the LFC Processare being borne separately by the joint venture members.
***Legal and Accounting Expenses.***Legal and accounting expensesfor the three and six month periods ended June 30, 2001, increased 39%and 18%, respectively, over the same prior year periods. The increase isrelated primarily to the recovery of certain legal expenses in the prioryear, resulting from the settlement of various lawsuits to which the Companyand AMS were parties. Legal and accounting expenses are expected to remainat current levels through the remainder of the year.
***Depreciation and Amortization Expenses*.**Depreciation andamortization expenses for the three and six month periods ended June 30,2001, decreased 8% and 9%, respectively, over the same prior year periods.The decrease for both periods is due primarily to a significant portionof the Company's laboratory assets becoming fully depreciated.
***Interest Expense.***Interest expense for the three and sixmonth periods ended June 30, 2001, increased 164% and 156%, respectively,over the same prior year periods. The increase for the three and six monthperiods ended June 30, 2001, is primarily due to non-cash interest chargesof approximately $308,000 and $604,000, respectively, related to the amortizationof the imputed beneficial conversion feature of various convertible notespayable, primarily issued during the last half of 2000.
***Other Income.***Other income for the three and six monthperiods ended June 30, 2001, remained substantially unchanged and increased156%, respectively over the same prior year periods. The increase in otherincome for the six months ended June 30, 2001, is due to the Company'sreceipt of $75,000 in the first quarter of the year in settlement of alawsuit.
**LIQUIDITY AND CAPITAL RESOURCES**
As of June 30, 2001, the Company had assets totaling $5,100,000, includingrestricted cash of $200,000, and a working capital deficiency of $8,533,000.Current maturities of approximately $4,170,000 of long-term debt, alongwith current notes payable, accounts payable and accrued salaries primarilycontribute to the working capital deficiency at June 30, 2001. This iscompared to assets of approximately $6,431,000 and a $2,046,000 workingcapital deficiency as of June 30, 2000. The Company anticipates continuedoperating losses over the next twelve months and has both short-term andlong-term liquidity deficiencies as of June 30, 2001.
In the short-term the Company has approximately $4,170,000 of unsecurednotes payable and convertible debentures which mature on September 30,2001 and must be paid or have the due date extended prior to October 31,2001. The Company anticipates, based on preliminary discussions with thesedebt holders, that it will be able to extend the due dates of these liabilitiesas it has done in the past. However, there is no assurance that the Companywill be successful partially or at all in extending the due dates onceagain. The rights to receive payment for both principal and interest ofboth the debenture holders and note holders are essentially similar withinterest being payable quarterly in cash and the principal being due onSeptember 30, 2001 as stated earlier. However, in the event the Companyfails to make either a scheduled principal payment or interest paymenton time, the rights for the two classes of debt holders are different.For the debenture holders, in the event the Company does not make eithera scheduled principal or interest payment ten days after written noticeof such non-payment from the debenture holder, then the debenture shallbecome immediately due and payable without presentment, demand, protestor further notice. For the note holders, in the event the Company doesnot make either a scheduled principal or interest payment on the due datethen the note shall become immediately due and payable without presentment,demand, protest or notice of any other kind. As of June 30, 2001 the Companywas in arrears on one quarter's interest payment to debenture and noteholders representing approximately $3,400,000 and $163,000, respectively,of principal. As of June 30, 2001 no written demands for payment had beenreceived by the Company. The Company believes that the reason for thisis that it is in contact with many of these debt holders and is workingdiligently to bring these obligations current.
Other short-term liquidity requirements are expected tobe satisfied from existing cash balances, proceeds from the sale of equitysecurities in the future or other collaborative arrangements. Negotiationsare on-going for the public and private placement of equity securities,the proceeds of which are intended to be used to satisfy the short-termliquidity deficiency. In the event that the Company is unable to financeoperations at the current level, various administrative activities wouldbe curtailed and certain research and development efforts would be reduced.The Company will not be able to sustain operations if it is unsuccessfulin securing sufficient financing and/or generating revenues from operations.
The Company had long-term liquidity deficiencies at June30, 2001. Over the long-term, the Company will require substantial additionalfunds to maintain and expand its research and development activities andultimately to commercialize, with or without the assistance of corporatepartners, any of its proposed technologies. Although there are no commitments,the Company believes the long-term liquidity deficiency will be satisfiedthrough a combination of future equity sales, increased positive cash flowsfrom operations, and research or other collaborative agreements, untilsuch time as the commercialization of the LFC and OCET Processes resultin positive cash flows. The Company is seeking additional funds throughthe financing, sale and operation of the ENCOAL Demonstration plant andthrough collaborative or other arrangements with larger well capitalizedcompanies, under which such companies may provide additional capital tothe Company in exchange for exclusive or non-exclusive licenses or otherrights to certain commercial projects, technologies and products the Companyis developing. Although the Company is presently engaged in discussionswith a number of suitable candidate companies, there can be no assurancethat an agreement or agreements will arise from these discussions in atimely manner, or at all, or that revenues that may be generated therebywill offset operating expenses sufficiently to reduce the Company's short-termor long-term funding requirements.
The use of cash in operating activities of approximately$1,441,000 and $1,850,000 for the six months ended June 30, 2001, and 2000,respectively, is primarily related to the Company's general operating expensesand R&D activities. The decrease of approximately 22% or $409,000 overthe previous year is essentially due to a decrease in accounts receivable,an increase in various accrued liabilities and an offsetting decrease inbillings in excess of costs.
The Company's investing activities amounted to a use ofcash of approximately $29,000 and $262,000 for the six months ended June30, 2001, and 2000, respectively. The use of cash in the current year isprimarily related to engineering costs associated with the future constructionand acquisition of machinery and equipment at the ENCOAL Demonstrationplant. AMS acquired approximately $12,000 of equipment during the six monthsended June 30, 2001.
In 2001, the Company is projecting no significant capitalexpenditures at OCET and AMS will delay its approximately $300,000 capitalimprovements project which it started in 2000. Further, the Company, throughcollaboration with another larger and better capitalized company, intendsto obtain financing estimated at $13,700,000 for the ENCOAL Demonstrationplant. The financing is for capital improvements and start-up expenditureswhich are necessary to set the plant on more of a commercial footing andto position it as a reference plant for potential future commercial LFCfacilities. Other than the improvements intended to be made to the ENCOALDemonstration plant, the Company as of June 30, 2001, does not have anymaterial requirements or commitments for capital expenditures. The amountof cash used for investing activities in a given period is directly relatedto development requirements and cash availability.
The Company's net financing activities raised approximately$1,205,000 and $2,142,000 for the six months ended June 30, 2001, and 2000,respectively. These funds were raised primarily through the private placementof debt and equity securities for both periods. See Note 3 "Financing Transactions"to the Notes to the Condensed Consolidated Financial Statements includedin this Form 10-QSB.
During the fourth quarter of 2000, the Company was successfulin obtaining a new line-of-credit to provide short term working capitalto AMS. The line allows maximum borrowings of $100,000 and bears interestat prime plus 1%. At June 30, 2001, AMS had borrowings of $100,000 on thisline of credit. The agreement expires November 5, 2001.
As stated earlier the Company intends to obtain financingprimarily related to improvements for the ENCOAL Demonstration plant estimatedat $13,700,000. The Company believes, due to the plant's special nature,that financing for these improvements will not likely be obtained throughconventional methods and that a strategic partner or financier capableof utilizing Internal Revenue Code Section 29 tax credits will be required.Due to the tax laws surrounding the realization of these tax credits thefinancing of the ENCOAL Demonstration plant's improvements will requirethat the Company sell or lease the plant directly to the financier in orderfacilitate the transaction. Following any such transaction the Companyexpects it will continue to be involved with various aspects of the project,including the supervision of the improvements. In this case the Companywill most likely not be required to make any expenditures for the improvementsdiscussed earlier or assume the repayment of the financing associated withthe improvements. There is no assurance that the Company will be able toobtain this financing, or if available, that its terms will be acceptable.
The amount of money raised during a given period is dependentupon financial market conditions, technological progress and the Company'sprojected funding requirements. The Company anticipates that future financingactivities will be influenced by the aforementioned factors. Significantfuture financing activities will be required to fund future operating andinvesting activities and to maintain debt service. While the Company isengaged in continuing negotiations to secure additional capital and financing,there is no assurance such funding will be available or if received willbe adequate.
**RECENT ACCOUNTING PRONOUNCEMENT**
In June, 2001, the FASB issued SFAS No. 142, "Goodwilland Other Intangible Assets", which requires that goodwill and certainintangibles assets, including those recorded in past business combinations,no longer be amortized to earnings, but instead be tested for impairmentat least annually. SFAS No. 142 will become effective for fiscal yearsbeginning after December 15, 2001. The Company is required to adopt SFASNo. 142 on January 1, 2002 and has not determined the impact that thisstatement will have on its consolidated financial statements.

**ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUTMARKET RISK**
[NONE]
**Part II. OTHER INFORMATION**
**ITEM 1. LEGAL PROCEEDINGS**
The Company and its subsidiaries are from time to time involved in litigationarising in the ordinary course of their respective businesses. As of June30, 2001, the Company was not party to any pending legal proceeding.
**ITEM 2. CHANGES IN SECURITIES**
During the quarter ended June 30, 2001, in accordance with the 2001Stock Plan, the Company issued warrants at fair market value to employeesand directors of the Company. The warrants are exercisable for a totalof 430,000 shares of common stock at $0.14 per share, the closing bid priceson the grant date. The warrants were granted in reliance upon exemptionsfrom registration pursuant to Section 4(2) of the Securities Act and RegulationD. Investment representations were obtained from each of the employees.The warrants are exercisable one year from the date of grant and expireon December 31, 2006.
During the quarter ended June 30, 2001, the Company issued approximately3,069,000 shares of restricted common stock to accredited investors forapproximately $280,000 in cash. In connection therewith the Company paidapproximately $8,500 in cash and 98,572 shares of restricted stock valuedat $9,500 for services rendered. These securities were issued pursuantto the exemptions provided by Section 4(2) of the Securities Act and RegulationD. Investment representations were obtained from the accredited investorsand legends were placed on the certificates.
During the quarter ended June 30, 2001, the Company, as provided intheir related consulting agreements, issued 215,000 restricted common sharesto consultants for services rendered, valued at approximately $38,000.These securities were issued pursuant to the exemptions provided by Section4(2) of the Securities Act and Regulation D. Investment representationswere obtained and legends were placed on the certificates.
During the quarter ended June 30, 2001, the Company, upon demand, exchanged$74,661 in principal of one note payable for 439,254 shares of common stock.The securities were issued pursuant to the exemptions provided by Section4(2) of the Securities Act and Regulation D. Investment representationswere obtained from the accredited investor involved and restrictive legendswere placed on the certificates.
During the quarter ended June 30, 2001, the Company sold two notes payableaggregating $57,000 for cash. The notes bear interest at 9% per annum,mature one year from the sale date and are unsecured. The notes and accruedinterest are payable in cash or upon maturity, at the Company's option,by issuing 887,573 shares of restricted common stock. The securities wereissued pursuant to the exemptions provided by Section 4(2) of the SecuritiesAct and Regulation D. Investment representations were obtained from theaccredited investors.
During the quarter ended June 30, 2001, the Company sold six notes payableaggregating $158,500 for cash. The notes bear interest at 9% per annum,mature two years from the sale date and are unsecured. The notes and accruedinterest are payable in cash or upon maturity, at the Company's option,by issuing 2,737,543 shares of restricted common stock. The securitieswere issued pursuant to the exemptions provided by Section 4(2) of theSecurities Act and Regulation D. Investment representations were obtainedfrom the accredited investors.
**ITEM 3. DEFAULTS UPON SENIOR DEBT SECURITIES**[NONE]**ITEM 4. SUBMISSION OF MATTERS TO A VOTE OFSECURITY HOLDERS.**[NONE]**ITEM 5. OTHER INFORMATION**
SGI International ("SGI")and subsidiaries of AEI Resources (collectively "AEI"), specifically, BluegrassCoal Development Company and Americoal Development Company have amendedeffective June 30, 2001, (the "Eleventh Amendment") certain terms and conditionsof the Amended and Restated Acquisition Agreement (the "Acquisition Agreement)between the parties, dated December 9, 1999. The Eleventh Amendment essentiallyprovided SGI with an extension of the June 30, 2001 date, to September30, 2001, in which to satisfy various terms and conditions more fully describedin the Acquisition Agreement. The extension was granted under substantiallysimilar terms and conditions as those agreed to in previous extensions.All other terms and conditions of the Acquisition Agreement remain in fullforce and effect.
**ITEM6. EXHIBITS AND REPORTS ON FORM 8-K**
(a) Exhibits
4.1 Form of Warrant (1)4.2 Form of Restricted Stock Subscription Agreement (2)4.3 Form of Promissory Note payable in cash or stock(3)
(1) Filed herewith.(2) Incorporatedby reference to Registrants report on Form 10KSB ending December 31, 2000.(3) Incorporatedby reference to Registrants report on Form 10QSB ending March 31, 2001 
(b) Reports on 8-K
On June 15, 2001, theCompany reported on its Current Report on form 8-K, filed with the Securitiesand Exchange Commission, that it had amended effective May 31, 2001 (the"Tenth Amendment"), certain terms and conditions of the Amended and RestatedAcquisition Agreement (the "Acquisition Agreement") between itself andcertain subsidiaries of AEI Resources, dated December 9, 1999. The TenthAmendment essentially provided SGI with an extension of the May 31, 2001,date to June 30, 2001, in which to satisfy various terms and conditionsmore fully described in the Acquisition Agreement.**Part III. Signatures**Pursuant to the requirements of the Securities Exchange Actof 1934, this report has been signed below by the following persons onbehalf of the Registrant and in the capacities and on the dates indicated.  
**SGI INTERNATIONAL**  
/s/ MICHAEL L. ROSE                     August 13, 2001Michael L. Rose,President and Chief Executive Officer  
/s/ GEORGE E. DONLOU                 August 13, 2001George E. DonlouVice President Finance and Controller    

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