** **

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

** **

### **FORM 10-Q**

### ** **

**ý****                                ****QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACTOF 1934**

 

**For the quarterly periodended September 30, 2005**

** **

**OR**

 

**o****                                ****TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACTOF 1934**

 

**For the transition periodfrom                           to**

** **

**CommissionFile No. ****001-31332**

 

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**LIQUIDMETAL TECHNOLOGIES, INC.**

(Exact name of Registrant as specified in itscharter)

 
| **Delaware**                    | ** ** | **33-0264467**      |
|---------------------------------|------------|---------------------|
| (State or other jurisdiction of |       | (I.R.S. Employer    |
| incorporation or organization)  |       | Identification No.) |

 

**25800 Commercentre Drive, Suite 100**

**LakeForest, California 92630**

(address of principal executive office, zip code)

 

Registrant’s telephonenumber, including area code: **(949) 206-8000**

 

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

 

Yes ýNo o

 

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2of the Exchange Act).

 

Yes ýNoo

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Exchange Act).  o  Yes  ý  No

 

#### **As of October 13, 2005, there were 42,164,121shares of the registrant’s common stock, $.001 par value, outstanding.**

 

 

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**LIQUIDMETAL TECHNOLOGIES, INC.FORM 10-QFOR THE QUARTER ENDED****SEPTEMBER 30,2005**

 

**FORWARD-LOOKING INFORMATION**

 

Statements in this report concerning the futuresales, expenses, profitability, financial resources, product mix, marketdemand, product development and other statements in this report concerning thefuture results of operations, financial condition and business of LiquidmetalTechnologies, Inc. are “forward-looking” statements as defined in theSecurities Act of 1933 and Securities Exchange Act of 1934. Investors arecautioned that the Company’s actual results in the future may differ materiallyfrom those projected in the forward-looking statements due to risks anduncertainties that exist in the Company’s operations and business environment,including competition, need for increased acceptance of products, ability tocontinue to develop and extend our brand identity, ability to anticipate andadapt to a competitive market, ability to effectively manage rapidly expandingoperations, amount and timing of operating costs and capital expendituresrelating to expansion of our business, operations and infrastructure, abilityto provide superior customer service, dependence upon key personnel and thelike. The Company’s most recent filings with the Securities and ExchangeCommission, including Form 10-K, contain additional information concerningmany of these risk factors, and copies of these filings are available from theCompany upon request and without charge.

 

2

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#### **TABLE OF CONTENTS**

 
| **PART I**                                                                                               | ** ** |
|---------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                                    | ** ** |
| **Item 1 –  Financial Statements**                                                                       | ** ** |
| Condensed  Consolidated Balance Sheets (unaudited)                                                            |       |
| Condensed  Consolidated Statements of Operations and Comprehensive Loss (unaudited)                           |       |
| Condensed  Consolidated Statements of Shareholders’ Equity (Deficiency) (unaudited)                      |       |
| Condensed  Consolidated Statements of Cash Flows (unaudited)                                                  |       |
| Notes  to Condensed Consolidated Financial Statements (unaudited)                                             |       |
|                                                                                                          |       |
| **Item 2 – Management’s Discussion and Analysis of  Financial Condition and Results of Operations** | ** ** |
| ** **                                                                                                    | ** ** |
| **Item 3 – Quantitative and Qualitative Disclosures  about Market Risk**                                 | ** ** |
| ** **                                                                                                    | ** ** |
| **Item 4 – Controls and Procedures**                                                                     | ** ** |
| ** **                                                                                                    | ** ** |
| **PART II – Other Information**                                                                     | ** ** |
| ** **                                                                                                    | ** ** |
| **Item  1 – Legal Proceedings**                                                                          | ** ** |
| ** **                                                                                                    | ** ** |
| **Item 2 – Unregistered Sales of Equity Securities and  Use of Proceeds**                                | ** ** |
| ** **                                                                                                    | ** ** |
| **Item 6 – Exhibits and Reports on Form 8-K**                                                       | ** ** |
| ** **                                                                                                    | ** ** |
| **Signatures**                                                                                                | ** ** |
| ** **                                                                                                    | ** ** |
| **Certifications**                                                                                            | ** ** |

 

3

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### **PART I**

### **FINANCIALINFORMATION**

### ** **

**Item 1 – Financial Statements**

 

**LIQUIDMETAL TECHNOLOGIES, INC. AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(inthousands, except share data)**

 
| ** **                                                                                                                                                                                                   | ** ** | **(unaudited)**        | ** ** | ** **            | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                   | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
| ** **                                                                                                                                                                                                   | ** ** | **2005**               | ** ** | **2004**              | ** ** |
|                                                                                                                                                                                                         |       |                   |       |                  |       |
| **ASSETS**                                                                                                                                                                                                   | ** ** | ** **             | ** ** | ** **            | ** ** |
| ** **                                                                                                                                                                                                   | ** ** | ** **             | ** ** | ** **            | ** ** |
| Current assets:                                                                                                                                                                                              |       |                   |       |                  |       |
|                                                                                                                                                                                                         |       |                   |       |                  |       |
| Cash and cash  equivalents                                                                                                                                                                                   |       | $                      | 933        |                  | $          | 742 |   |
| Restricted cash                                                                                                                                                                                              |       | —                 |       | 754                   |       |
| Trade accounts  receivables, net of allowance for doubtful accounts of $82 and $108                                                                                                                          |       | 2,193                  |       | 1,668                 |       |
| Inventories                                                                                                                                                                                                  |       | 2,332                  |       | 2,353                 |       |
| Prepaid expenses  and other current assets                                                                                                                                                                   |       | 1,363                  |       | 930                   |       |
| Total current assets                                                                                                                                                                                         |       | 6,821                  |       | 6,447                 |       |
|                                                                                                                                                                                                         |       |                   |       |                  |       |
| Property, plant and equipment, net                                                                                                                                                                           |       | 13,889                 |       | 16,434                |       |
| Idle equipment                                                                                                                                                                                               |       | 190                    |       | 1,906                 |       |
| Long-term inventory                                                                                                                                                                                          |       | —                 |       | 1,810                 |       |
| Other intangibles, net                                                                                                                                                                                       |       | 1,151                  |       | 1,143                 |       |
| Other assets                                                                                                                                                                                                 |       | 950                    |       | 768                   |       |
| Total assets                                                                                                                                                                                                 |       | $                      | 23,001     |                  | $          | 28,508 |   |
|                                                                                                                                                                                                         |       |                   |       |                  |       |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                                                                                                                |       |                   |       |                  |       |
|                                                                                                                                                                                                         |       |                   |       |                  |       |
| Current liabilities:                                                                                                                                                                                         |       |                   |       |                  |       |
|                                                                                                                                                                                                         |       |                   |       |                  |       |
| Accounts payable  and accrued expenses                                                                                                                                                                       |       | $                      | 5,701      |                  | $          | 4,969 |   |
| Settlement  payable                                                                                                                                                                                          |       | 3,234                  |       | 3,246                 |       |
| Deferred revenue                                                                                                                                                                                             |       | 879                    |       | 900                   |       |
| Short-term debt                                                                                                                                                                                              |       | 237                    |       | —                |       |
| Long-term debt,  current portion, net of debt discount of $0 and $851                                                                                                                                        |       | 1,204                  |       | 5,991                 |       |
| Other  liabilities, current portion                                                                                                                                                                          |       | 701                    |       | 1,032                 |       |
| Warrant  liability                                                                                                                                                                                           |       | 4,633                  |       | 550                   |       |
| Total current  liabilities                                                                                                                                                                                   |       | 16,589                 |       | 16,688                |       |
|                                                                                                                                                                                                         |       |                   |       |                  |       |
| Long-term debt, net of current portion and debt  discount of $7,023 and $0                                                                                                                                   |       | 6,953                  |       | 2,618                 |       |
| Other long-term liabilities, net of current portion                                                                                                                                                          |       | 431                    |       | 342                   |       |
| Total  liabilities                                                                                                                                                                                           |       | 23,973                 |       | 19,648                |       |
|                                                                                                                                                                                                         |       |                   |       |                  |       |
| Shareholders’ equity (deficiency):                                                                                                                                                                      |       |                   |       |                  |       |
|                                                                                                                                                                                                         |       |                   |       |                  |       |
| Preferred stock,  $0.001 par value; 10,000,000 shares authorized and none issued and outstanding  at September 30, 2005 and December 31, 2004                                                      |       | —                 |       | —                |       |
| Common stock,  $0.001 par value; 100,000,000 shares authorized and 42,164,121 issued  and outstanding at September 30, 2005  and 41,609,652 issued and outstanding at  December 31, 2004 |       | 42                     |       | 42                    |       |
| Additional paid  in capital                                                                                                                                                                                  |       | 136,025                |       | 132,160               |       |
| Accumulated  deficit                                                                                                                                                                                         |       | (139,088               | )          | (125,313              | )          |
| Accumulated  other comprehensive income                                                                                                                                                                      |       | 2,049                  |       | 1,971                 |       |
| Total  shareholders’ equity (deficiency)                                                                                                                                                                |       | (972                   | )          | 8,860                 |       |
|                                                                                                                                                                                                         |       |                   |       |                  |       |
| Total liabilities  and shareholders’ equity (deficiency)                                                                                                                                                |       | $                      | 23,001     |                  | $          | 28,508 |   |

 

The accompanyingnotes are an integral part of the condensed consolidated financial statements.

 

4

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**LIQUIDMETAL TECHNOLOGIES, INC. AND SUBSIDIARIES**

 

### **CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS**

**(inthousands, except per share data)**

**(unaudited)**

 
| ** **                                                             | ** ** | **For the Three**                   | ** ** | **For the Nine**                    | ** ** |
|------------------------------------------------------------------------|------------|-------------------------------------|------------|-------------------------------------|------------|
| ** **                                                             | ** ** | **Months Ended September 30,** | ** ** | **Months Ended September 30,** | ** ** |
| ** **                                                             | ** ** | **2005**                            | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                   |       |                                |       |                                |       |   |   |   |   |
| Revenue                                                                |       | $                                   | 4,342      |                                | $          | 4,615 |   | $ | 10,912 |   | $ | 14,958 |   |
| Cost of sales                                                          |       | 3,756                               |       | 3,241                               |       | 10,553 |   | 9,273 |   |
|                                                                   |       |                                |       |                                |       |   |   |   |   |
| Gross profit                                                           |       | 586                                 |       | 1,374                               |       | 359 |   | 5,685 |   |
|                                                                   |       |                                |       |                                |       |   |   |   |   |
| Operating expenses:                                                    |       |                                |       |                                |       |   |   |   |   |
| Selling,  general, and administrative                                  |       | 2,364                               |       | 3,569                               |       | 6,521 |   | 9,178 |   |
| Research and  development                                              |       | 196                                 |       | 374                                 |       | 806 |   | 1,060 |   |
| Impairment of  long lived assets                                       |       | —                              |       | —                              |       | 3,394 |   | — |   |
| Total expenses                                                         |       | 2,560                               |       | 3,943                               |       | 10,721 |   | 10,238 |   |
|                                                                   |       |                                |       |                                |       |   |   |   |   |
| Loss from operations                                                   |       | (1,974                              | )          | (2,569                              | )          | (10,362 | ) | (4,553 | ) |
|                                                                   |       |                                |       |                                |       |   |   |   |   |
| Loss from extinguishments of debt                                      |       | (1,247                              | )          | (1,663                              | )          | (1,247 | ) | (1,663 | ) |
| Other expense                                                          |       | (20                                 | )          | (434                                | )          | (120 | ) | (434 | ) |
| Other income                                                           |       | 1,132                               |       | 302                                 |       | 1,265 |   | 1,582 |   |
| Interest expense                                                       |       | (1,159                              | )          | (1,805                              | )          | (3,325 | ) | (3,242 | ) |
| Interest income                                                        |       | 7                                   |       | —                              |       | 14 |   | 34 |   |
| Loss from  continuing operations                                       |       | (3,261                              | )          | (6,169                              | )          | (13,775 | ) | (8,276 | ) |
|                                                                   |       |                                |       |                                |       |   |   |   |   |
| Loss from  discontinued equipment manufacturing operations, net of tax |       | —                              |       | —                              |       | — |   | (749 | ) |
|                                                                   |       |                                |       |                                |       |   |   |   |   |
| Net loss                                                               |       | (3,261                              | )          | (6,169                              | )          | (13,775 | ) | (9,025 | ) |
|                                                                   |       |                                |       |                                |       |   |   |   |   |
| Other comprehensive loss                                               |       |                                |       |                                |       |   |   |   |   |
| Foreign exchange  translation gain (loss)                              |       | (306                                | )          | 68                                  |       | 78 |   | 490 |   |
| Comprehensive  loss                                                    |       | $                                   | (3,567     | )                                   | $          | (6,101 | ) | $ | (13,697 | ) | $ | (8,535 | ) |
|                                                                   |       |                                |       |                                |       |   |   |   |   |
| Net loss per common share – basic and diluted:                    |       |                                |       |                                |       |   |   |   |   |
| Loss per share –  continuing operations                           |       | $                                   | (0.08      | )                                   | $          | (0.15 | ) | $ | (0.33 | ) | $ | (0.20 | ) |
| Loss per share –  discontinued operations                         |       | $                                   | —     |                                | $          | — |   | $ | — |   | $ | (0.02 | ) |
| Loss per share  basic and diluted                                      |       | $                                   | (0.08      | )                                   | $          | (0.15 | ) | $ | (0.33 | ) | $ | (0.22 | ) |
|                                                                   |       |                                |       |                                |       |   |   |   |   |
| Number of  weighted average shares – basic and diluted            |       | 41,933                              |       | 41,610                              |       | 41,717 |   | 41,610 |   |

 

The accompanyingnotes are an integral part of the condensed consolidated financial statements.

 

5

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**LIQUIDMETAL TECHNOLOGIES, INC. AND SUBSIDIARIES**

 

**CONDENSEDCONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY (DEFICIENCY)**

###### **Forthe Nine Months Ended September 30, 2005**

**(inthousands, except per share data)**

**(unaudited)**

 
| ** **                             | ** ** | ** ** | ** ** | ** ** | ** ** | ** **     | ** ** | ** **      | ** ** | **Accumulated**   | ** ** | ** ** | ** ** |
|----------------------------------------|------------|------------|------------|------------|------------|----------------|------------|-----------------|------------|-------------------|------------|------------|------------|
| ** **                             | ** ** | ** ** | ** ** | ** ** | ** ** | **Additional** | ** ** | ** **      | ** ** | **Other**         | ** ** | ** ** | ** ** |
| ** **                             | ** ** | **Common** | ** ** | **Common** | ** ** | **Paid in**    | ** ** | **Accumulated** | ** ** | **Comprehensive** | ** ** | ** ** | ** ** |
| ** **                             | ** ** | **Shares** | ** ** | **Stock**  | ** ** | **Capital**    | ** ** | **Deficit**     | ** ** | **Income**        | ** ** | **Total**  | ** ** |
| ** **                             | ** ** | ** ** | ** ** | ** ** | ** ** | ** **     | ** ** | ** **      | ** ** | ** **        | ** ** | ** ** | ** ** |
| **Balance, December 31, 2004**    |       | 41,609,652 |       | $          | 42         |           | $          | 132,160         |       | $                 | (125,313   | )          | $          | 1,971 |   | $ | 8,860 |   |
| Beneficial  conversion feature         |       |       |       | —     |       | 3,187          |       | —          |       | —            |       | 3,187      |       |
| Conversion of  notes payable           |       | 462,250    |       | —     |       | 462            |       | —          |       | —            |       | 462        |       |
| Common stock  issued as directors fees |       | 92,219     |       | —     |       | 175            |       | —          |       | —            |       | 175        |       |
| Stock based  compensation              |       | —     |       | —     |       | 41             |       | —          |       | —            |       | 41         |       |
| Foreign exchange  translation gain     |       | —     |       | —     |       | —         |       | —          |       | 78                |       | 78         |       |
| Net loss                               |       | —     |       | —     |       | —         |       | (13,775         | )          | —            |       | (13,775    | )          |
| **Balance, September 30, 2005**   |       | 42,164,121 |       | $          | 42         |           | $          | 136,025         |       | $                 | (139,088   | )          | $          | 2,049 |   | $ | (972 | ) |

 

The accompanyingnotes are an integral part of the condensed consolidated financial statements.

 

6

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**LIQUIDMETAL TECHNOLOGIES, INC.  AND SUBSIDIARIES**

 

### **CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(inthousands, except per share data)**

**(unaudited)**

 
| ** **                                                                                    | ** ** | **For the Nine Months**      | ** ** |
|-----------------------------------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                                                    | ** ** | **Ended September 30,** | ** ** |
| ** **                                                                                    | ** ** | **2005**                     | ** ** | **2004** | ** ** |
|                                                                                          |       |                         |       |   |   |
| **Operating activities:**                                                                     |       |                         |       |   |   |
| Net loss                                                                                      |       | $                            | (13,775    | ) | $ | (9,025 | ) |
|                                                                                          |       |                         |       |   |   |   |   |
| Adjustments to  reconcile net loss from operations to net cash used for operating activities: |       |                         |       |   |   |
| Impairment of  long lived assets                                                              |       | 3,394                        |       | — |   |
| (Gain) loss on  disposal of asset                                                             |       | (14                          | )          | 8 |   |
| Depreciation and  amortization                                                                |       | 2,516                        |       | 2,585 |   |
| Loss on  extinguishments of debt                                                              |       | 1,247                        |       | 1,663 |   |
| Amortization of  debt discount                                                                |       | 1,447                        |       | 2,692 |   |
| Stock-based  compensation                                                                     |       | 41                           |       | 276 |   |
| Bad debt  (recovery) expense                                                                  |       | (21                          | )          | 111 |   |
| Warranty expense                                                                              |       | 126                          |       | 269 |   |
|                                                                                          |       |                         |       |   |   |
| Changes in operating assets and liabilities:                                                  |       |                         |       |   |   |
| Accounts  receivable                                                                          |       | (504                         | )          | 47 |   |
| Inventories                                                                                   |       | 178                          |       | (1,950 | ) |
| Prepaid expenses  and other current assets                                                    |       | (404                         | )          | (1,111 | ) |
| Other assets                                                                                  |       | (632                         | )          | (877 | ) |
| Accounts payable  and accrued expenses                                                        |       | 752                          |       | 3,887 |   |
| Deferred revenue                                                                              |       | (21                          | )          | (597 | ) |
| Warrant  liabilities                                                                          |       | (1,145                       | )          | 449 |   |
| Other  liabilities                                                                            |       | (142                         | )          | (4,708 | ) |
| Net cash used  for continuing operations                                                      |       | (6,957                       | )          | (6,281 | ) |
|                                                                                          |       |                         |       |   |   |
| Net cash  provided by discontinued operations                                                 |       | —                       |       | 822 |   |
| Net cash used  for operating activities                                                       |       | (6,957                       | )          | (5,459 | ) |
|                                                                                          |       |                         |       |   |   |
| **Investing Activities:**                                                                     |       |                         |       |   |   |
| Purchases of  property and equipment                                                          |       | (153                         | )          | (73 | ) |
| Proceeds from  sale of property and equipment                                                 |       | 69                           |       | 11 |   |
| Investment in  patents and trademarks                                                         |       | (92                          | )          | (202 | ) |
| Net cash used  for investing activities                                                       |       | (176                         | )          | (264 | ) |
|                                                                                          |       |                         |       |   |   |
| **Financing Activities:**                                                                     |       |                         |       |   |   |
| Proceeds from  borrowings                                                                     |       | 16,180                       |       | 9,924 |   |
| Repayment of  borrowings                                                                      |       | (9,850                       | )          | (4,898 | ) |
| Repayment of  other liabilities                                                               |       | (100                         | )          | (91 | ) |
| Proceeds from  restricted cash                                                                |       | 754                          |       | (1,000 | ) |
| Net cash  provided by financing activities                                                    |       | 6,984                        |       | 3,935 |   |
|                                                                                          |       |                         |       |   |   |
| Effect of  foreign exchange translation                                                       |       | 340                          |       | 57 |   |
| Net increase in  cash and cash equivalents                                                    |       | 191                          |       | 1,731 |   |
|                                                                                          |       |                         |       |   |   |
| Cash and cash equivalents at beginning of period                                              |       | 742                          |       | 3,127 |   |
| Cash and cash equivalents at end of period                                                    |       | $                            | 933        |   | $ | 1,396 |   |
|                                                                                          |       |                         |       |   |   |
| Supplemental cash flow information:                                                           |       |                         |       |   |   |
| Interest paid                                                                                 |       | $                            | 1,400      |   | $ | 463 |   |
| Taxes paid                                                                                    |       | $                            | —     |   | $ | — |   |

 

The accompanyingnotes are an integral part of the condensed consolidated financial statements.

 

7

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During the nine monthsended September 30, 2004, the Company sold it’s 51% ownership interest inDongyang to the 49% minority shareholder, which resulted in a loss of $46 fromdisposal of discontinued operations as of September 30, 2004.

 

During the nine monthsended September 30, 2005, $462 of the Company’s 6% senior convertible notes dueJuly 2007 was converted into 462,250 of the Company’s common stock at a conversionprice of $1.00 per share.

 

The accompanyingnotes are an integral part of the condensed consolidated financial statements

 

8

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**LIQUIDMETAL TECHNOLOGIES ANDSUBSIDIARIES**

### ** **

### **NOTESTO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**For the Nine Months EndedSeptember 30, 2005 and 2004**

**(in thousands, except share data)**

**(unaudited)**

 

**1.****                                      Basisof Presentation / Description of Business**

 

The accompanying unaudited condensed consolidated financial statementshave been prepared in accordance with accounting principles generally acceptedin the United States of America (“generally accepted accounting principles”)for interim financial information and with the instructions to Form 10-Q.  Accordingly, they do not include all of theinformation and notes required by generally accepted accounting principles forcomplete financial statements.  In theopinion of management, all adjustments (consisting only of normal recurringaccruals) considered necessary for a fair presentation have been included.  In addition, certain reclassifications havebeen made for consistent presentation. Operating results for the three and nine months ended September 30,2005 are not necessarily indicative of the results that may be expected for anyfuture periods or the year ending December 31, 2005.  The accompanying unaudited condensedconsolidated financial statements should be read in conjunction with theCompany’s Form 10-K filed with the Securities and Exchange Commission on March 30,2005.

 

Liquidmetal Technologies, Inc. (“Liquidmetal Technologies”) and itssubsidiaries (collectively “the Company”) are in the business of developing,manufacturing, and marketing products made from amorphous alloys. LiquidmetalTechnologies markets and sells Liquidmetal® alloy industrial coatings and alsomanufactures, markets and sells products and components from bulk Liquidmetalalloys that can be incorporated into the finished goods of its customers acrossa variety of industries.   The Companyalso partners with third-party licensees and distributors to develop andcommercialize Liquidmetal alloy products.

 

The Company classifies operations into two reportable segments:Liquidmetal alloy industrial coatings and bulk Liquidmetal alloys. Liquidmetalalloy industrial coatings are used primarily as a protective coating forindustrial machinery and equipment, such as drill pipe used by the oil drillingindustry and boiler tubes used by coal-burning power plants. Bulk Liquidmetalalloys include potential market opportunities to manufacture and sell productsand components for electronic devices, medical devices, defense applications,and sporting goods.  In addition, thebulk Liquidmetal alloys segment includes tooling and prototype sampling, andthe manufacture and sale of die casting equipment (see Note 7).  In addition, such alloys are used to generateresearch and development services revenue for developing uses related primarilyto defense and medical applications as well as potential license fees,royalties, and other compensation from strategic partnering transactions.

 

Stock-based compensation

 

TheCompany applies Accounting Principles Board (“APB”) Opinion No. 25 foroptions when the exercise price of options granted to employees is less thanthe fair value of the underlying stock on the date of grant.  The Company applies Statement of FinancialAccounting Standards (“SFAS”) No. 123 for options granted to non-employeeswho perform services for the Company.

 

Hadthe Company determined compensation cost based on the fair value at the grantdate for stock options consistent with the method of SFAS No. 123, theCompany’s loss from continuing operations and basic and dilutedloss per share from continuing operations would have been as follows:

 

9

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| ** **                                                                                                                                                                                                                                                          | ** ** | **For the Three**                   | ** ** | **For the Nine**                    | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                                                                                                                                                                                          | ** ** | **Months Ended September 30,** | ** ** | **Months Ended September 30,** | ** ** |
| ** **                                                                                                                                                                                                                                                          | ** ** | **2005**                            | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                                                                                                                                                                                                                |       |                                |       |                                |       |   |   |   |   |
| Net loss as  reported                                                                                                                                                                                                                                               |       | $                                   | (3,261     | )                                   | $          | (6,169 | ) | $ | (13,775 | ) | $ | (9,025 | ) |
|                                                                                                                                                                                                                                                                |       |                                |       |                                |       |   |   |   |   |
| *Add:**                         *stock-based  employee compensation expense included in reported net loss, net of related  tax effects |       | 41                                  |       | —                              |       | 41 |   | 276 |   |
|                                                                                                                                                                                                                                                                |       |                                |       |                                |       |   |   |   |   |
| *Deduct:**        *total stock-based  employee compensation expense determined under the fair value based method  for all awards, net of related tax effects                                                                |       | (695                                | )          | (910                                | )          | (2,237 | ) | (3,720 | ) |
|                                                                                                                                                                                                                                                                |       |                                |       |                                |       |   |   |   |   |
| Proforma net  loss:                                                                                                                                                                                                                                                 |       | $                                   | (3,915     | )                                   | $          | (7,079 | ) | $ | (15,971 | ) | $ | (12,469 | ) |
|                                                                                                                                                                                                                                                                |       |                                |       |                                |       |   |   |   |   |
| Basic and  diluted loss per share:                                                                                                                                                                                                                                  |       |                                |       |                                |       |   |   |   |   |
| As reported                                                                                                                                                                                                                                                         |       | $                                   | (0.08      | )                                   | $          | (0.15 | ) | $ | (0.33 | ) | $ | (0.22 | ) |
| Proforma                                                                                                                                                                                                                                                            |       | $                                   | (0.09      | )                                   | $          | (0.17 | ) | $ | (0.38 | ) | $ | (0.30 | ) |

 

The fair value of each option grant is estimated onthe date of the grant using the Black-Scholes option-pricing model with thefollowing weighted-average assumptions used for grants for the nine months endedSeptember 30, 2005 and 2004, respectively: expected volatility ofapproximately 100% for all periods; dividend yield of 0.0% for all periods;expected option life of approximately 5 years; and a risk-free interestrate ranging from 2.9% to 4.2%.

 

**2.****                                      Basisof Presentation and Recent Accounting Pronouncements**

 

Translation of Foreign Currency

 

The Company applies **FASB No. 52,Foreign Currency Translation**, for translating foreigncurrency into US dollars in our consolidation of the financialstatements.  Upon consolidation of the Company’s foreign subsidiaries intothe Company’s consolidated financial statements, any balances with thesubsidiaries denominated in the foreign currency are translated at the exchangerate at year-end. The financial statements of Liquidmetal Korea have beentranslated based upon Korean Won as the functional currency. Liquidmetal Korea’sassets and liabilities were translated using the exchange rate at period endand income and expense items were translated at the average exchange rate forthe reporting period. The resulting translation adjustment was included inother comprehensive income (loss).

 

Reclassifications

 

Certain amounts from theprior year have been reclassified to conform to current year’s presentation.

 

Recent Accounting Pronouncements

 

In March 2004, theEmerging Issues Task Force (“EITF”) reached a consensus on recognition andmeasurement guidance previously discussed under EITF 03-01 The consensusclarifies the meaning of other-than-temporary impairment and its application toinvestments classified as either available-for-sale or held-to-maturity underFASB Statement No. 115, “Accounting for Certain Investments in Debt andEquity Securities,” and other investments accounted for under the cost method.The recognition and measurement  guidancefor which the consensus was reached in March 2004 is to be applied toother-than-temporary impairment evaluations in reporting  periods beginning after June 15, 2004.In September 2004, the FASB issued a final FASB Staff Position that delaysthe effective date for the measurement and recognition guidance for allinvestments within the scope of EITF Issue No. 03-01; however, thedisclosure requirements remain effective for annual periods ending after June 15,2004. The Company does not believe that the adoption of this statement willhave a material effect on the Company’s results of operation and financialposition.

 

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In December 2004,the FASB issued SFAS No. 123R, “Share-Based Payment”, which replaces SFAS No. 123.SFAS No. 123R requires public companies to recognize an expense forshare-based payment arrangements including stock options and employee stockpurchase plans. The statement eliminates a company’s ability to account for share-basedcompensation transactions using APB 25, and generally requires instead thatsuch transactions be accounted for using a fair value based method. SFAS No. 123Rrequires an entity to measure the cost of employee services received inexchange for an award of equity instruments based on the fair value of theaward on the date of grant, and to recognize the cost over the period duringwhich the employee is required to provide service in exchange for the award. InApril 2005, the SEC amended the compliance dates for SFAS 123(R), to allowcompanies to implement the standard at the beginning of their next fiscal year,instead of the next reporting period beginning after June 15, 2005. SFAS No. 123Ris effective for the Company in the quarter ending March 31, 2006. Uponadoption of SFAS 123R, companies are allowed to select one of three alternativetransition methods, each of which has different financial reportingimplications. The Company is currently evaluating the transition methods,valuation methodologies and other assumptions for employee stock options inlight of SFAS No. 123R. Current estimates of option values using theBlack-Scholes method may not be indicative of results from valuationmethodologies ultimately implemented by the Company upon adoption of SFAS No. 123R.Although the Company has not yet fully quantified the impact this standard willhave on its financial statements, it is likely that the adoption of SFAS No. 123Rwill have a material impact on the Company’s financial position and results ofoperations.  Stock-based Compensationunder Note 1 included in these Condensed Consolidated Financial Statementsprovides the pro forma net income and earnings per share as if the Company hadused a fair-value-based method similar to the methods required under SFAS123(R) to measure the compensation expense for employee stock awards during thethree and six months ended June 30, 2005 and 2004.

 

On March 29, 2005,the SEC issued Staff Accounting Bulletin No. 107 (SAB 107) regarding theStaff’s interpretation of SFAS 123(R). This interpretation expresses the viewsof the staff regarding the interaction between SFAS 123(R) and certain SEC rules andregulations and provides the staff’s views regarding the valuation ofshare-based payment arrangements for public companies. In particular, this SABprovides guidance related to share-based payment transactions withnonemployees, the transition from nonpublic to public entity status, valuationmethods, the accounting for certain redeemable financial instruments issuedunder share-based payment arrangements, the classification of compensationexpense, non-GAAP financial measures, first-time adoption of SFAS 123(R) in aninterim period, capitalization of compensation cost related to share-basedpayment arrangements, the accounting for income tax effects of share-basedpayment arrangements upon adoption of SFAS 123(R), the modification of employeeshare options prior to adoption of Statement 123(R) and disclosures inManagement’s Discussion and Analysis subsequent to adoption of SFAS 123(R). TheCompany will adopt SAB 107 in connection with its adoption of SFAS 123(R).

 

In May 2005, theFASB issued SFAS No. 154, “Accounting Changes and Error Corrections – areplacement of APB Opinion No. 20 and FASB Statement No. 3.” SFAS No. 154 replaces APB Opinion No. 20, “Accounting Changes,” andFASB Statement No. 3, “Reporting Accounting Changes in Interim FinancialStatements” and changes the requirements for the accounting for and reportingof a change in accounting principle.  This statement applies to allvoluntary changes in accounting principle.  It also applies to changesrequired by an accounting pronouncement in the unusual instance that thepronouncement does not include specific transition provisions.  When apronouncement includes specific transition provisions, those provisions shouldbe followed.  SFAS No. 154 is effective for accounting changes andcorrections of errors made in fiscal years beginning after December 31,2005.  The Company does not believe the adoption of SFAS No. 154 willhave a material effect on its consolidated financial position, results ofoperations or cash flows.

 

In June 2005, theEITF reached a consensus on Issue No. 05-2 “The Meaning of ‘ConventionalConvertible Debt Instrument’ in EITF Issue No. 00-19, ‘Accounting forDerivative Financial Instruments Indexed to, and Potentially Settled in, aCompany’s Own Stock.’” Issuers of convertible debt are required by Statement133 to evaluate whether it is necessary to separate the “embedded” conversionfeature from the debt contract and account for the conversion feature as if itwere a separate derivative instrument.  If the issuer determines that the embedded conversion feature would beclassified in equity if it were a freestanding instrument, the conversionfeature is not separated from the debt contract. EITF 00-19’s criteria must beapplied to determine whether a conversion feature qualifies for equityclassification, but it exempts a conversion feature embedded in a “conventionalconvertible debt instrument” from some of the criteria. EITF 05-2 requiresconvertible instruments that may be settled in a combination of cash or shares,e.g., those referred to as “Instrument C” in EITF 90-19, and instruments thatmay be convertible into a variable number of shares are not “conventional.”  As a result, nonconventional

 

11

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instruments would need tosatisfy all requirements of EITF 00-19 to support a conclusion that theconversion feature does not require accounting separate from that for the debtcontract.  The adoption of this Issue didnot have an impact on the Company’s financial statements.

 

In June 2005, theEITF reached a consensus on Issue 05-6, “Determining the Amortization Periodfor Leasehold Improvements,” which requires that leasehold improvementsacquired in a business combination or purchased subsequent to the inception ofa lease be amortized over the lesser of the useful life of the assets or a termthat includes renewals that are reasonably assured at the date of the businesscombination or purchase. EITF 05-6 is effective for periods beginning after June 29,2005. Earlier application is permitted in periods for which financialstatements have not been issued. The adoption of this Issue did not have animpact on the Company’s financial statements.

 

InSeptember 2005, the EITF reached a consensus on Issue 05-7 “Accountingfor Modifications to Conversion Options Embedded in Debt Instruments andRelated Issues,” which requiresthat a change in the fair value of a conversion option brought about bymodifying the debt agreement be included in analyzing in accordance with EITF 96-19“Debtor’s Accounting for a Modification or Exchange of Debt Instruments”whether a debt instrument is consideredextinguished. Under EITF 96-19’s requirements, an issuer whomodifies a debt instrument must compare the present value of the original debtinstrument’s cash flows to the present value of the cash flows of the modifieddebt. If the present value of those cash flows varies by more than 10 percent,the modification is considered significant and extinguishments accounting isapplied to the original debt. If the change in the present value of the cashflows is less than 10 percent, the debt is considered to be modified and issubject to EITF 96-19’s modification accounting. EITF 05-7’s Consensus requiresthat in applying the 10 percent test the change in the fair value of theconversion option be treated in the same manner as a current period cash flow.The Consensus also requires that, if a modification does not result in anextinguishment, the change in fair value of the conversion option be accountedfor as an adjustment to interest expense over the remaining term of the debt.The issuer should not recognize a beneficial conversion feature or reassess anexisting beneficial conversion feature upon modification of the conversionoption of a debt instrument that does not result in an extinguishment.  EITF 05-7 is effective formodifications of debt instruments beginning in the first interim or annualreporting period beginning after December 15, 2005.  The Company does not expect theadoption of the EITF to have material impact on the Company’s financialstatements.

 

In September 2005,the EITF reached a consensus on Issue No. 05-8, “Income Tax Consequencesof Issuing Convertible Debt with a Beneficial Conversion Feature.”  Under EITF 05-8, the issuance of convertible debt with a beneficialconversion feature results in a temporary difference for purposes of applying Statement109.  Thedeferred taxes recognized for the temporary difference should be recorded as anadjustment to paid-in capital. EITF 98-5 “Accounting for ConvertibleSecurities with Beneficial Conversion Features or Contingently AdjustableConversion Ratios” and EITF 00-27  “Application of Issue No. 98-5 to CertainConvertible Instruments” require thatthe nondetachable conversion feature of a convertible debt security beaccounted for separately if it is a beneficial conversion feature.  A beneficial conversion feature is recognizedand measured by allocating to additional paid-in capital a portion of theproceeds equal to the conversion feature’s intrinsic value. A discount on theconvertible debt is recognized for the amount that is allocated to additionalpaid-in capital. The debt discount is accreted from the date of issuance to thestated redemption date of the convertible instrument or through the earliestconversion date if the instrument does not have a stated redemption date. TheU.S. Federal Income Tax Code includes the entire amount of proceeds received atissuance as the tax basis of the convertible debt security.  The EITF 05-8 Consensus should be appliedretrospectively to all instruments with a beneficial conversion featureaccounted for under EITF 98-5 and EITF 00-27 for periods beginning after December 15,2005. The Company does not expect the adoption of the EITF to have materialimpact on the Company’s financial statements.

 

Other recent accountingpronouncements issued by the FASB (including its Emerging Issues Task Force),the AICPA and the SEC did not or are not believed by management to have amaterial impact on the Company’s present or future consolidated financialstatements.

 

**3.****                                     ****Liquidity / SarbanesOxley Act of 2002**

 

TheCompany has experienced losses from continuing operations during the last twofiscal years and has an accumulated deficit of $139,088 as of September 30, 2005.  Cash used for continuing operations for thenine months ended September 30,

 

12

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2005was $6,957 and cash flow from continuing operations will likely be negativethrough the 4th quarter of 2005. At September 30, 2005 working capital (deficit) was ($9,768).As of September 30, 2005, the Company’s principal source of liquidity is$933 of cash and $2,193 of trade accounts receivable.  Such conditions raise substantial doubt thatthe Company will be able to continue as a going concern.  These operating results occurred while theCompany was developing and continues to develop and to commercialize andmanufacture products from an entirely new and unique technology.  . These factors have placed a significant strain on the financialresources of the Company.  The ability ofthe Company to overcome these challenges depends on its ability to correct itsproduction inefficiencies, continue to reduce its operating costs, generatehigher revenue, and achieve positive cash flow from continuing operations andprofitability and continued sources of debt and equity financing.  The consolidated financial statements do notinclude any adjustments that might result from the outcome of the uncertainty.

 

The Company completed $3,250 private placement of 10% convertible debt on June 13,2005, and $9,878 private placement of 7% convertible debt on August 9,2005 for $5,000 aggregate cash received, $4,280 of previously issued notes, andsatisfaction of accrued interest and fees of $598 from previously issuedconvertible notes (see Note 8).  TheCompany also entered into a Factoring, Loan, and Security Agreement (“FactoringAgreement”) on April 21, 2005, which allows for borrowing up to $1,500, tomeet working capital needs of the Company (see Note 8).  Borrowings made under the Factoring Agreementare secured by the Company’s trade receivables. Such borrowings totaled $2,855, which was offset by $2,618 of repaymentsmade as September 30, 2005.  TheCompany has $1,263 available for future borrowings under the FactoringAgreement as of September 30, 2005, which is contingent on approval of eligiblereceivables by the financing company.

 

Capital requirements during the next 12 months will depend onnumerous factors, including the success of existing products, the developmentof new applications for Liquidmetal alloys, the resources devoted to developand support Liquidmetal alloy products, and the cost of successfulimplementation of Section 404 of the Sarbanes-Oxley Act of 2002.  If the available funds and cash generatedfrom operations are insufficient to satisfy liquidity requirements, the Companywill need additional funds in the future to support working capitalrequirements and for other purposes, and will need to raise additional fundsthrough public or private equity financing, bank debt financing, or from othersources. Adequate funds may not be available when needed or may not beavailable on favorable terms. However, the Company anticipates capitalexpenditures in the next 12 months will be less than $0.5 million. The Companyexpects to continue to devote limited capital to our research and developmentactivities, to further develop and strengthen our manufacturing capabilities,and for working capital and other general corporate purposes.

 

Pursuant to Section 404of the Sarbanes-Oxley Act of 2002 (“SOX 404”), the SEC has adopted rules requiringpublic companies to include a report of management on the company’s internalcontrols over financial reporting in their annual reports on Form 10-K.  In addition, the public accounting firmauditing a public company’s financial statements must attest to and report onmanagement’s assessment of the effectiveness of the company’s internal controlsover financial reporting.  Although theserequirements were first applicable to the Company’s annual report on Form 10-Kfor the fiscal year ended December 31, 2004, the Company did not complywith these requirements for such fiscal year as described in the followingparagraphs.

 

****The time********and resources committed to the restatement of priorperiods’ financial statements as aforementioned delayed our internal timetablewith respect to our documentation, assessment and evaluation of internalcontrol over financial reporting.  Due tothe issues described in the foregoing paragraph, as well as limitation onfinancial and internal resources, management’s assessment of the effectivenessof our internal control over financial reporting had been substantiallydelayed, which in turn had delayed the Company’s independent registered publicaccounting firm, Stonefield Josephson Inc., in performing its audit ofmanagement’s assessment of the effectiveness of internal control over financialreporting pursuant to SOX 404. Therefore, the Company’s independent registered public accounting firm issueda disclaimer of opinion with respect to the Company’s internal control over financialreporting as of December 31, 2004, and such disclaimer was filed with theCompany’s amended Form 10-K filed on May 10, 2005.****

 

****In addition,********whilemanagement has devoted as much financial and internal resources during 2005 tothe SOX 404 effort as possible for compliance as of fiscal year 2005,management believes that there is significant work remaining to be done in alimited amount of time.  Thus, theCompany will not be able to complete its assessment of internal controls inaccordance with SOX 404 requirements as of December 31, 2005 (see “Item 4– Controls and Procedures” on this quarterly report for further discussion onmaterial deficiencies identified as of November 18, 2005).****

 

****The Company has been advised by the SEC that thefiling of a disclaimer does not comply with the SEC’s rules andregulations under Section 404, and the SEC has further advised us thatthis noncompliance has resulted in the Company being in violation of Section 13(a) underthe Securities Exchange Act of 1934.  Section 13(a) establishesthe general requirement that public companies must file with the****

**** ****

****13****

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**** ****

****SEC, in accordance with such rules andregulations as the SEC may prescribe, such information, documents, and reportsas the SEC may from time to time require for the protection of investors,including Form 10-Ks and 10-Qs.****

 

****In addition to the foregoing, although the Company’scommon stock was admitted to the OTC Bulletin Board for quotation on June 15,2005, the SEC has further advised that, as a result of our noncompliance with Section 404for the 2005 fiscal year, it may not have been appropriate for the OTC BulletinBoard to admit our common stock for quotation on June 15, 2005.  Consequently, there is no assurance that theCompany’s common stock will remain eligible for quotation on the OTC BulletinBoard.****

 

**4.****                                     ****Inventories**

 

TheCompany maintains certain of its raw material inventories in amounts in excessof our operating cycle of one year due to the nature of our manufacturingprocess, production lead time, and the recyclability of our raw material. Theseinventories were classified as long-term inventory as of December 31,2004. The Company determined that its current and projected raw materialrequirements are not sufficient enough to warrant the use of such raw materialsin the foreseeable future. Accordingly, the Company reduced the carrying valueof raw materials held by its subsidiary, Liquidmetal Korea, by the amountsconsidered to be excessive during the second quarter of 2005. The write-downduring the quarter ended June 30, 2005 amounted to $1,653 and is includedin “Impairment of long lived assets” in the accompanying Condensed ConsolidatedStatement of Operations and Comprehensive Loss for the nine months ended September 30,2005. The total amount of long term inventory was $0 and $1,810 as of September 30,2005 and December 31, 2004, respectively.

 

Inventorieswere comprised of the following:

 
| ** **                 | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|----------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                 | ** ** | **2005**               | ** ** | **2004**              | ** ** |
| Raw materials              |       | $                      | 1,206      |                  | $          | 1,688 |   |
| Work in process            |       | 735                    |       | 352                   |       |
| Finished goods             |       | 391                    |       | 313                   |       |
| Total current  inventories |       | 2,332                  |       | 2,353                 |       |
| Long-term inventories      |       | —                 |       | 1,810                 |       |
| Total  inventories         |       | $                      | 2,332      |                  | $          | 4,163 |   |

 

**5.****                                     ****Idle Equipment**

 

Idleequipment consists of certain equipment held by the Company for use inexpansion of bulk alloy parts manufacturing.  Due to excess manufacturingcapacity, the Company classified the equipment as idle equipment at December 31,2004.  While the equipment may be used internally to meet future capacityrequirements, considering our current revenue and foreseeable productionrequirements, the Company does not anticipate utilizing this equipmentinternally in the near future. For these reasons, during the quarter ended June 30,2005, the Company determined to write down the carrying value of the idleequipment held by its subsidiary, Liquidmetal Korea, to its net realizablevalue. The write-down amounted to $1,741 and is included in operating expensesas “Impairment of long lived assets” in the accompanying Condensed ConsolidatedStatement of Operations and Comprehensive Loss for the three and nine monthsended September 30, 2005. Total amount of idle equipment remaining was$190 and $1,906 as of September 30, 2005 and December 31, 2004,respectively.

 

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**6.****                                     ****Discontinued Operations**

 

*Dongyang*

 

On June 28, 2002, the Company acquired a 51%interest in Chusik Hoesa Dongyang Yudoro (“Dongyang”).   In March 2004, the Company sold its 51%investment in Dongyang to the 49% minority shareholder.  The selling price of the Company’s 51%interest in Dongyang was $80, which was equal to the Company’s net carryingvalue for the 51% ownership held. Further, the Company agreed to pay Dongyang $155 for the purchase of areceivable balance from Growell.  Thetransaction resulted in net payable to Dongyang of $75 and a loss of $46 fromtransfer of the Company’s interest in Donyang to the minority shareholder.  The loss from operations for the nine monthsended June, 2004 totaled $50 and is included in the loss from discontinuedequipment manufacturing operations for the period.  The net payable balance of $75 is to be paidin quarterly installments throughout 2004, with $25 to be paid subsequent to2004.  The outstanding amount payable toDongyang is $11 and $25 as of September 30, 2005 and December 31,2004, respectively, and is included in accounts payable and accruedliabilities.

 

Summarizedoperating results of Dongyang’s discontinued operations are as follows.

 
| ** **                                                             | ** ** | **For the Nine months  Ended September 30,** | ** ** | **For the Nine months  Ended September 30,** | ** ** |
|------------------------------------------------------------------------|------------|---------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                             | ** ** | **2005**                                          | ** ** | **2004**                                          | ** ** |
|                                                                   |       |                                              |       |                                              |       |
| Revenue                                                                |       | $                                                 | —     |                                              | $          | 22 |   |
| Loss from discontinued equipment manufacturing  operations, net of tax |       | —                                            |       | (96                                               | )          |
|                                                                        |            |                                                   |            |                                                   |            |  |  |

 

*Taesung*

 

On June 14, 2004, the Company entered into anAsset Purchase Agreement whereby all the assets and liabilities of its Taesungequipment manufacturing division in Korea were sold to a third party for $345which is payable by the third party in four equal installments with the lastinstallment being due on June 30, 2005. As of March 31, 2004, management determined that no impairment wasanticipated on the divestiture of its Taesung division.  Ultimately, the sale resulted in a loss ofapproximately $184.  The loss from operations for the threeand nine months ended September 30, 2004 totaled $0 and $653 and isincluded in the loss from discontinued equipment manufacturing operations forthe period.

 

Summarizedoperating results of Taesung’s operations are as follows:

 
| ** **                                                             | ** ** | **For the Nine months  Ended September 30,** | ** ** | **For the Nine months  Ended September 30,** | ** ** |
|------------------------------------------------------------------------|------------|---------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                             | ** ** | **2005**                                          | ** ** | **2004**                                          | ** ** |
|                                                                   |       |                                              |       |                                              |       |
| Revenue                                                                |       | $                                                 | —     |                                              | $          | 172 |   |
| Loss from discontinued equipment manufacturing  operations, net of tax |       | —                                            |       | (653                                              | )          |
|                                                                        |            |                                                   |            |                                                   |            |  |  |

 

**7.****                                     ****Product Warranty**

 

Management estimatesproduct warranties as a percentage of bulk alloy product sales earned duringthe period.  As of September 30,2005, the Company used 5 percent of bulk alloy product sales as an estimate ofwarranties to be claimed.  The percentageis based on industry averages and historical information.  During the three and nine months ended September 30,2005, the Company recorded $50 and $126, respectively, of warrantyexpense.  During the three and ninemonths ended September 30, 2004, the Company recorded $131 and $269,respectively, of warranty expense.  Theproduct warranty accrual balance is included in accounts payable and accruedexpenses.

 

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**8.****                                     ****Notes Payable**

 

Senior ConvertibleNote

 

On March 3,2004, the Company issued $9.9 million of 6.0% senior convertible notes due 2007(the “March Notes”) to investor groups in a transaction led by MichiganVenture Capital Co., Ltd, a South Korea-based institutional investment firm,and IndiGo Ventures LLC, a New York-based investment firm (the “Placement Agents”)that served as a financial advisor to the Company for the transaction.  The notes were collateralized by the patentsheld by the Company and second priority mortgage interest in plant facilitiesand certain equipment in South Korea. The notes were convertible at any time into common stock at a price of$3.00 per share.  Investors in theprivate placement and the Placement Agents received warrants to purchase anaggregate amount of up to approximately 1.2 million shares of common stock,exercisable at $3.00 per share for varying periods but no later than 100 daysfollowing the effectiveness of a registration statement covering the resale ofshares issuable upon exercise of the warrants. In addition, the investors had the right to call for repayment of thenotes prior to maturity at any time after the second anniversary of the closingof the transaction.

 

Thefair value of the 1.2 million warrants totaled $1,883 and was computed usingthe Black-Scholes pricing model under the following assumptions: (1) expectedlife of 3 years; (2) volatility of 82%, (3) risk free interest of0.95% and dividend rate of 0%.  Inaddition, since this debt is convertible into equity at the option of the noteholder at beneficial conversion rates, an embedded beneficial conversionfeature was recorded as a debt discount and will be amortized using theeffective interest rate method over the life of the debt in accordance withEmerging Issues Task Force No. 00-27, “Application of Issue No. 98-5to Certain Convertible Instruments.”  In March 2004,total cost of beneficial conversion feature of $3,395 and the fair value of the0.6 million warrants issued to investors of $584 were recorded as discounts ofthe convertible note.  In addition, $718relating to the fair value of the 0.6 million warrants issued to the PlacementAgents and $581 direct costs incurred relating to issuance of the convertiblenote were recorded as debt issuance cost as a contra liability account inwarrant liability and other assets, respectively.

 

During2004, the Company redeemed $4,465 of the outstanding note balance in cash.  The redemption resulted in a write down ofdebt issuance costs and debt discount of $2,071 to interest expense during theyear ended December 31, 2004. Further, 500,000 of warrants originally issued to a financial advisorfor the transaction expired during June 2004 and 163,748 of unexercisedwarrants originally issued to investors were cancelled as a result of theCompany’s redemption of the note balances during the year ended December 31,2004.  The 663,748 total expired andcanceled warrants immediately prior to the expiration and cancellation resultedin a reduction of warrant liability of $7 and $279 to paid in capital andchange in value of warrants, respectively, during the year ended December 31,2004.

 

On August 19,2004, the Company completed a private exchange offer for its March Noteswith the remaining holders after the redemption.  Under terms of the exchange offer,approximately $5.5 million in aggregate principal amount of the March Noteshave been exchanged for an aggregate of (i) $2.75 million of 6% SeniorSecured Notes Due 2007 (the “Long-Term Notes”) and (ii) $2.75 million of10% Senior Secured Notes Due 2005 (the “Short-Term Notes”), collectivelyreferred to as “Exchange Notes”.  TheExchange Notes are collateralized by certain patents owned by the Company andsecond priority mortgage interest in plant facilities and certain equipment atour South Korea plant.  The Short-TermNotes have a maturity date of July 29, 2005, and a conversion price of$2.00 per share (compared to a conversion price of $3.00 per share under the March Notes).  The Short-Term Notes have been exchanged andredeemed subsequent to the close of the second quarter of 2005 (see 2005 SeniorConvertible Notes below). The Long-Term Notes have a maturity date of July 29,2007, and a conversion price of $1.00 per share.   Further, the exchange notes are convertibleinto Common Stock, at the option of the Company, if at any time after theissuance of the notes, the closing per share price of the Common Stock exceeds$4.00 (as adjusted for stock splits, reverse splits, stock dividends, andrecapitalizations) for 30 consecutive trading days, and further provided thatthere has been effective registration during such period.  Holders of the Long-Term Notes also have theright to call for repayment of the Long-Term Notes prior to maturity at anytime after the second anniversary of the closing of the exchange offer.   The Long-Term Notes have been amendedsubsequent to the close of the second quarter of 2005 to provide for an AmendedRegistration Rights Agreement, and Amended and Restated Security Agreement (see2005 Senior Convertible Notes below).

 

Atotal of 563,151 warrants to purchase our common stock at an exercise price of$3.00 per share—all of which were previously issued in connection with thepurchase of the March Notes—have been amended to provide for an extended

 

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expirationdate of March 1, 2006.  The warrantexercise price is subject to price adjustment for anti-dilution purposes.  As of September 30, 2005, the warrantprice was determined to be exercisable at $2.73.

 

Theexchange offer was treated as an extinguishment of the March Notes inaccordance with Emerging Issues Task Force No. 96-19, “Debtors Accountingfor a Modification or Exchange of Debt Instruments.”  The exchange resulted in a $1,663 loss fromextinguishment of the March Notes, write down of $352 of deferred issuecosts in other assets, $189 of contra liability deferred issuance costs, and$1,122 of debt discount  as a result ofthe change in carrying value of exchanged notes.

 

Inconnection with the private exchange offer, the Company issued $250 of privateplacement notes to certain Placement Agents as issuance costs.  Of the $250 notes issued, $125 was paid inthe form of long-term notes which is due in 2007 with interest rate of 6% perannum (Long-Term Notes) and $125 was paid in the form of short-term notes whichis due in 2005 with interest rate of 10% per annum (Short-Term Notes).  The Short-Term and Long-Term Notes areconvertible into Common Stock at $2.00 and $1.00, respectively, and have thesame terms as the Exchange Notes issued to the investors.  Further, a beneficial conversion feature wasrecorded from the $125 Long-Term Notes issued to Placement Agents of $29 duringAugust 2004.

 

TheCompany was obligated, pursuant to a Registration Rights Agreement, as amendedby the Exchange Notes, between the Company, the Placement Agents and the noteholders to file a registration statement with the Securities and ExchangeCommission (“SEC”) to register the shares of Common Stock issuable uponconversion of the notes payable and the related warrants within 90 daysfollowing the effective closing date of the exchange notes (July 29,2004), and to use best efforts to cause such registration statement to becomeeffective within 60 days following the SEC’s first written comments on theregistration statement.  Further, if theCompany is not in compliance with the registration or listing requirements, theholders have rights to late registration payments equal to between 2 and 3percent of the purchase price paid for the unconverted notes for the first 30business days of late registration, and 1 and 3 percent for each 30 businessdays thereafter, but no more than 18 percent of the purchase price of theunconverted note balance.  Lateregistration fee of $0 and $1,028 has been recorded as interest expense duringthe three and nine months ended September 30, 2005, respectively.

 

Interestpayments are due quarterly, and failure to make timely interest payments willresult in increase in interest rate to 10% and 14% on the 6% and 10% seniorconvertible notes (“Default Rates”).  TheDefault Rates became effective on April 1, 2005 from non-payment of ascheduled interest payment.  As of September 30,2005, the Company has complied with all scheduled interest payments.

 

On August 9,2005, the Short-Term Notes, accrued interest and late registration fees wereredeemed in cash and exchanged for 7% Convertible Secured Promissory Notes due August 2007  (see 2005 Senior Convertible Notes below).

 

Subsequentto the closing of the 2005 Senior Convertible Notes in August 2005, $462of the Long-Term Notes were converted into 462,250 of the Company’s commonstock at a conversion price of $1.00 per share as of September 30, 2005.

 

As of September 30,2005, our gross outstanding loan balance of the Short-Term and Long-Term Notestotaled $0 and $2,392, respectively.  As of December 31, 2004, our grossoutstanding loan balance of the Short-Term and Long-Term Notes totaled $2,854and $2,855, respectively.  As of September 30,2005 and December 31, 2004, un-amortized discounts for beneficial conversionfeature and warrants totaled $352 and $851, and other asset debt issuance coststotaled $49 and $183, respectively. Interest expense for the amortization of debt issuance cost and discounton note was $225 and $633 for the three and nine months ended September 30,2005, and $217 and $622 for the three and nine months ended September 30,2004, respectively.  As of September 30,2005, the effective interest rate for the Long-Term Notes was 32%.

 

Pursuantto EITF 00-19, “Accounting for Derivative Financial Instruments Indexed to, andPotentially Settled in, a Company’s Own Stock”, the original relative fairvalues of the warrants of $1,302 have been recorded as warrant liability as theCompany has not yet filed the registration statement.  In addition, the Company is required to reporta value of the warrant as a fair value and record the fluctuation to the fairvalue of the warrant liability to current operations.  The change in the fair value of the warrantsresulted in a net gain of $170 and $457 for the three and nine months ended September 30,2005, and a loss of $434, which is included in other expense, and a net gain of$846, which is recorded as net other income, for the three and nine monthsended September 30, 2004.  The fairvalue of warrants outstanding at September 30, 2005 of $93 was computedusing

 

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theBlack-Scholes model under the following assumptions: (1) expected life of0.42 years; (2) volatility of 90%, (3) risk free interest of 3.93%anddividend rate of 0%.

 

ConvertibleNotes

 

On June 13, 2005,the Company completed a private placement (the “Private Placement”) of 10%Convertible Unsecured Notes Due June 13, 2006 in the aggregate principalamount of $3,250 (the “Notes”), together with warrants to purchase up to anaggregate of 893,750 shares of the Company’s common stock (the “Warrants”).

 

The Notes issued by theCompany in the Private Placement are unsecured and was due on the earlier of June 13,2006 or the consummation of a follow-on equity or debt offering orrestructuring transaction pursuant to which the Company receives gross proceedsof at least $4,000.  Prior to maturity, the Notes are interest-only, withinterest payments due quarterly, at the rate of 10% per year.  The Notescan be prepaid by the Company at any time without penalty.  If, within 120days following the issue date of the Notes, the Company either fails to redeemthe notes for the principal amount and accrued interest thereon or fails toclose a “Qualified Financing,” then the Notes will thereafter be convertible ata conversion price equal to seventy five percent (75%) of the closing price ofthe Company’s common stock on the first trading day immediately preceding theconversion date.  A “Qualified Financing “ is defined in the Notes as anydebt or equity financing of the Company resulting in aggregate gross proceedsto the Company of at least $5,000 and in which the holders of at least sixtypercent (60%) of the aggregate principal amount of the Company’s Long TermNotes due July 2007 either (i) agree that the equity or debtsecurities to be issued in such financing shall be*pari passu* in order of payment to the 2007 Notes held bythem or (ii) exchange their 2007 Notes for new securities in the financingtransaction.  On August 9, 2005, theCompany successfully completed Qualified Financing, which resulted in exchangeand redemption of the Convertible Notes (see 2005 Senior ConvertibleDebt).  As a result, the Notes neverbecame convertible.

 

As a part of the PrivatePlacement, the Company issued warrants to the purchasers of the Notes givingthem the right to purchase up to an aggregate of 812,500 shares of the Company’scommon stock.  In addition, warrants to purchase 81,250 shares of theCompany’s common stock were issued to the placement agent in thetransaction.  The warrants have an exercise price of $2.00 per share,provided that upon the consummation of the first ensuing public or privateequity or debt offering or restructuring transaction in which the Companyreceives gross proceeds of at least $3,250 (including without limitation anyrestructuring of the Company’s previously issued 10% Senior Secured Notes Due July 29,2005), the exercise price will be automatically adjusted downward (but notupward) as of the closing date of such offering or restructuring transaction sothat it is equal to the lowest effective common stock purchase price paid forany securities issued by the Company to the investors in such offering orrestructuring transaction.  The warrants will expire on June 13, 2010.

 

The fair value of the 893,750 warrants totaled $1,160 and was computedusing the Black-Scholes pricing model under the following assumptions: (1) expectedlife of 5 years; (2) volatility of 118%, (3) risk free interest of3.87% and dividend rate of 0%.  Inaccordance with Emerging Issues Task Force No. 00-27, “Application ofIssue No. 98-5 to Certain Convertible Instruments” the embedded beneficialconversion feature of the debt was not recorded as the debt is consideredcontingently  convertible at the time ofissuance, and as a result of the completion of the Qualified Financing the debtsubsequent to the close of the second quarter, the debt was determined to benot convertible. In June 2005, the fair value of the 812,500 warrantsissued to investors of $1,055 was recorded as discounts of the convertiblenote.  In addition $105 relating to thefair value of the 81,250 warrants issued to the Placement Agents and $278direct costs incurred relating to issuance of the convertible note wererecorded as debt issuance cost as a contra liability account in debt discountand other assets, respectively, and will be amortized using the effectiveinterest rate method over the life of the loan.

 

On August 9, 2005, the Notes were redeemed in cash and exchanged for7% Convertible Secured Promissory Notes due August 2007 (see 2005 SeniorConvertible Notes below).  The exchangeoffer was treated as an extinguishment of the Notes in accordance with EmergingIssues Task Force No. 96-19, “Debtors Accounting for a Modification orExchange of Debt Instruments.”  Theexchange resulted in a $1,247 loss from extinguishment of the Notes whichconsists of write down of $240 of deferred issue costs in other assets, $92 ofcontra liability deferred issuance costs, and $915 of debt discount  as a result of the change in carrying valueof exchanged notes.

 

Pursuantto EITF 00-19, “Accounting for Derivative Financial Instruments Indexed to, andPotentially Settled in, a Company’s Own Stock”, the original fair values of thewarrants of $1,160 have been recorded as other liability as the Company has not

 

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yetfiled the registration statement.  Inaddition, the Company is required to report a value of the warrant as a fairvalue and record the fluctuation to the fair value of the warrant liability tocurrent operations.  The change in thefair value of the warrants resulted in a net gain of $349 and  $95 for the three and nine months ended September 30,2005.  The fair value of warrants outstandingat September 30, 2005 of $1,065 was computed using the Black-Scholes modelunder the following assumptions: (1) expected life of 4.70 years; (2) volatilityof 90%, (3) risk free interest of 4.18%and dividend rate of 0%.

 

2005Senior Convertible Debt

 

On August 9, 2005, the Company completed aprivate placement (the “Private Placement”) of $9,878 in principal amount ofnew 7% Convertible Secured Promissory Notes due August 2007 (the “2005Senior Notes”).  The issuance consistedof $5,000 cash, exchange of $1,284 in principal amount of previously issued 10%Senior Secured Notes Due July 29, 2005 (the “July 2005 Notes”), theexchange of $2,996 in principal amount of previously issued 10% ConvertibleUnsecured Notes Due June 2006 (the “June 2006 Notes”), satisfactionof accrued interest and late registration fees in the amount of $589 on thepreviously issued July 2005 Notes, and satisfaction of accrued interest of$9 previously issued June 2006 Notes. The 2005 Senior Notes were issued pursuant to a Securities PurchaseAgreement dated effective as of August 2, 2005 among the Company, thepurchasers of the 2005 Senior Notes, and the holders of previously issued July 2005Notes and June 2006 Notes of the Company due June 2006.

 

Interest payments are due quarterly, and failure tomake timely interest payments will result in increase in interest rates to 14%per annum on the 2005 Senior Notes (“Default Rates”).  As of September 30, 2005, the Companyhas made timely interest payments.

 

The 2005 Senior Notes are convertible into shares ofthe Company’s common stock at $2.00 per share pursuant to an Amended andRestated Security Agreement.  The 2005Senior Notes are secured by substantially all assets of the Company and rank senior to all other obligations ofthe Company, other than the Company’s loan with Kookmin Bank of South Korea (orany refinancing of such loan), the 6% Senior Secured Notes Due July 29,2007 (“July 2007Notes”), purchase money asset financing, trade creditors in the ordinary courseof business, and any inventory or receivables-based credit facility that theCompany may obtain in the future, provided that the amount of the creditfacility does not exceed 50% of eligible inventory and 80% of eligiblereceivables. The 2005 Senior Notes will automatically convert into common stockif the Company’s common stock has an average closing price of more than $5.00per share during 30 consecutive trading days.

 

The Company also issued warrants to the purchasersof the 2005 Senior Notes and placement agents giving them the right to purchaseup to 2,469,470 and 414,495 shares of Company common stock, respectively, withan exercise price of  $2.00 pershare.  The warrants will expire on August 2,2010.  The fair value of the warrantsissued totaled $4,068 as of effective date of the 2005 Senior Notes, and wascomputed using the Black-Scholes pricing model under the following assumptions:(1) expected life of 5 years; (2) volatility of 93%; (3) riskfree interest of 4.17% and dividend rate of 0%. Further, the beneficialconversion feature of the 2005 Senior Notes totaled $3,187 as of the effectivedate of the 2005 Senior Note.

 

Inconnection with the transaction, the Company, all purchasers of the 2005 SeniorNotes, and all holders of previously issued notes entered into a single Amendedand Restated Registration Rights Agreement that replaces the prior registrationrights agreements entered into by the Company with the various noteholders.Under the Amended and Restated Registration Rights Agreement, the Company isrequired to file a resale registration statement for the shares underlying the2005 Senior Notes, July 2007 Notes, and warrants within ninety (90) daysof the closing of the 2005 Senior Notes. The Company is required to cause thisregistration statement to become effective within 60 days after the Companyreceives the first written comments on the registration statement from the SEC,or if the SEC notifies the Company that it will not review the registrationstatement, within five days after such notification. The Company will besubject to certain monetary penalties, as set forth in the registration rightsagreement, if the registration statement is not filed or does not becomeeffective on a timely basis.  As the Companywas unable to complete the documentation, assessment and evaluation of internalcontrol over financial reporting, which are required to be undertaken to complywith Section 404 of the Sarbanes-Oxley Act of 2002 (“SOX 404”) as of December 31,2004, the Company cannot determine the impact of the non-compliance as of December 31,2004 on the registration statement and cannot ensure that the registrationstatements will be completed in a timely manner. Although the Company hasdevoted substantial efforts to the SOX 404 compliance, there is significantwork remaining to be done in a limited amount of time and consequently, theCompany does not believe that it will be able to complete its assessment ofinternal controls in accordance with SOX 404 requirements as of December 31,2005.  As a result, there can be noassurance

 

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that the Company will be in compliance with Section 404as of December 31, 2005 and 2004 and/or that the Company will have theRegistration statement declared effective by the SEC prior to such compliance.

 

As of September 30,2005, our gross outstanding loan balance of the 2005 Senior Notes totaled$9,878.  As of September 30, 2005,un-amortizeddiscounts for beneficial conversion feature and warrants totaled $6,133, and other asset debt issuance coststotaled $434, and contra liability debt issuance cost totaled $538.  Interest expense for the amortization of debtissuance cost and discount on note was $622 and for the three and nine monthsended September 30, 2005.  As of September 30,2005, the effective interest rate for the 2005 Senior Notes was 46%.

 

Pursuantto EITF 00-19, “Accounting for Derivative Financial Instruments Indexed to, andPotentially Settled in, a Company’s Own Stock”, the original fair values of thewarrants of $4,068 have been recorded as warrant liability as the Company hasnot yet filed the registration statement. In addition, the Company is required to report a value of the warrant asa fair value and record the fluctuation to the fair value of the warrantliability to current operations.  Thechange in the fair value of the warrants resulted in a net gain of $593 whichis recorded as net other income for the three and nine months ended September 30,2005.  The fair value of warrantsoutstanding at September 30, 2005 of $3,475 was computed using theBlack-Scholes model under the following assumptions: (1) expected life of4.84 years; (2) volatility of 90%, (3) risk free interest of 4.18%anddividend rate of 0%.

 

Factoring Agreement

 

The Company entered intoa Factoring, Loan, and Security Agreement (the “Agreement”) with a financingcompany on April 21, 2005, which allows for borrowings of up to$1,500.  The Agreement expires on April 21,2006, and automatically renews annually thereafter. All borrowings are securedby outstanding receivables specifically assigned to the financing company.  Assigned receivables are considered “Approved”or “Non-Approved” by the financing company. Advances are made on 80% of Approved receivables assigned and 30% ofNon-Approved receivables assigned. Payments on assigned receivables are received directly by the financingcompany, and applied to outstanding advances. All outstanding advances and uncollected assigned receivables aresubject to fees and interest charges ranging from 0.65 percent to 2 percentplus prime rate as published by the Wall Street Journal, with a minimum annualfee of $30. All receivables assigned and advances made are subject to returnand recall by the financing company, respectively.  As such, the advances have been classified asshort-term secured borrowings in accordance with SFAS 140 “Accounting forTransfer and Servicing of Financial Assets and Extinguishments of Liabilities.”  As of September 30, 2005, the Companyhas borrowed $2,855 and repaid $2,618. The total outstanding advance made under the agreement is $237 as of September 30,2005, which is presented as short-term debt.  The Company has $1,263 available for future borrowings under theAgreement as of September 30, 2005, which is contingent on approval ofeligible receivables by the financing company.

 

Kookmin Note

 

On February 4, 2003,our Korean subsidiary received 6,500,000 in South Korean Won, or approximately$5,488, under a loan from Kookmin Bank of South Korea.  The loan bears interest at an annual rate of7.1%.  In the event of delayed repayment,the interest increases to a maximum of 21%, depending on the length of time therepayment is delayed.  As of September 30,2005, the interest rate was increased to 9.2% from delayed interest paymentsmade.  This loan is collateralized by theplant facilities and certain equipment in South Korea.  During the first eighteen months from theorigination date, interest was payable on a monthly basis.  In October 2003, the Company paid $873of principal at the request of Kookmin Bank due to the sale of machines thathad been part of the collateral on the loan. Subsequent to October 31, 2003, Kookmin Bank requested that theCompany pay an additional $866 of principal by February 2004 due to theCompany’s current credit rating.  TheCompany made two payments on the requested additional loan pay down in November andDecember 2003 of $320 and $205, respectively.  The remaining payment of $341 wassubsequently made in February 2004. Beginning in September 2004, the Company is required to make equalmonthly installments of principal and interest to repay the remaining balanceof the loan over a 36-month period. Principal payments made to Kookmin Bank totaled $841 for the nine monthsended September 30, 2005, which includes $89 of foreign exchangetranslation loss.  The outstanding loanbalance totaled $2,910, of which $1,204 is included in current portion oflong-term debt, as of September 30, 2005.

 

**9.     StockCompensation Plan**

 

During the three and ninemonths ended September 30, 2005, under the Company’s 2002 Equity IncentivePlan which provides

 

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for the grant of stockoptions to officers, employees, consultants and directors, the Company grantedoptions to purchase 0 and 791,165 common shares of the Company for an averageexercise price of $0 and $2.16, respectively, which equaled the fair marketvalue on the date of grant

 

During the three and ninemonths ended September 30, 2005, under the Company’s 2002 Non-employeeDirector Stock Option Plan which provides for the grant of stock options tonon-employee directors, the Company granted 20,000 and 200,000 common shares of the Company for an averageexercise price of $1.87 and $2.28, respectively, under this plan.  Further, all options granted under this planhad exercise prices that were equal to the fair market value on the date ofgrant.

 

In September 2005, the non-employee directors of our company weregiven the opportunity to receive shares of stock under the plan in lieu ofpast-due director and committee fees that were due to them for periods through September 30,2005.  Such shares were issuable to suchdirectors at an average price of $1.89 per share.  As of September 30, 2005, a total of 92,219shares were issued to non-employee directors in lieu of these past-due fees.

 

The Company canceled31,517 and 275,701 options during the three and nine months ended September 30,2005, respectively, for terminated employees and directors.

 

**10.****                               SegmentReporting and Geographic Information**

 

SFAS No. 131,*Disclosures aboutSegments of an Enterprise and Related Information,*requirescompanies to provide certain information about their operating segments.  In April 2002, the Company beganclassifying operations into two reportable segments: Liquidmetal alloyindustrial coatings and bulk Liquidmetal alloys.  The Liquidmetal alloy industrial coatings areused primarily as a protective coating for industrial machinery and equipment,such as drill pipe used by the oil drilling industry and boiler tubes used bycoal burning power plants.  BulkLiquidmetal alloys include market opportunities to manufacture and sell casingcomponents for electronic devices, medical devices, sporting goods, tooling,prototype sampling, defense applications and metal processing equipment.  Primarily, the expenses incurred by the bulkLiquidmetal alloy segment are research and development costs and sellingexpenses associated with identifying and developing market opportunities.  Bulk Liquidmetal alloys products can bedistinguished from Liquidmetal alloy coatings in that the bulk Liquidmetalalloy can have significant thickness, up to approximately one inch, whichallows for their use in a wider variety of applications other than a thinprotective coating applied to machinery and equipment.   Revenue and expenses associated withresearch and development services and product licensing arrangements areincluded in the bulk Liquidmetal alloy segment. The accounting policies of the reportable segments are the same as thosedescribed in Note 3 to the consolidated financial statements included in theCompany’s Form 10-K filed with the Securities and Exchange Commission on March 30,2005.

 

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Summarized financial information concerning the Company’s reportablesegments is shown in the following tables:

 
| ** **                                                            | ** ** | ** **   | ** ** | ** **     | ** ** | **Segment** | ** ** |
|-----------------------------------------------------------------------|------------|--------------|------------|----------------|------------|-------------|------------|
| ** **                                                            | ** ** | **Coatings** | ** ** | **Bulk Alloy** | ** ** | **Totals**  | ** ** |
| Three months ended September 30, 2005:                           |       |         |       |           |       |        |       |
| Revenue to  external customers                                        |       | $            | 1,549      |           | $          | 2,793       |       | $ | 4,342 |   |
| Gross profit  (loss)                                                  |       | 635          |       | (49            | )          | 586         |       |
| Income (loss)  before interest expense and discontinued operations    |       | 420          |       | (596           | )          | (176        | )          |
| Total  identifiable assets at end of period                           |       | 772          |       | 17,247         |       | 18,019      |       |
|                                                                  |       |         |       |           |       |        |       |
| Three months ended September 30, 2004:                           |       |         |       |           |       |        |       |
| Revenue to  external customers                                        |       | $            | 988        |           | $          | 3,627       |       | $ | 4,615 |   |
| Gross profit                                                          |       | 466          |       | 908            |       | 1,374       |       |
| Income before  interest expense, discontinued operations, and general |       | 264          |       | 129            |       | 393         |       |
| Total  identifiable assets at end of period                           |       | 814          |       | 23,202         |       | 24,016      |       |
|                                                                  |       |         |       |           |       |        |       |
| Nine months ended September 30, 2005:                            |       |         |       |           |       |        |       |
| Revenue to  external customers                                        |       | $            | 3,930      |           | $          | 6,982       |       | $ | 10,912 |   |
| Gross profit                                                          |       | 1,691        |       | (1,332         | )          | 359         |       |
| Income (loss)  before interest expense and discontinued operations    |       | 1,182        |       | (6,437         | )          | (5,255      | )          |
| Total  identifiable assets at end of period                           |       | 772          |       | 17,247         |       | 18,019      |       |
|                                                                  |       |         |       |           |       |        |       |
| Nine months ended September 30, 2004:                            |       |         |       |           |       |        |       |
| Revenue to  external customers                                        |       | $            | 2,710      |           | $          | 12,248      |       | $ | 14,958 |   |
| Gross profit                                                          |       | 1,260        |       | 4,425          |       | 5,685       |       |
| Income before  interest expense and discontinued operations           |       | 804          |       | 2,237          |       | 3,041       |       |
| Total  identifiable assets at end of period                           |       | 814          |       | 23,202         |       | 24,016      |       |

 

Reconciling information between reportable segments and the Company’sconsolidated totals is shown in the following table:

 
| ** **                                                                                             | ** ** | **For the Three**                   | ** ** | **For the Nine**                    | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                             | ** ** | **Months Ended September 30,** | ** ** | **Months Ended September 30,** | ** ** |
| ** **                                                                                             | ** ** | **2005**                            | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                                                   |       |                                |       |                                |       |   |   |   |   |
| Total operating  income (loss) before minority interest, interest expense and discontinued  operations |       | $                                   | (176       | )                                   | $          | 393 |   | $ | (5,255 | ) | $ | 3,041 |   |
| General and  administrative expenses not allocated to segments                                         |       | (1,798                              | )          | (2,962                              | )          | (5,107 | ) | (7,594 | ) |
| Loss before  interest, other income, income taxes, minority interest and discontinued  operations      |       | (1,974                              | )          | (2,569                              | )          | (10,362 | ) | (4,553 | ) |
| Loss from  extinguishments of debt                                                                     |       | (1,247                              | )          | (1,663                              | )          | (1,247 | ) | (1,663 | ) |
| Other expense                                                                                          |       | (20                                 | )          | (434                                | )          | (120 | ) | (434 | ) |
| Other income                                                                                           |       | 1,132                               |       | 302                                 |       | 1,265 |   | 1,582 |   |
| Interest expense                                                                                       |       | (1,159                              | )          | (1,805                              | )          | (3,325 | ) | (3,242 | ) |
| Interest income                                                                                        |       | 7                                   |       | —                              |       | 14 |   | 34 |   |
| Loss from  discontinued operations, net                                                                |       | —                              |       | —                              |       | — |   | (749 | ) |
| Consolidated net loss                                                                                  |       | $                                   | (3,261     | )                                   | $          | (6,169 | ) | $ | (13,775 | ) | $ | (9,025 | ) |

 

Excluded general andadministrative expenses are attributable to the Company’s corporateheadquarters.  These expenses primarilyinclude corporate salaries, consulting, professional fees and facilitycosts.  Research and development expensesare included in the operating costs of the segment that performed the researchand development.

 

Revenuesfrom sales to companies in the United States were $2,234 and $1,215 during thethree months ended September 30, 2005 and 2004, respectively.  The revenue related to the United States ofAmerica was earned under defense-related research and development contracts andsales of coatings products.

 

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As of September 30,2005, two customers represented 32%, or $706, of the total outstanding tradeaccounts receivable.  As of December 31,2004, two customers represented 30%, or $497, of the total outstanding tradeaccounts receivable.  One customerrepresented 11%, or $1,199, of total sales for the nine months ended September 30,2005.   Four customers represented 60%,or $9,036, of total sales for the nine months ended of September 30, 2004.

 

Duringthe three months ended September 30, 2005, the Company had revenues fromcompanies outside of the United States of $2,108 of which $1,665 representedsales to companies located in South Korea. During the three months ended September 30, 2004, the Company hadrevenue from sales to companies outside of the United States of $3,400 of which$2,895 represented sales to companies located in South Korea.  The revenue related to sales to companiesoutside of the United States was from bulk alloy products including equipmentsales.

 

Long-lived assets includenet property, plant, and equipment, and net intangible assets. The Company hadlong-lived assets of $1,742 and $1,594 located in the United States at September 30,2005 and December 31, 2004, respectively. The Company had long-livedassets of $13,298 and $15,422 located in South Korea at September 30, 2005and December 31, 2004, respectively.

 

Reconciling informationbetween reportable segments and the Company’s consolidated totals is shown inthe following table:

 
| ** **                                 | ** ** | **September 30,** | ** ** |
|--------------------------------------------|------------|------------------------|------------|
| ** **                                 | ** ** | **2005**               | ** ** |
| Total segment assets                       |       | $                      | 18,019     |   |
| Cash and cash  equivalents                 |       | 933                    |       |
| Prepaid expenses  and other current assets |       | 1,363                  |       |
| Other property,  plant and equipment, net  |       | 585                    |       |
| Intangibles, net                           |       | 1,151                  |       |
| Other assets                               |       | 950                    |       |
| Total consolidated assets                  |       | $                      | 23,001     |   |

 

Assets excluded from segment assets include assets attributable to theCompany’s corporate headquarters.  Thelargest asset represents the Company’s intangible assets, consisting primarilyof the Company’s patents and trademarks.

 

**11.****                               Income(Loss) Per Common Share**

 

Basic earnings per share (“EPS”) is computed bydividing earnings (loss) attributable to common shareholders by the weightedaverage number of common shares outstanding for the periods. Diluted EPS reflectsthe potential dilution of securities that could share in the earnings.  Common stock equivalents consist of13,077,001 and 8,526,068 equity instruments and 11,672,051 and 4,844,903 seniorequity convertible debt instruments at September 30, 2005 and 2004,respectively, and have not been included in the EPS calculation at September 30,2005 and 2004 as the amounts are anti-dilutive.

 

**12.****                               Commitmentsand Contingencies**

 

In September 2004,as part of a security agreement to finance a certain insurance policy, theCompany used certificates of deposits with maturities of less than one year ascollateral.  The $754 held incertificates of deposits is presented as restricted cash at December 31,2004.  During the quarter ended March 31,2005, the certificate of deposits was liquidated and the proceeds were used topaydown the balance of the financing on the insurance policy.

 

In August 2004, theCompany entered into a consulting agreement whereby the Company was to receiveservices from a third party to improve the Company’s bulk alloy manufacturingprocess.  The service is to be providedfrom August 2004 through October 2005.  The total amount of service fees is $172, ofwhich $9 was included in trade accounts payable as of September 30,2005.  As of December 31, 2004, thetotal amount of outstanding balance included in trade accounts payable was $15.

 

The Company is from timeto time a party to certain legal proceedings arising in the ordinary course ofbusiness. Although

 

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outcomes cannot bepredicted with certainty, the Company does not believe that any legalproceeding to which it is a party will have a material adverse effect on theCompany’s financial position, results of operations, and cash flows.

 

The Company and certain of its present and formerofficers and directors were named as defendants in nine purported class actioncomplaints filed in the United States District Courts for the Middle Districtof Florida, Tampa Division, and the Central District of California, SouthernDivision, alleging violations of Sections 11 and 15 of the Securities Act of1933 and Sections 10(b) and 20(a) of the Securities Exchange Act of1934 and Rule 10b-5 promulgated thereunder. In August 2004, fourcomplaints were consolidated in the United States District Court for the MiddleDistrict of Florida under the caption *Primavera Investors v.Liquidmetal Technologies, Inc., et al.*, Case No. 8:04-CV-919-T-23EAJ.  John Lee, Chris Cowley, Dwight Mamanteo,Scott Purcell and Mark Rabold were appointed co-lead plaintiffs (the “LeadPlaintiffs”).  In September 2004,the five complaints filed in the Central District of California weretransferred to the Middle District of Florida for consolidation with the *Primavera Investors* action. The Lead Plaintiffs served their Consolidated Amended Class ActionComplaint on January 12, 2005.  TheAmended Complaint alleges that the Prospectus issued in connection with theCompany’s initial public offering in May 2002 contained materialmisrepresentations and omissions regarding the Company’s historical financialcondition and regarding a personal stock transaction by the Company’s chiefexecutive officer.  The Lead Plaintiffsfurther generally allege that during the proposed Class Period of May 21,2002, through May 13, 2004, the defendants engaged in improper revenuerecognition with respect to certain of the Company’s business transactions,failed to maintain adequate internal controls, and knowingly disclosedunrealistic but favorable information about market demand for and commercialviability of the Company’s products to artificially inflate the value of theCompany’s stock.  The Amended Complaintseeks unspecified compensatory damages and other relief.  The Company, along with other defendants, fileda Motion to Dismiss Plaintiffs’ Consolidated Amended Class ActionComplaint on March 28, 2005.  TheLead Plaintiffs served their Memorandum in Opposition to Defendants’ Motion toDismiss Consolidated Amended Class Action Complaint on June 3,2005.  The Company cannot predict whenthe court will rule on the Motion to Dismiss.  The Company intends to vigorously defendagainst the class action.  The Companycannot currently predict the impact or resolution of this litigation orreasonably estimate a range of possible loss, which could be material.  The resolution of this lawsuit may harm ourbusiness and have a material adverse impact on our financial condition.

 

In addition to the above, certain present and formerofficers and directors of Liquidmetal Technologies, as well as LiquidmetalTechnologies as a nominal defendant, have been named in three shareholderderivative actions.  Two shareholderderivative complaints were filed in California state court styled *Brian Clair, Derivatively on Behalf of Liquidmetal Technologies, Inc.v. John Kang, et al.*, Case No. 04CC00551, and *Joseph Durgin, Derivatively on Behalf of Liquidmetal Technologies, Inc.  v. John Kang, et al.*, Case No. 04CC00553,both commenced in the Superior Court of Orange County, California.  A third shareholder derivative complaint wasfiled in Florida federal court styled *Robert Story v. John Kang,et al.*, Case No. 8:04-CV-1587-T-23TBM, commenced in the MiddleDistrict of Florida, Tampa Division. These shareholder derivative lawsuits allege that the defendantsbreached various fiduciary duties and otherwise violated state law basedprimarily upon the same underlying facts and circumstances as alleged in thefederal shareholder class action. The plaintiffs seek unspecified compensatorydamages, restitution and disgorgement of profits, equitable and/or injunctiverelief as permitted by law and other relief.

 

The two shareholder derivative complaints inCalifornia state court have been consolidated. Plaintiffs served a Consolidated Shareholder Derivative Complaint on October 12,2004.  The defendants served a Demurrerto the Consolidated Shareholder Derivative Complaint on November 22, 2004,seeking dismissal of that complaint.  Ata hearing on February 10, 2005, the court sustained the demurrer, dismissingthe Consolidated Shareholder Derivative Complaint but giving the plaintiffs 45days within which to amend the complaint. Plaintiffs filed their Consolidated Amended Shareholder DerivativeComplaint on March 28, 2005.  TheCompany, along with other defendants, filed a corrected demurrer on May 17,2005, again seeking dismissal of the amended complaint.  At a hearing on July 7, 2005, the Courtagain sustained the demurrer, dismissing the Consolidated Amended ShareholderDerivative Complaint but giving the plaintiffs 40 days within which to furtheramend the complaint.  On August 16,2005, the plaintiffs filed a Consolidated Second Amended Shareholder DerivativeComplaint.  The Company, along with theother defendants, filed a demurrer on September 15, 2005, again seekingdismissal of the second amended complaint. A hearing on that demurrer was held on October 19, 2005, but wascontinued pending resolution of a dispute regarding the Company’s participationin discovery in the California derivative action before the Motion to Dismissthe class action is resolved.  On October 28,2005, the presiding judge in the class action resolved the discovery dispute bydenying the Company’s Motion to Stay Discovery in Related State Action, and theCompany is now required to produce discovery materials in the Californiaderivative

 

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action.  Oncethose discovery materials are produced to and reviewed by the plaintiffs’counsel in the California derivative action, the judge will reconvene thehearing to determine whether the pending demurrer should be sustained withoutleave to amend.

 

In the Florida derivative action, the Plaintifffiled a First Amended Shareholder Derivative Complaint on November 22,2004.  The Company’s Motion to Dismiss,which was filed on December 20, 2004, is fully briefed.  The Company cannot predict when the courtwill rule on the Motion to Dismiss. The Company intends to vigorously defend against the derivativeactions.  The Company cannot currentlypredict the impact or resolution of this litigation or reasonably estimate arange of possible loss, which could be material.  The resolution of these lawsuits may harm ourbusiness and have a material adverse impact on our financial condition.

 

As of September 30,2005, the Company has accrued $835 as receivables from insurance companies fromexcess legal costs incurred to defend against the class action and derivativelawsuits.   The amount is included inprepaid expenses and other current assets.

 

In March 1996, theCompany entered into a distribution agreement whereby it granted to a thirdparty exclusive rights to market and sell golf products incorporatingLiquidmetal Technology to certain Japanese sporting equipment companies.  The third party paid the Company a $1.0million distribution fee as part of this agreement, of which a portion wasrefundable according to a formula based on the gross profit earned by the thirdparty.  On March 28, 2003, thedistribution agreement was terminated and the Company entered into a newagreement to pay to the same third party a commission on the net sales price ofall Liquidmetal golf equipment that is shipped by the Company or its affiliatesto Japanese golf companies for sale into the Japanese end-market.  This commission will apply to golf equipmentshipped by the Company or its affiliates during the period beginning on March 28,2003 and ending on March 28, 2006. If, by March 28, 2006, the Company has not paid $350 in commissionpayments, the balance between commission paid and $350 will be paid by April 30,2006, thereby guaranteeing the third party a $350 minimum payment during theterm of the agreement.  The Company willrecognize the unearned distribution fee of $830 as revenue proportionately withthe payment of commissions under the new agreement.  As of September 30, 2005 and December 31,2004, the unearned distribution fee remained unchanged at $830.

 

Under terms of the January 2004settlement of the dispute over certain sales transactions from 2003 and 2002between Liquidmetal Korea and Growell Metal Co., Ltd., a South Korean metalsprocessing company (“Growell”), Liquidmetal Korea agreed to pay Growell $4,895to purchase Growell’s investment in alloy inventories, proprietary alloyingequipment purchased from Liquidmetal Korea, and supporting equipment purchasedfrom other suppliers.  Also as part ofthe settlement, Growell satisfied in full a balance of $2,058 owed toLiquidmetal Korea for the die casting machines Growell purchased from

 

Liquidmetal Korea in thefirst quarter of 2003 as part of a license agreement to manufacture Liquidmetalalloy parts for the South Korean automotive industry.  The remaining settlement payable of $2,837and trade accounts payable of $14 were to be paid to Growell (in cash or stockat the Company’s discretion) by December 31, 2004.  As of December 31, 2004, the settlementpayable of $3,246, net of foreign exchange translation loss, was not paid toGrowell due to Growell’s breach of warranty on equipment repurchased by LiquidmetalKorea.  In January 2005, Growell wasacquired by a third party.  As of September 30,2005, the outstanding settlement payable to the third party of $3,234, net offoreign exchange translation gain, was not paid, and the Company is currentlyin negotiations to settle this balance with the third party.

 

**13.****                               RelatedParty Transactions**

 

In June 2003, the Company entered into anexclusive, ten-year license agreement with LLPG, Inc. (“LLPG”), acorporation headed by a former director of the Company.  Under the terms of the agreement, LLPG hasthe right to commercialize Liquidmetal alloys, particularly precious-metalbased compositions, in jewelry and high-end luxury product markets.  The Company, in turn, will receive royaltypayments over the life of the contract on all Liquidmetal products produced andsold by LLPG.  In conjunction with itstechnology licensing contract, LLPG purchased two proprietary Liquidmetal alloymelting machines and three proprietary Liquidmetal alloy casting machines for atotal purchase price of $2,000.  At December 31,2003, the Company had a remaining receivable balance of $500 due from LLPG,which was subsequently paid in full in March 2004.

 

We are a party to a consulting agreement with Chitnis Consulting, Inc.,which is owned 100% by Shekhar Chitnis, a former director and executive officerof our company.  Under this agreement, wehave engaged Chitnis Consulting to provide consulting services on an as-neededbasis through December 31, 2005. During the three and nine months ended September

 

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30, 2005, we incurred $14 and $39, in consulting fees from ChitnisConsulting, respectively.  During thethree and nine months ended September 30, 2004, we incurred $13 and $38,in consulting fees from Chitnis Consulting, respectively.

 

We are a party to aconsulting agreement with William Johnson, a board member.  Under this agreement, Mr. Johnsonprovides consulting services on an as-needed basis through 2004 as it relatesto marketing and development Liquidmetal alloy. The agreement currently continues on a month-to-month basis.  During the three and nine months ended September 30,2005, we incurred $15 and $25 in consulting fees from Mr. Johnson,respectively.  During the three and ninemonths ended September 30, 2004, we incurred $40 and $54 in consultingfees from Mr. Johnson, respectively.

 

In November 2004, we entered into an agreement with John Kang, ourChairman, President, and Chief Executive Officer, in which Mr. Kang agreedthat certain stock transactions by him in 2002 involving our common stockshould have resulted in a liability under Section 16(b) of theSecurities Exchange Act of 1934, as amended (“Section 16(b)”).  These transactions include Mr. Kang’sprivate sale of 285,715 shares of his personal Liquidmetal Technologies commonstock to Growell Metal Co., Ltd. in February 2002, prior to our initialpublic offering.  They also include Mr. Kang’ssubsequent indirect purchase and disposition of Liquidmetal Technologies commonstock in order to satisfy a personal agreement Mr. Kang made to GrowellMetal in February 2002 regarding the guaranteed minimum value of the stockpurchased by Growell Metal in February 2002 (the purchases anddispositions incident to this agreement occurred in August and November 2002,respectively).  Lastly, the transactionsinclude open-market purchases of an aggregate of 89,300 shares of our commonstock made by Mr. Kang in August 2002.

 

TheAudit Committee of our Board of Directors conducted an independent inquiry intothe above-described transactions with the aid of independent legal counsel and,as a result of such inquiry, the Audit Committee concluded that thetransactions should have resulted in a liability to the Company under Section 16(b) inthe amount of $302.  Mr. Kang hasacknowledged this liability, and in an agreement negotiated between Mr. Kangand the Audit Committee and approved by the full Board, Mr. Kang will paythis liability through periodic installments in 2005 and 2006.  As a result, the Company accrued for the $302receivable in other assets and other income as of December 31, 2004.  The above-described transactions involvingGrowell Metal was reported on a new Form 4 filed by Mr. Kang onNovember 15, 2004, and the open-market purchases were previously reportedon a timely basis in August 2002. As of September 30, 2005, the outstanding amount of the receivablewas $235, which is included in other assets. Mr. Kang has paid $0 and $67 for the three and nine months ended ofSeptember 30, 2005.  The Company hasagreed to defer Mr. Kang’s payment schedule until 2006 as Mr. Kanghas agreed accept reduced compensation for the remainder of 2005. The remainingoutstanding balance of $235 will be due before the end of 2006.

 

Duringthe period ended September 30, 2005, the Company executed a $198promissory note with CK Cho, member of our Board of Directors, for workingcapital purposes. The note was due and paid in full as of June 30,2005.  The note has an  annual rate of interest of 6% resulting inthe Company paying approximately $2 in interest.  Mr. Cho also is a Chief ExecutiveOfficer of Winvest Venture Partners Inc., who holds $500 of Senior ConvertibleNotes as of June 30, 2005 (see Note 8). Further, during the three months ended September 30, 2005, Mr. Choadvanced approximately $387 to cover short-term liquidity needs.  The advances were made without interest andwere repaid as of September 30, 2005.

 

** 14. Subsequent Events**

 

Inconnection with the senior convertible debt funded in August 2005, theCompany, all purchasers of the senior notes, and all holders of previouslyissued convertible notes entered into a single Amended and RestatedRegistration Rights Agreement that replaces the prior registration rightsagreements entered into by the Company with the various noteholders (see Note8). Under the Amended and Restated Registration Rights Agreement, the Companyis required to file a resale registration statement for the shares underlyingthe convertible notes and warrants within 90 days of the closing of the August 2005senior convertible debt. The Company is required to cause this registrationstatement to become effective within 60 days after the Company receives thefirst written comments on the registration statement from the SEC, or if theSEC notifies the Company that it will not review the registration statement,within five days after such notification. If the Company is not in compliance with the registration filingrequirements, the holders of the convertible notes and warrants have rights tolate registration filing payments equal to 3 percent of a) warrant exerciseprice

 

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multipliedby the number of outstanding warrants; plus b) the outstanding principlebalance for each 30 business days of late registration, but on more than 18% ofa) warrant exercise price multiplied by the number of outstanding warrants;plus b) the outstanding principle balance. The Company has 30 days of grace period to file the registration statementafter the 90-day period has expired before the penalties are assessed and thenotes are declared in default.  The 90-dayperiod expired on November 2, 2005. As such, the Company will be default under the late filing requirementsof the agreement and will  be liable forthe penalty if the registration agreement has not been filed by December 2,2005.   As of the filing of this report,the Company has not yet filed the registration statement.  If the Company is unable to timely file theregistration statement, the Company will be liable for late filing fees of $645for every 30-day period the statement has not been filed for a maximum penaltyof $1,935.

 

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**Item2.  Management’s Discussion and Analysisof Financial Condition and Results of Operations**

** **

*Thismanagement’s discussion and analysis should be read in conjunction with thecondensed consolidated financial statements and notes included elsewhere inthis report on Form 10-Q.*

 

*Thismanagement’s discussion and analysis, as well as other sections of this reporton Form 10-Q, may contain “forward-looking statements” that involve risksand uncertainties, including statements regarding our plans, future events,objectives, expectations, forecasts, or assumptions. Any statement that is nota statement of historical fact is a forward-looking statement, and in somecases, words such as “believe,” “estimate,” “ project,” “expect,” “intend,” “may,”“anticipate,” “plans,” “seeks,” and similar expressions identify forward-lookingstatements. These statements involve risks and uncertainties that could causeactual outcomes and results to differ materially from the anticipated outcomesor results, and undue reliance should not be placed on these statements. Theserisks and uncertainties include, but are not limited to, the matters discussedunder the caption “Factors Affecting Future Results” in our Annual Report on Form 10-Kfor the fiscal year ended December 31, 2004 and other risks anduncertainties discussed in filings made with the Securities and ExchangeCommission (including risks described in subsequent reports on Form 10-Q, Form 10-K,Form 8-K, and other filings). Liquidmetal Technologies disclaims anyintention or obligation to update or revise any forward-looking statements,whether as a result of new information, future events, or otherwise.*

 

**Overview**

 

Weare a materials technology company that develops and commercializes productsmade from amorphous alloys.  OurLiquidmetal® family of alloys consists of a variety of coatings, powders, bulkalloys, and composites that utilize the advantages offered by amorphous alloytechnology.  We develop, manufacture, andsell products and components from bulk amorphous alloys that are incorporatedinto the finished goods of our customers, and we also market and sell amorphousalloy industrial coatings.  We alsopartner with third-party licensees and distributors to develop andcommercialize Liquidmetal alloy products. We have the exclusive right to develop, manufacture, and sell what webelieve are the only commercially viable bulk amorphous alloys.

 

Amorphous alloys are unique materials that aredistinguished by their ability to retain a random atomic structure when theysolidify, in contrast to the crystalline atomic structure that forms inordinary metals and alloys when they solidify. Liquidmetal alloys possess acombination of performance, processing, and cost advantages that we believemakes them preferable to other materials in a variety of applications. Theamorphous atomic structure of our alloys enables them to overcome certainperformance limitations caused by inherent weaknesses in crystalline atomicstructures, thus facilitating performance and processing characteristicssuperior in many ways to those of their crystalline counterparts. For example,our zirconium-titanium Liquidmetal alloys are approximately 250% stronger thancommonly used titanium alloys, such as Ti-6Al-4V, but they have processingcharacteristics similar in many respects to plastics. We believe theseadvantages could result in Liquidmetal alloys supplanting other incumbentmaterials in a wide variety of applications. Moreover, we believe theseadvantages will enable the introduction of entirely new products andapplications that are not possible or commercially viable with other materials.

 

Our revenues are derived from two principal operatingsegments: Liquidmetal alloy industrial coatings and bulk Liquidmetal alloyproducts.  Liquidmetal alloy industrialcoatings are used primarily as a protective coating for industrial machineryand equipment, such as drill pipe used by the oil drilling industry and boilertubes used in coal-burning power plants. The historical operating informationfor fiscal year 2001 is based substantially on sales of Liquidmetal alloycoatings. In the second half of 2002, we began producing bulk Liquidmetal alloycomponents and products for incorporation into our customers’ finished goods.Bulk Liquidmetal alloy segment revenue includes sales of parts or components ofelectronic devices, medical products, and sports and leisure goods; tooling andprototype parts (including demonstration parts and test samples) for customerswith products in development, product licensing and arrangements, and researchand development revenue relating primarily to defense and medicalapplications.  We expect that thesesources of revenue will continue to significantly change the character of ourrevenue mix.

 

Thecost of sales for our Liquidmetal coatings segment consists primarily of thecosts of outsourcing our manufacturing to third parties. Consistent with ourexpectations, our cost of sales has been increasing over historical results aswe further build our bulk Liquidmetal alloy business. Although we plan tocontinue outsourcing the manufacturing of our coatings, we will internallymanufacture many products derived from our bulk Liquidmetal alloys.

 

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Selling,general, and administrative expenses currently consist primarily of salariesand related benefits, severance costs, travel, consulting and professionalfees, depreciation and amortization, insurance, office and administrativeexpenses, and other expenses related to our operations.

 

Researchand development expenses represent salaries, related benefits expense,stock-based compensation, depreciation of research equipment, consulting andcontract services, expenses incurred for the design and testing of newprocessing methods, expenses for the development of sample and prototypeproducts, and other expenses related to the research and development ofLiquidmetal alloys. Costs associated with research and development activitiesare expensed as incurred. We plan to enhance our competitive position byimproving our existing technologies and developing advances in amorphous alloytechnologies. We believe that our research and development efforts will focuson the discovery of new alloy compositions, the development of improvedprocessing technology, and the identification of new applications for our alloys.

 

OnAugust 4, 2004, the Company established a plant in the city of Weihai inShandong province of China under Weihai Liquidmetal Company Limited, which is100 percent owned by Liquidmetal Korea, to facilitate our bulk alloymanufacturing business.  WeihaiLiquidmetal is consolidated into Liquidmetal Technologies with all intercompanytransactions eliminated.

 

Thefollowing discussion and analysis of our financial condition and results ofoperations focuses on the historical results of our continuing operations.

 

**Critical Accounting Policies and Estimates**

** **

Thepreparation of condensed consolidated financial statements in conformity withaccounting principles generally accepted in the United States requires us tomake estimates and assumptions that affect reported amounts of assets andliabilities and disclosure of contingent assets and liabilities at the date ofthe financial statements and the reported amounts of revenues and expensesduring the reporting period.  Theseestimates and assumptions are based on historical experience and various otherfactors that are believed to be reasonable under the circumstances.  Actual results could differ materially fromthese estimates under different assumptions or conditions.

 

We believe that the following accounting policies arethe most critical to our condensed consolidated financial statements sincethese policies require significant judgment or involve complex estimates thatare important to the portrayal of our financial condition and operatingresults:

 

•                  Exchange rate fluctuations

•                  Warranty accrual

•                  Allowance for doubtful accounts

•                  Inventories at lower of cost or net realizablevalue

•                  Deferred tax assets

 

Our10-K Report as of December 31, 2004 contains further discussions on ourcritical accounting policies and estimates.

 

**Resultsof Operations**

 

Comparison of thethree months ended September 30, 2005 and 2004

 

*Revenue*.Revenue decreased $0.3 million to $4.3 million for the three months ended September 30,2005 from $4.6 million for the three months ended September 30,2004.  The decrease consisted of adecrease of $0.8 million from the sales and prototyping of parts manufacturedfrom bulk Liquidmetal alloys to consumer electronics customers as a result ofdecreased demand for conventional hinge components used in certain cellularphone models, which is offset by an increase of $0.6 million from sales of ourcoatings products.

 

*Cost ofSales*. Cost of sales increased to $3.8 million, or 87% ofrevenue, for the three months ended September 30, 2005 from $3.2 million,or 70% of revenue, for the three months ended September 30, 2004.  The decrease was a result of continuedmaturing of our manufacturing process, which represents the Company’s effortsto manage costs and focus on our core business, and an increase in revenuesgenerated from our higher margin coatings products. Significant portions of ourmanufacturing costs  continue to remainfixed.  We believe that highermanufacturing volumes and greater mix of higher-margin products in the futurewill cause the gross profit to improve over time.  The cost to manufacture parts from our bulk

 

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Liquidmetal alloys isvariable and differs based on the unique design of each product.  However, the cost of sales for the productssold by the coatings business segment is generally consistent because theLiquidmetal coatings products are produced by third parties and sold wholesaleto various industries.

 

*Selling,General, and Administrative Expenses*. Selling, general, andadministrative expenses decreased to $2.4 million, or 54% of revenue, forthe three months ended September 30, 2005 from $3.6 million, or 77%of revenue, for the three months ended September 30, 2004. This decreasewas primarily a result of decrease professional services by $0.8 million,decrease in insurance costs of $0.4 million, decrease in product warranty costsof $0.1 million, and decrease in depreciation and travel expenses of $0.1million, offset by an increase in wages and compensation of $0.3 millionprimarily from severance costs. These and other decreases in selling, generaland administrative expenses represent the Company’s efforts to manage costs andfocus on our core business while continuing to build our corporateinfrastructure required to prepare for and support the anticipated growth ofour bulk Liquidmetal alloy business.

 

*Researchand Development Expenses*. Research and development expensesdecreased to $0.2 million, or 5% of revenue, for the three months ended September 30,2005 from $0.4 million, or 8% of revenue, for the three months ended September 30,2004. The Company continues to perform research and development of newLiquidmetal alloys and related processing capabilities, develop newmanufacturing techniques, and contract with consultants to advance thedevelopment of Liquidmetal alloys.  Thedecrease was primarily due to decreases in salaries, wages and the relatedcosts of $0.1 million and decreases in other miscellaneous expenses of$0.1 million.

 

*Impairmentof Long Lived Assets*. There was no impairment of long livedassets during the three months ended September 30, 2005 and 2004.

 

*Lossfrom Extinguishments of Debt.* Loss from extinguishments of debt decreased to $1.2 million, or 29% ofrevenue, for the three months ended September 30, 2005 from $1.7 million,or 36% of revenue, for the three months ended September 30, 2004.  The $1.2 million loss from extinguishments ofdebt was recognized from the exchange of our 6% Convertible Notes due 2006 in August 2005.  The $1.7 million loss from extinguishments ofdebt was recognized during the three months ended September 30, 2004 fromexchange of our 6% Senior Convertible Notes due March 2007 in August 2004.

 

*OtherExpense*. Other expense decreased to  $20 thousand for the three months ended September 30,2005 from $0.4 million, or 9% of revenue, for the three months ended September 30,2004.  Other expense consists of changein value of warrants issued from the senior convertible debt funded in March 2004and exchanged in August 2004, convertible debt funded in June 2005,and senior convertible debt funded in August 2005 primarily as a result offluctuations in our stock price.

 

*OtherIncome*. Other income increased to  $1.1 million, or 26% of revenue, for thethree months ended September 30, 2005 from $0.3 million, or 7% of revenue,for the three months ended September 30, 2004.  During the three months ended September 30,2005, other income consisted of change in value of warrants issued from thesenior convertible debt funded in March 2004 and exchanged in August 2004,convertible debt funded in June 2005, and senior convertible debt fundedin August 2005 primarily as a result of fluctuations in our stockprice.   During the three months ended September 30,2004, other income consisted of $0.3 million recognized from an agreemententered into with John Kang, our Chairman, President, and Chief ExecutiveOfficer from stock transactions during 2002.

 

*InterestExpense*. Interest expense was $1.2 million, or 27% of revenue, for the three months ended September 30,2005 and was $1.8 million, or 39% of revenue, for the three months ended September 30,2004.  During each of the three monthsended September 30, 2005 and 2004, the interest expense was primarily dueto the interest accrued on the Kookmin Bank loan funded on February 4,2003, senior convertible debt funded on March 3, 2004 and exchanged in August 2004,convertible debt funded on June 13, 2005, and senior convertible debtfunded on August 9, 2005, as well as amortization of debt issuance costsand discount on the convertible debt. The decrease was primarily due to acceleration of amortization of debtissuance costs and discount on debt during the three months ended September 30,2004 from principal payments made.

 

*InterestIncome.* Interestincome was $7 thousand for the three months ended September 30, 2005 frominterest earned on cash deposits.  Therewas no interest income earned for the three months ended September 30,2004.

 

Comparison of thenine months ended September 30, 2005 and 2004

 

*Revenue*.Revenue decreased $4.1 million to $10.9 million for the nine months ended September 30,2005 from $15.0 million

 

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for the nine months endedSeptember 30, 2004.  The decreaseincluded a $2.6 million decrease from restatement of revenues from 2003 to 2004as a part of our 2003 financial statement restatement which resulted inone-time recognition of revenues during the first quarter of 2004, a decreaseof $1.7 million from the sales and prototyping of parts manufactured from bulkLiquidmetal alloys to consumer electronics customers as a result of decreaseddemand for conventional hinge components used in certain cellular phone models,and a decrease of $1.0 million from decreased activity from research anddevelopment services related primarily to defense, leisure, and luxury goodsapplications, offset by an increase of $1.2 million from sale of our coatingsproducts.

 

*Cost ofSales*. Cost of sales increased to $10.6 million, or 97% ofrevenue, for the nine months ended September 30, 2005 from$9.3 million, or 62% of revenue, for the nine months ended September 30,2004.  The increase was a result ofdecreases in bulk Liquidmetal alloy business. Cost of sales as a percentage of revenue has increased as a result oflower business volumes generated from our bulk Liquidmetal alloys.  Significant portion of our manufacturingcosts continue to remain fixed.   Webelieve that higher manufacturing volumes and greater mix of higher-marginproducts in the future will cause the gross profit to improve over time. Thecost to manufacture parts from our bulk Liquidmetal alloys is variable anddiffers based on the unique design of each product.  However, the cost of sales for the productssold by the coatings business segment is generally consistent because theLiquidmetal coatings products are produced by third parties and sold wholesaleto various industries.

 

*Selling,General, and Administrative Expenses*. Selling, general, andadministrative expenses decreased to $6.5 million, or 60% of revenue, forthe nine months ended September 30, 2005 from $9.2 million, or 61% ofrevenue, for the nine months ended September 30, 2004. This decrease wasprimarily a result of decrease in professional and contracted services of $1.9million, decrease in advertising and promotions expense of $0.2 million,decrease in bad debt expenses of $0.1 million, decrease in product warrantexpense of 0.1 million, decrease in insurance costs of $0.1 million, decreasein amortization and depreciation costs of $0.1 million, and decrease in travelcosts of $0.1 million.  These and otherdecreases in selling, general and administrative expenses represent the Company’sefforts to manage costs and focus on our core business while continuing to buildour corporate infrastructure required to prepare for and support theanticipated growth of our bulk Liquidmetal alloy business.

 

*Researchand Development Expenses*. Research and development expensesdecreased to $0.8 million, or 7% of revenue, for the nine months ended September 30,2005 from $1.1 million, or 7% of revenue, for the nine months ended September 30,2004. The Company continues to perform research and development of newLiquidmetal alloys and related processing capabilities, develop new manufacturingtechniques, and contract with consultants to advance the development ofLiquidmetal alloys.  The decrease wasprimarily due to decrease in laboratory and prototype supplies used by$0.1 million and decrease in wages and related expenses by $0.1 million.

 

*Impairmentof Long Lived Assets*. Impairment of long lived assetsincreased to  $3,394, or 31% of revenue,for the nine months ended September 30, 2005 from $0 for the nine monthsended September 30, 2004. Impairment expense represents write-down of $1,653 of raw materialsconsidered to be long term inventory and $1,741 of idle equipment.  While we may use the excess raw materialsbeyond one year to fulfill future customer order, we have determined that ourcurrent capacity was not significant enough to warrant holding this inventoryas a long term asset.  Further, while wehave actively marketed the idle equipment for ultimate sale since early 2004,we were unable to sell this equipment. In addition, while the equipment may beused internally to meet future capacity requirements, considering our currentrevenue, we do not anticipate utilizing this equipment internally in the nearfuture.  As such, we have reduced thecarrying values of the excess raw material and idle equipment.

 

*Lossfrom Extinguishments of Debt.* Loss from extinguishments of debt decreased to $1.2 million, or 11% ofrevenue, for the nine months ended September 30, 2005 from $1.7 million,or 11% of revenue, for the nine months ended September 30, 2004.  The $1.2 million loss from extinguishments ofdebt was recognized from the exchange of our 6% Convertible Notes due 2006 in August 2005.  The $1.7 million loss from extinguishments ofdebt was recognized during the three months ended September 30, 2004 fromexchange of our 6% Senior Convertible Notes due March 2007 in August 2004.

 

*OtherExpense*. Other expense decreased to  $0.1 million, or 1% of revenue, for the ninemonths ended September 30, 2005 from $0.4 million, or 3% of revenue, forthe nine months ended September 30, 2004. Other expense consists of change in value of warrants issued from thesenior convertible debt funded in March 2004 and exchanged in August 2004,convertible debt funded in June 2005, and senior convertible debt fundedin August 2005 primarily as a result of fluctuations in our stock price.

 

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*OtherIncome*. Other income increased to  $1.3 million, or 12% of revenue, for the ninemonths ended September 30, 2005 from $1.6 million, or 11% of revenue, forthe nine months ended September 30, 2004. During the nine months ended September 30, 2005, other incomeconsisted of change in value of warrants issued from the senior convertibledebt funded in March 2004 and exchanged in August 2004, convertibledebt funded in June 2005, and senior convertible debt funded in August 2005primarily as a result of fluctuations in our stock price.   During the nine months ended September 30,2004, other income consisted of $1.3 million from change in value of warrantsissued from our convertible debt as a result of fluctuations in our stockprice, and $0.3 million recognized from an agreement entered into with JohnKang, our Chairman, President, and Chief Executive Officer from stocktransactions during 2002.

 

*InterestExpense*. Interest expense was $3.3 million, or 30% of revenue, for the nine months ended September 30,2005 and was $3.2 million, or 22% of revenue, for the nine months ended September 30,2004.  During each of the nine monthsended September 30, 2005 and 2004, the interest expense was primarily dueto the interest accrued on the Kookmin Bank loan funded on February 4,2003, senior convertible debt funded on March 3, 2004 and exchanged in August 2004,convertible debt funded on June 13, 2005, and senior convertible debt fundedin August 9, 2005, as well as amortization of debt issuance costs anddiscount on the convertible debt.  As of September 30,2005, $0.1 million of interest expense was accrued from default interest ratesapplied to the senior convertible notes effective April 1, 2005 from nonpayment of quarterly scheduled interest payments and $1.0 million of lateregistration penalty fee of our senior convertible debt was accrued as interestexpense.

 

*InterestIncome.* Interestincome was $14 thousand for the nine months ended September 30, 2005, and$34 thousand for the nine months ended September 30, 2004 from interestearned on cash deposits.

 

**Liquidity and Capital Resources**

** **

Ourcash used for operating activities was $7.0 million for the nine monthsended September 30, 2005 and $5.5 million, which includes cash usedin our discontinued equipment manufacturing business of $0.8 million, for thenine months ended September 30, 2004. Our working deficit decreased from $(10.2) million at December 31,2004 to $(9.7) million at September 30, 2005.  The Company’s working deficit decrease of$0.5 million was primarily attributable to increase in cash and cashequivalents of $0.2 million, increase in trade accounts receivable of $0.5million, increase in prepaid and other current assets of $0.4 million, decreasein current portion of long term debt of $4.8 million, decrease in currentportion of other liabilities of $0.3 million, offset by decrease in restrictedcash of $0.8 million, increase in accounts payable and accrued liability of$0.7 million, increase in short-term debt of $0.2 million, increase in warrantliabilities of $4.0 million.

 

Ourcash used in investing activities was $0.2 million for the nine months ended September 30,2005 for the acquisition of property and equipment and investments in patentsand trademarks.

 

Ourcash provided by financing activities was $7.0 million for the nine monthsended September 30, 2005, which consists of $0.8 million in proceeds fromrestricted cash and $3.25 million and $9.9 million in proceeds from convertibledebt funded in June 2005 and senior convertible debt funded in August 2005,respectively, $0.2 million in proceeds from borrowings from our short term debtexecuted in March 2005, $2.9 million in proceeds from factoring agreementexecuted in April 2005, offset by $10.0 million on repayment ofborrowings.  The proceeds from theconvertible and senior convertible debt funded in June 2005 and August 2005,respectively have been used to meet working capital requirements.

 

We anticipate that ourcapital expenditures will be approximately less than $0.5 million for the fullyear 2005 for the acquisition of furniture, fixtures, and other businessequipment. This amount is subject to change, however, depending upon the natureand the amount of the product orders that we actually receive from customers.

 

Our capital requirementsduring the next twelve months will depend on numerous factors, includingthe success of existing products either in manufacturing or development, thedevelopment of new applications for Liquidmetal alloys, the resources we devoteto develop and support our Liquidmetal alloy products, the success of pursuingstrategic licensing and funded product development relationships with externalpartners, and the cost of successful implementation of Section 404 of theSarbanes-Oxley Act of 2002. During the next twelve months, based on ourcurrent business plan, we expect to have sufficient resources to continue todevote limited capital to our research and development activities, to furtherdevelop and strengthen our manufacturing technology, and to provide for workingcapital and other general corporate purposes. However, based on our historical operating results and the continued developmentof our manufacturing capabilities and alloy compositions, there

 

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exists the possibilitythat these resources will not be adequate to operate at the proposed businessplan levels.  These expenses and capitalexpenditures could consume a material amount of our cash resources, but theamount of these requirements will depend on the nature and amount of orders wereceive for the purchase of our bulk Liquidmetal alloy products.

 

Ourbusiness is based on commercializing an entirely new and unique technology, andour current business plan contains a variety of assumptions and expectationsthat are subject to uncertainty, including assumptions and expectations aboutorder flow, unit volumes, manufacturing efficiencies, product cost and pricing,continuing technology improvements, customer adoption practices, strategiclicensing relationships and other relevant matters. These assumptions take intoaccount recent significant cost reductions, as well as recent improvements toour manufacturing processes. We have experienced losses from continuingoperations during the last two fiscal years and have an accumulated deficit of$139.1 million as of September 30, 2005. At September 30, 2005, ourprincipal source of liquidity was $0.9 million of cash and cash equivalents and$2.2 million of trade accounts receivables.  Such conditions raise substantial doubt that our Company will be able tocontinue as a going concern for a reasonable period of time without receivingadditional funding.  These operating resultsoccurred while we were developing and attempting to commercialize andmanufacture products from an entirely new and unique technology. This businessplan required significant spending related to start-up costs and capitalexpenditures. These factors have placed a significant strain on our financialresources. The ultimate success of the Company depends on our ability tocontinue to reduce operating costs, generate higher revenue, achieve positivecash flow from continuing operations and achieve profitability.

 

Ourfuture success depends on our ability to continue reducing operating costs andultimately to generate higher revenue and attain profitability. We cannot becertain that additional capital, whether through selling additional debt orequity securities or obtaining a line of credit or other loan, will beavailable to us or, if available, will be on terms acceptable to us. If weissue additional securities to raise funds, these securities may have rights,preferences, or privileges senior to those of our common stock, and our currentstockholders may experience dilution.

 

**Contractual Obligations**

** **

The following table summarizes the Company’sobligations and commitments as of September 30, 2005:

 
| ** **                            | ** ** | **Payments Due by Period (in thousands)** | ** ** |
|---------------------------------------|------------|-------------------------------------------|------------|
| **Contractual  Cash Obligations (1)** | ** ** | **Total**                                 | ** ** | **Less Than  1 Year** | ** ** | **1-3 Years** | ** ** | **3-5 Years** | ** ** | **After 5 Years** | ** ** |
|                                  |       |                                      |       |   |   |   |   |   |   |   |   |
| Long-term debt  (2)                   |       | $                                         | 15,180     |   | $ | 1,204 |   | $ | 13,976 |   | $ | — |   | $ | — |   |
| Short-term debt  (3)                  |       | 237                                       |       | 237 |   | — |   | — |   | — |   |
| Capital lease  obligation (4)         |       | 108                                       |       | 33 |   | 75 |   | — |   | — |   |
| Operating leases  and rents           |       | 1,062                                     |       | 120 |   | 763 |   | 178 |   | 1 |   |
| Growell  settlement payable (5)       |       | 3,234                                     |       | 3,234 |   | — |   | — |   | — |   |
| Consulting  services payable          |       | 68                                        |       | 68 |   | — |   | — |   | — |   |
| Dongyang payable                      |       | 11                                        |       | 11 |   | — |   | — |   | — |   |
|                                  |       | $                                         | 19,900     |   | $ | 4,907 |   | $ | 14,814 |   | $ | 178 |   | $ | 1 |   |

 

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(1) Contractualcash obligations include Long-Term Debt comprised of $2,392 of SeniorConvertible Notes issued in 2004, $9,878 of Convertible Notes issued in 2005,and $2,910 of Kookmin Notes, Short-Term Debt comprised of $237 advancesreceived under factoring, loan, and security agreement, and future minimumlease payments under capital and operating leases, liabilities incurred fromsettlement with a former customer (Growell) and divesture of our equipmentmanufacturing business, and purchase commitments from a consultant.

(2) Doesnot include interest payments of  $1,869,un-amortized discounts for beneficial conversion feature and warrants, deferredissuance costs of $7,507 of our convertible notes.

(3) Doesnot include minimum interest and fee payments of $30.

(4) Includesimputed interest of $4.

(5) InJanuary 2005 Growell was acquired by a third party, and we****are currently innegotiations to settle this balance with the third party.****

 

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**OffBalance Sheet Arrangements**

 

An off-balance sheet arrangement is any transaction,agreement or other contractual arrangement involving an unconsolidated entityunder which a company has (1) made guarantees, (2) a retained or acontingent interest in transferred assets, (3) an obligation underderivative instruments classified as equity, or (4) any obligation arisingout of a material variable interest in an unconsolidated entity that providesfinancing, liquidity, market risk or credit risk support to the company, orthat engages in leasing, hedging, or research and development arrangements withthe company.

 

We have made no arrangements of the types described in any of thecategories that may have a material current or future effect on our financial condition,liquidity or results of operations.

 

**Item 3 –Quantitative and Qualitative Disclosures about Market Risk**

 

We are exposed to various markets risks in conducting the business of theCompany, and we anticipate that this exposure will increase as a result of ourplanned growth.  In an effort to mitigatelosses associated with these risks, we may at times enter into derivativefinancial instruments, although we have not historically done so.  These may take the form of forward salescontracts, option contracts, foreign currency exchange contracts, and interestrate swaps.  We have not, and do notintend to, engage in the practice of trading derivative securities for profit.

 

*InterestRates.*  We are exposedto market risks relating to changes in interest rates.  Some of the proceeds of our initial publicoffering are invested in short-term, interest-bearing, investment gradesecurities.  The value of thesesecurities will be subject to interest rate risk and could fall in value ifinterest rates rise.

 

*CommodityPrices. *We are exposedto price risk related to anticipated purchases of certain commodities used asraw materials by our businesses, including titanium and zirconium.  Although we do not currently enter intocommodity future, forward, and option contracts to manage the fluctuations inprices of anticipated purchases, we may enter into such contacts in the futureas our business grows and as our purchases of these raw materials increase.

 

*ForeignExchange Rates.*  As aresult of our operation of a manufacturing facility in South Korea, asubstantial portion of our costs will be denominated in the South Koreanwon.  Consequently, fluctuations in theexchange rates of the South Korean won to the U.S. dollar will affect our costsof goods sold and operating margins and could result in exchange losses.  Although we do not currently enter intoforeign exchange hedge transactions, we may do so in the future as our businessgrows.

 

**Item4 – Controls and Procedures**

** **

Evaluation of disclosure controls and procedures**.**  During the courseof the re-audit of our financial statements for the fiscal years ended December 31,2001, 2002, and 2003, it was determined that revenues from certain salesmade by the Company to various customers were either not recognizedin the proper periods or should not have been recognized as revenue.  It ****was also determined that compensation expenserelated to certain stock options granted in 2001 and 2002 were not calculatedin accordance with generally accepted accounting principles under APB Opinion No. 25,SFAS No. 123, and EITF 00-23.** **Thesedeterminations and the associated restatement of previously issued financialstatements in the Form 10-K for the year ended December 31, 2003,filed on November 10, 2004, determined that at the time of the subjecttransactions and the preparation of our financial statements for the relevantperiods, the Company’s disclosure controls and procedures (as definedin Rule 13a-15 under the Securities Exchange Act of 1934) wereineffective as of the period covered by the Form 10-K filed on November 10,2004 for purposes of ensuring that all information required to be disclosedby the Company was adequately accumulated and communicatedto the Company’s management at such time

 

Pursuant to Section 404of the Sarbanes-Oxley Act of 2002 (“SOX 404”), the SEC has adopted rules requiringpublic companies to include a report of management on the company’s internalcontrols over financial reporting in their annual reports on Form 10-K asof the Company’s fiscal year-ended December 31, 2004. SOX 404 alsorequires the public accounting firm auditing a public company’s financialstatements to attest and report on management’s assessment of the effectivenessof the company’s internal controls over financial reporting.  Although these requirements were firstapplicable to the Company’s annual report on Form 10-K for the fiscal yearended December 31, 2004, the Company did not comply with theserequirements for such fiscal year as described in the following paragraphs. ****Therefore,****the Company’s independent

 

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registered public accounting firm issued adisclaimer of opinion with respect to the Company’s internal control overfinancial reporting as of December 31, 2004, and such disclaimer was filedwith the Company’s amended Form 10-K filed on May 10, 2005.

 

During the first quarter of 2005, LiquidmetalTechnologies (the “Company”) carried out an evaluation, under the supervisionand with the participation of the Company’s management, including the Company’sChief Executive Officer and Chief Financial Officer, of the effectiveness ofthe design and operation of the Company’s disclosure controls and procedurespursuant to Rule 13a-15 under the Securities Exchange Act of 1934, as amended.  Based on that evaluation, the Chief ExecutiveOfficer and Chief Financial Officer have concluded that these disclosurecontrols and procedures were ineffective by reason of the material weaknessesmentioned in more detail below in timely alerting them to material informationrelating to the Company, including its consolidated subsidiaries, required tobe included in this quarterly report on Form 10-Q.

 

Update on Management’s Assessment of InternalControl Over Financial Reporting.****  The time********and resources committed to the restatement of priorperiods’ financial statements as aforementioned delayed management incommencing and completing its documentation, assessment and evaluation ofinternal control over financial reporting. Due to the issues described in the foregoing paragraph, as well aslimitation on financial and internal resources, management’s assessment of theeffectiveness of our internal control over financial reporting had beensubstantially delayed, which in turn prohibited the Company’s independentregistered public accounting firm, Stonefield Josephson Inc., in performing itsaudit of management’s assessment of the effectiveness of internal control overfinancial reporting pursuant to SOX 404.****

 

****The Company has been advised bythe SEC that the filing of this disclaimer does not comply with the SEC’s rules andregulations under Section 404, and the SEC has further advised us thatthis noncompliance has resulted in the Company being in violation of Section 13(a) underthe Securities Exchange Act of 1934 Section 13(a) establishes thegeneral requirement that public companies must file with the SEC, in accordancewith such rules and regulations as the SEC may prescribe, suchinformation, documents, and reports as the SEC may from time to time requirefor the protection of investors, including Form 10-Ks and 10-Qs.****

 

****During 2005, the Company has taken steps to complywith Section 404 as of December 31, 2005, including hiringindependent consulting firms, Assurance Consulting 3 in January 2005 andLogin Financial in July 2005, to assist the Company with its Section 404compliance and to identify and propose remedial actions to address and mitigatedeficiencies in internal controls over financial reporting.  In addition, beginning July 2005 theCompany has devoted additional internal resources including having an executivemanager lead the SOX 404 compliance effort on a full time.  However, the Company has been limited in theinvolvement of the outside firms due to cash flow limitations which has slowedtheir efforts in completing their assessment.****

 

****In the ongoing process of makingour assessment of internal control over financial reporting, management usedthe criteria established in “Internal Control - Integrated Framework” issued bythe Committee of Sponsoring Organizations of the Treadway Commission (COSO).Although our work is incomplete, of the various control procedures that we havedocumented, performed walkthroughs, and tested as of November 18, 2005,management has identified several control deficiencies, some of which have beendetermined to be material weaknesses in internal control over financialreporting as follows.****

 

****1. Lack of adequate segregation ofduties in the Company’s South Korean Operations in accounts receivableinvolving cash receipts, shipping, delivery of products and customer invoicereconciliations.****

 

2. Lack of adequate segregation of duties in the Company’s CoatingsDivision in Texas in order processing and invoicing.

 

****3. Lack of adequate controls anddocumentation in the Company’s South Korean Operations to evidence propercustomer invoicing and revenue recognition in the proper period.****

 

****4. Lack of progress in documenting,assessing and evaluating our internal controls in our South Korean Operationsevidenced by aforementioned deficiencies of which remediations will need to becompleted as of December 31, 2005.****

 

****5. Lack of  controls over internalaccess to the Company’s SAP system of reporting by unauthorized users.****

 

****6.  Manual performance of numerous procedures that could be automated usingcurrent reporting systems.****

 

****Beginning August 2005, management has allocateda consultant from Login Financial and an executive manager to our South Koreanoperations and is in the process of re-evaluating its controls as well asimplementing additional control procedures. Our evaluation will include revising our documentation, re-performingwalkthroughs and re-testing our internal controls.******** ********Inaddition, on November 14, 2005 management hired an additional “Big 4”third party consultant who is experienced in the SOX 404 effort for companiesoperating in South Korea to address and mitigate these material deficienciesduring the fourth quarter of 2005 and into 2006.  However,********as a result of these identified and unidentified materialweaknesses and considering********thenature of the Company’s operations having substantial presence in South Koreain addition to the Company’s US operations in Texas and California as well asthe amount of time, financial resources, complexity associated with Section 404compliance, limited****

**** ****

****35****

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**** ****

****financial resources of the Company and management’slate start in identifying and documenting it’s internal controls, the Company’sauditors have advised the Company and the Audit Committee of the Board ofDirectors that they believe it is highly unlikely that the Company’s managementwill be able to finish its testing and assessment of the Company’s internalcontrols in time for the auditors to begin their testing of management’s assertionsover internal controls by the end of fiscal year 2005 in accordance with thestandards of Section 404.****

 

****While management has devoted substantial efforts tothe SOX 404 compliance, management agrees that there is significant workremaining to be done in a limited amount of time and consequently, managementbelieves that the Company will not be able to complete its assessment of internalcontrols in accordance with SOX 404 requirements as of December 31, 2005.****

 

****In general, the SEC has broadauthority under the Securities Exchange Act of 1934 to instituteinvestigations, to seek injunctions, to seek monetary penalties, and tootherwise pursue enforcement actions for violations of Section 13(a),including a failure to file a Form 10-K or for the omission of necessarystatements in a Form 10-K. Therefore, a violation under Section 404 could potentially subjecta company to these same investigations and penalties. Section 404 is arelatively new legal requirement, and there is very little precedent establishingthe consequences or appropriate response to a public company’s failure tocomply with Section 404. Accordingly, although the Company has discussed its Section 404noncompliance for 2004 with the SEC, the Company cannot predict what action, ifany, the SEC may take against the Company as a result of a failure to becompliant with its obligations under Section 404.****

 

Changes in internalcontrols. The Company has made significant changes to theinternal controls over financial reporting of deficiencies noted during thefirst quarter of 2005.  T****he Company hasidentified and remediated the following deficiencies noted previously as of November 2005.****

 

****1. Lack of adequate segregation ofduties in accounts payable and accounts receivable involving cash receipts anddeposits, bank reconciliations, cash disbursements, purchasing, and accountsreceivable reconciliations.  We haverotated responsibilities of employees and added secondary reviews oftransactions and reconciliations.****

 

****2. Lack of adequate controls andmonitoring of payroll and payroll processing, currently outsourced to a thirdparty provider.  We have added additionalreview procedures and secondary review and approval to our payroll processes.  We have also changed our third party providerwith a provider that performs regular internal controls reviews andtesting.  The results of such testing isreviewed by management to ensure the provider has adequate internal controls.****

 

****3. Lack of documentation toevidence reviews of certain reconciliations; lack of documentation ofauthorization of transactions.  We haveadded additional review procedures and secondary reviews of reconciliations andauthorizations of transactions.****

 

****4. Managements’ documentation of the Company’s internalcontrols were not sufficient.  We havecompleted our initial documentation of our internal controls and we arecurrently identifying and assessing deficiencies noted to date.****

 

The Company is currently in the process ofre-evaluating its internal controls pursuant to SOX 404 (see Item 4 Controlsand Procedures, Evaluations of disclosure controls and procedures).

 

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### **PART II**

**OTHERINFORMATION**

 

**Item 1 – Legal Proceedings**

 

There were no materialdevelopments in our legal proceedings during the current quarter.

 

**Item2 – Unregistered Sales of Equity Securities and Use of Proceeds**

 

On August 9, 2005, we completed a privateplacement (the “Private Placement”) of $9.9 million in principal amount of new7% Convertible Secured Promissory Notes due August 2007 (the “2005 SeniorNotes”).  The issuance consisted of $5.0million cash, exchange of $1.3 million in principal amount of previously issued10% Senior Secured Notes Due July 29, 2005 (the “July 2005 Notes”),the exchange of $3.0 million in principal amount of previously issued 10%Convertible Unsecured Notes Due June 2006 (the “June 2006 Notes”),satisfaction of accrued interest and late registration fees in the amount of $0.6million on the previously issued July 2005 Notes, and satisfaction ofaccrued interest of $9 thousand previously issued June 2006 Notes.  The 2005 Senior Notes were issued pursuant toa Securities Purchase Agreement dated effective as of August 2, 2005 amongthe Company, the purchasers of the 2005 Senior Notes, and the holders ofpreviously issued July 2005 Notes and June 2006 Notes of the Companydue June 2006.

 

The 2005 Senior Notes are convertible into shares ofthe Company’s common stock at $2.00 per share pursuant to an Amended andRestated Security Agreement.  The 2005Senior Notes are secured by substantially all assets of the Company and rank senior to all other obligations ofthe Company, other than the Company’s loan with Kookmin Bank of South Korea (orany refinancing of such loan), the 6% Senior Secured Notes Due July 29,2007 (“July 2007Notes”), purchase money asset financing, trade creditors in the ordinary courseof business, and any inventory or receivables-based credit facility that theCompany may obtain in the future, provided that the amount of the creditfacility does not exceed 50% of eligible inventory and 80% of eligiblereceivables. The 2005 Senior Notes will automatically convert into common stockif the Company’s common stock has an average closing price of more than $5.00per share during 30 consecutive trading days.

 

The Company also issued warrants to the purchasersof the 2005 Senior Notes and placement agents giving them the right to purchaseup to 2,469,470 and 414,495 shares of Company common stock, respectively, withan exercise price of  $2.00 pershare.  The Warrants will expire on August 2,2010.

 

Inconnection with the transaction, the Company, all purchasers of the 2005 SeniorNotes, and all holders of previously issued notes entered into a single Amendedand Restated Registration Rights Agreement that replaces the prior registrationrights agreements entered into by the Company with the various noteholders.Under the Amended and Restated Registration Rights Agreement, the Company isrequired to file a resale registration statement for the shares underlying the2005 Senior Notes and July 2007 Notes and warrants within ninety (90) daysof the closing of the 2005 Senior Notes. The Company is required to cause thisregistration statement to become effective within 60 days after the Company receivesthe first written comments on the registration statement from the SEC, or ifthe SEC notifies the Company that it will not review the registrationstatement, within five days after such notification. The Company will besubject to certain monetary penalties, as set forth in the registration rightsagreement, if the registration statement is not filed or does not becomeeffective on a timely basis.

 

As of September 30,2005, we have used $1.0 million of the net proceeds from the Private Placementfor working capital purposes and used $2.6 million to repay principal andaccrued interest from the previously issued notes.

 

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**Item 6 – Exhibits and Reports on Form 8-K**

 

(a)                                  Exhibits

 

The following documents arefiled as an exhibit to this Report:

 
| **Exhibit  Number** | ** ** | **Description of Document**                                                                                                            |
|---------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                                                   |
| 31.1                |       | Certification of the President and Chief Executive  Officer, John Kang, as required by Section 3.02 of Sarbane-Oxley Act of  2002 |
|                |       |                                                                                                                                   |
| 31.2                |       | Certification of Chief Financial Officer, Young  Ham, as required by Section 3.02 of Sarbane-Oxley Act of 2002                    |
|                |       |                                                                                                                                   |
| 32.1                |       | Certification of Principal Executive Officer, John  Kang, as required by Section 9.06 of Sarbane-Oxley Act of 2002                |
|                |       |                                                                                                                                   |
| 32.2                |       | Certification of Chief Financial Officer, Young  Ham, as required by Section 9.06 of Sarbane-Oxley Act of 2002                    |

 

(b)                                 Reportson Form 8-K

 

-Filed April 15,2005

-Filed May 10, 2005

-Filed June 16, 2005

-Filed August 9,2005

-Filed August 22,2005

-Filed November 14,2005

-Filed November 30, 2005

 

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**SIGNATURES**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned hereunto dulyauthorized.

 
|                          | LIQUIDMETAL TECHNOLOGIES                         |
|-------------------------------|--------------------------------------------------|
|                          | (Registrant)                                     |
|                          |                                             |
| Date: November 30,  2005 | /s/ John Kang                                    |   |
|                          | John Kang                                        |
|                          | Chairman, President and  Chief Executive Officer |
|                          | (Principal Executive  Officer)                   |
|                          |                                             |
| Date: November 30,  2005 | /s/ Young Ham                                    |   |
|                          | Young  Ham                                       |
|                          | Chief Financial Officer                          |
|                          | (Principal Financial  and Accounting Officer)    |

 

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