Table of Contents

 

 

 

**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 

**(MarkOne)**

 
| **x** | ** ** | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|-------|------------|--------------------------------------------------------------------------------------------------------|

 

**For the quarterly period ended June 30, 2010**

 

**OR**

 
| **o** | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|-------|------------|---------------------------------------------------------------------------------------------------------|

 

**For the transition period from                to                 **

 

**Commission file number: 001-34463**

 

**A123Systems, Inc.**

(Exactname of registrant as specified in its charter)

 

| **Delaware**                                                                                                  | ** ** | **04-3583876**                          |
|---------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------|
| (State  or other jurisdiction of incorporation or

organization)                                              |       | (I.R.S.  Employer

Identification  No.) |
|                                                                                                          |       |                                    |
| **A123 Systems, Inc.**

**Arsenal on the Charles**

**321 Arsenal Street**

**Watertown, Massachusetts** | ** ** | **02472**                               |
| (Address  of principal executive offices)                                                                     |       | (Zip  Code)                             |

 

**617-778-5700**

(Registrant’stelephone number, including area code)

 

 

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

 

Indicate by check markwhether the registrant: (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the Registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes x  No o

 

Indicate by check markwhether the registrant has submitted electronically and posted on its corporateWeb site, if any, every Interactive Data File required to be submitted andposted pursuant to Rule 405 of Regulation S-T (§232.405 of thischapter) during the preceding 12 months (or for such shorter period thatthe registrant was required to submit and post such files). Yes o  No o

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, anon-accelerated filer, or a smaller reporting company. See the definitions of “largeaccelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2of the Exchange Act. (Check one):

 
| Large  accelerated filer  o               |   | Accelerated  filer  o         |
|------------------------------------------------|--------|------------------------------------|
|                                           |   |                               |
| Non-accelerated  filer  x                 |   | Smaller  reporting company  o |
| (Do  not check if a smaller reporting company) |   |                               |

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act). Yes o  No x

 

As of August 9, 2010,there were 104,739,660 shares of the registrant’s Common Stock, par value $.001per share, outstanding.

 

 

 

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**A123 Systems, Inc.Quarterly Report on Form 10-QFor the Quarterly Period Ended June 30, 2010**

 

**INDEX**

 
| ** **                                                                                                                            | **PAGE**   |
|---------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                                                            | **NUMBER** |
| **PART I.  FINANCIAL INFORMATION**                                                                                               | 1          |
|                                                                                                                                  |       |
| ITEM 1: Financial Statements (Unaudited)                                                                                              | 1          |
| Condensed Consolidated Balance Sheets                                                                                                 | 1          |
| Condensed Consolidated Statements of Operations                                                                                       | 2          |
| Condensed Consolidated Statements of Stockholders’  (Deficit) Equity                                                             | 3          |
| Condensed Consolidated Statements of Cash Flows                                                                                       | 4          |
| Notes to Condensed Consolidated Financial Statements                                                                                  | 5          |
|                                                                                                                                  |       |
| ITEM 2:  Management’s Discussion and Analysis of Financial Condition and Results of  Operations                                  | 17         |
| ITEM 3: Quantitative and Qualitative Disclosures about  Market Risk                                                                   | 30         |
| ITEM 4T: Controls and Procedures                                                                                                      | 31         |
|                                                                                                                                  |       |
| **PART II.  OTHER INFORMATION**                                                                                                  | 31         |
| ITEM  1: Legal Proceedings                                                                                                            | 31         |
| ITEM  1A: Risk Factors                                                                                                                | 32         |
| ITEM 2: Unregistered Sales of Equity Securities and  Use of Proceeds                                                                  | 53         |
| ITEM 6:  Exhibits                                                                                                                     | 53         |
| Signatures                                                                                                                            | 54         |
|                                                                                                                                  |       |
| EX-10.1 Lease Agreement, dated May 19, 2010,  by and between Boston Properties Limited Partnership and the Registrant.           |
| EX-10.2  Form of Restricted Stock Unit Agreement under 2009 Stock Incentive Plan.                                                |       |
| EX-10.3 Supply Agreement, dated June 23,  2010, by and between ConocoPhillips Specialty Products, Inc. and the  Registrant. |
| EX-31.1  CEO Certification pursuant to Section 302 of the Sarbanes-Oxley Act                                                     |       |
| EX-31.2  CFO Certification pursuant to Section 302 of the Sarbanes-Oxley Act                                                     |       |
| EX-32.1  CEO Certification pursuant to Section 906 of the Sarbanes-Oxley Act                                                     |       |
| EX-32.2  CFO Certification pursuant to Section 906 of the Sarbanes-Oxley Act                                                     |       |

 

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Tableof Contents

 

**Part I.Financial Information**

 

**Item 1.Financial Statements**

 

**A123Systems, Inc.**

**CondensedConsolidated Balance Sheets**

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

**(Unaudited)**

 
| ** **                                                                                                                                                                                    | ** ** | **December 31,** | ** ** | **June 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-------------------|------------|
| ** **                                                                                                                                                                                    | ** ** | **2009**              | ** ** | **2010**          | ** ** |
|                                                                                                                                                                                          |       |                  |       |              |       |
| **ASSETS**                                                                                                                                                                                    | ** ** | ** **            | ** ** | ** **        | ** ** |
| Current assets:                                                                                                                                                                               |       |                  |       |              |       |
| Cash and cash equivalents                                                                                                                                                                     |       | $                     | 457,122    |              | $          | 353,326 |   |
| Restricted cash                                                                                                                                                                               |       | 1,742                 |       | 674               |       |
| Accounts receivable, net                                                                                                                                                                      |       | 17,718                |       | 18,332            |       |
| Inventory                                                                                                                                                                                     |       | 37,438                |       | 41,688            |       |
| Prepaid expenses and other current assets                                                                                                                                                     |       | 8,895                 |       | 7,648             |       |
| Total current assets                                                                                                                                                                          |       | 522,915               |       | 421,668           |       |
|                                                                                                                                                                                          |       |                  |       |              |       |
| Property, plant and equipment, net                                                                                                                                                            |       | 71,662                |       | 116,571           |       |
| Goodwill                                                                                                                                                                                      |       | 9,581                 |       | 9,581             |       |
| Intangible assets, net                                                                                                                                                                        |       | 1,254                 |       | 730               |       |
| Deposits and other assets                                                                                                                                                                     |       | 11,698                |       | 22,818            |       |
| Restricted cash                                                                                                                                                                               |       | 980                   |       | 1,987             |       |
| Investment                                                                                                                                                                                    |       | —                |       | 20,495            |       |
| Total assets                                                                                                                                                                                  |       | $                     | 618,090    |              | $          | 593,850 |   |
|                                                                                                                                                                                          |       |                  |       |              |       |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                                                                                | ** ** | ** **            | ** ** | ** **        | ** ** |
| Current liabilities:                                                                                                                                                                          |       |                  |       |              |       |
| Revolving credit lines                                                                                                                                                                        |       | $                     | 8,000      |              | $          | 8,000 |   |
| Current portion of long-term debt                                                                                                                                                             |       | 6,456                 |       | 5,153             |       |
| Current portion of capital lease obligations                                                                                                                                                  |       | 411                   |       | 766               |       |
| Accounts payable                                                                                                                                                                              |       | 16,475                |       | 29,595            |       |
| Accrued expenses                                                                                                                                                                              |       | 11,689                |       | 29,946            |       |
| Other current liabilities                                                                                                                                                                     |       | 1,859                 |       | 1,841             |       |
| Deferred revenue                                                                                                                                                                              |       | 7,543                 |       | 2,059             |       |
| Deferred rent                                                                                                                                                                                 |       | 58                    |       | 134               |       |
| Total current liabilities                                                                                                                                                                     |       | 52,491                |       | 77,494            |       |
|                                                                                                                                                                                          |       |                  |       |              |       |
| Long-term debt, net of current portion                                                                                                                                                        |       | 7,438                 |       | 4,797             |       |
| Capital lease obligations, net of current portion                                                                                                                                             |       | 193                   |       | 795               |       |
| Deferred revenue, net of current portion                                                                                                                                                      |       | 26,142                |       | 25,347            |       |
| Deferred rent, net of current portion                                                                                                                                                         |       | 630                   |       | 1,210             |       |
| Other long-term liabilities                                                                                                                                                                   |       | 2,866                 |       | 5,022             |       |
| Total liabilities                                                                                                                                                                             |       | 89,760                |       | 114,665           |       |
| ** **                                                                                                                                                                                    | ** ** | ** **            | ** ** | ** **        | ** ** |
| Commitments and contingencies (Note 7)                                                                                                                                                        | ** ** | ** **            | ** ** | ** **        | ** ** |
|                                                                                                                                                                                          |       |                  |       |              |       |
| Stockholders’ equity:                                                                                                                                                                    |       |                  |       |              |       |
| Preferred stock, $0.001 par value—5,000,000 shares  authorized; 0 shares issued and outstanding at December 31, 2009 and  June 30, 2010                                        |       | —                |       | —            |       |
| Common stock, $0.001 par value—250,000,000 shares  authorized; 102,606,088 and 104,633,868 shares issued and outstanding at  December 31, 2009 and June 30, 2010, respectively |       | 103                   |       | 105               |       |
| Additional paid-in capital                                                                                                                                                                    |       | 767,694               |       | 781,681           |       |
| Accumulated deficit                                                                                                                                                                           |       | (238,668              | )          | (301,911          | )          |
| Accumulated other comprehensive loss                                                                                                                                                          |       | (909                  | )          | (654              | )          |
| Total A123 Systems, Inc. stockholders’ equity                                                                                                                                       |       | 528,220               |       | 479,221           |       |
| Noncontrolling interest                                                                                                                                                                       |       | 110                   |       | (36               | )          |
| Total stockholders’ equity                                                                                                                                                               |       | 528,330               |       | 479,185           |       |
|                                                                                                                                                                                          |       |                  |       |              |       |
| Total liabilities and stockholders’ equity                                                                                                                                               |       | $                     | 618,090    |              | $          | 593,850 |   |

 

Seenotes to unaudited condensed consolidated financial statements.

 

1

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**A123Systems, Inc.**

**CondensedConsolidated Statements of Operations**

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

**(Unaudited)**

** **
| ** **                                                                   | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                   | ** ** | **2009**                              | ** ** | **2010**                            | ** ** | **2009** | ** ** | **2010** | ** ** |
|                                                                         |       |                                  |       |                                |       |   |   |   |   |
| Revenue:                                                                     | ** ** | ** **                            |       |                                |       |   |   |   |   |
| Product                                                                      |       | $                                     | 16,517     |                                | $          | 15,558 |   | $ | 36,638 |   | $ | 35,332 |   |
| Services                                                                     |       | 3,185                                 |       | 7,050                               |       | 6,284 |   | 11,744 |   |
| Total revenue                                                                |       | 19,702                                |       | 22,608                              |       | 42,922 |   | 47,076 |   |
|                                                                         |       |                                  |       |                                |       |   |   |   |   |
| Cost of revenue:                                                             |       |                                  |       |                                |       |   |   |   |   |
| Product                                                                      |       | 19,616                                |       | 18,977                              |       | 39,186 |   | 41,331 |   |
| Services                                                                     |       | 2,661                                 |       | 6,580                               |       | 4,505 |   | 10,735 |   |
| Total cost of revenue                                                        |       | 22,277                                |       | 25,557                              |       | 43,691 |   | 52,066 |   |
| Gross loss                                                                   |       | (2,575                                | )          | (2,949                              | )          | (769 | ) | (4,990 | ) |
|                                                                         |       |                                  |       |                                |       |   |   |   |   |
| Operating expenses:                                                          |       |                                  |       |                                |       |   |   |   |   |
| Research, development and engineering                                        |       | 11,587                                |       | 13,832                              |       | 22,814 |   | 27,948 |   |
| Sales and marketing                                                          |       | 2,245                                 |       | 3,366                               |       | 4,227 |   | 6,166 |   |
| General and administrative                                                   |       | 5,990                                 |       | 8,804                               |       | 12,273 |   | 17,044 |   |
| Production start-up                                                          |       | 179                                   |       | 3,606                               |       | 179 |   | 5,417 |   |
| Total operating expenses                                                     |       | 20,001                                |       | 29,608                              |       | 39,493 |   | 56,575 |   |
| Operating loss                                                               |       | (22,576                               | )          | (32,557                             | )          | (40,262 | ) | (61,565 | ) |
|                                                                         |       |                                  |       |                                |       |   |   |   |   |
| Other income (expense):                                                      |       |                                  |       |                                |       |   |   |   |   |
| Interest expense, net                                                        |       | (292                                  | )          | (372                                | )          | (510 | ) | (590 | ) |
| Gain (loss) on foreign exchange                                              |       | 673                                   |       | (1,226                              | )          | (115 | ) | (981 | ) |
| Unrealized loss on preferred stock warrant  liability                        |       | (22                                   | )          | —                              |       | (70 | ) | — |   |
| Other income (expense), net                                                  |       | 359                                   |       | (1,598                              | )          | (695 | ) | (1,571 | ) |
|                                                                         |       |                                  |       |                                |       |   |   |   |   |
| Loss from operations, before tax                                             |       | (22,217                               | )          | (34,155                             | )          | (40,957 | ) | (63,136 | ) |
| Provision for income taxes                                                   |       | 123                                   |       | 132                                 |       | 267 |   | 253 |   |
| Net loss                                                                     |       | (22,340                               | )          | (34,287                             | )          | (41,224 | ) | (63,389 | ) |
| Less: Net loss attributable to the noncontrolling  interest                  |       | 427                                   |       | 69                                  |       | 574 |   | 146 |   |
| Net loss attributable to A123 Systems, Inc.                             |       | $                                     | (21,913    | )                                   | $          | (34,218 | ) | $ | (40,650 | ) | $ | (63,243 | ) |
| Accretion to preferred stock                                                 |       | (17                                   | )          | —                              |       | (28 | ) | — |   |
| Net loss attributable to A123 Systems, Inc.  common stockholders        |       | $                                     | (21,930    | )                                   | $          | (34,218 | ) | $ | (40,678 | ) | $ | (63,243 | ) |
|                                                                         |       |                                  |       |                                |       |   |   |   |   |
| Net loss per share attributable to common  stockholders - basic and diluted: |       | $                                     | (2.36      | )                                   | $          | (0.33 | ) | $ | (4.39 | ) | $ | (0.61 | ) |
| Weighted average number of common shares  outstanding - basic and diluted    |       | 9,277                                 |       | 104,333                             |       | 9,272 |   | 103,825 |   |

 

See notes to unauditedcondensed consolidated financial statements.

 

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**A123 Systems, Inc.**

**Condensed Consolidated Statements of Stockholders’(Deficit) Equity**

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

**(Unaudited)**

 
|                                                                     |   | **Series B-1  Convertible  Preferred Stock, $0.001  Par Value** |   | **Common  Stock, $0.001  Par Value** |   | **Additional  Paid-in** |    | **Accumulated** |   | **Accumulated  Other  Comprehensive** |   | **Total  Stockholders’  (Deficit)** |    | **Noncontrolling** |   | **Comprehensive** |     |
|--------------------------------------------------------------------------|--------|----------------------------------------------------------------------|--------|--------------------------------------|--------|-------------------------|---------|-----------------|--------|---------------------------------------|--------|------------------------------------------|---------|--------------------|--------|-------------------|----------|
|                                                                     |   | **Shares**                                                           |   | **Amount**                           |   | **Shares**              |    | **Amount**      |   | **Capital**                           |   | **Deficit**                              |    | **Loss**           |   | **Equity**        |     | **Interest** |   | **Loss** |   |
|                                                                     |   |                                                                 |   |                                 |   |                    |    |            |   |                                  |   |                                     |    |               |   |              |     |   |   |   |   |
| BALANCE - January 1, 2009                                           |   | 1,493                                                                |   | $                                    | 1      |                    | 7,662   |            | $      | 8                                     |   | $                                        | 19,649  |               | $      | (152,889          | )        | $ | (197 | ) | $ | (133,428 | ) | $ | 871 |   |   |   |
| Accretion of redeemable convertible preferred  stock to redemption value |   | —                                                               |   | —                               |   | —                  |    | —          |   | (28                                   | )      | —                                   |    | —             |   | (28               | )        | — |   |   |   |
| Stock-based compensation                                                 |   | —                                                               |   | —                               |   | —                  |    | —          |   | 4,034                                 |   | —                                   |    | —             |   | 4,034             |     | — |   |   |   |
| Issuance of common stock                                                 |   | —                                                               |   | —                               |   | 35                      |    | —          |   | 24                                    |   | —                                   |    | —             |   | 24                |     | — |   |   |   |
| Comprehensive loss:                                                      |   |                                                                 |   |                                 |   |                    |    |            |   |                                  |   |                                     |    |               |   |              |     |   |   |   |   |
| Net loss                                                                 |   | —                                                               |   | —                               |   | —                  |    | —          |   | —                                |   | (40,650                                  | )       | —             |   | (40,650           | )        | (574 | ) | $ | (41,224 | ) |
| Foreign currency translation adjustment                                  |   | —                                                               |   | —                               |   | —                  |    | —          |   | —                                |   | —                                   |    | (271               | )      | (271              | )        | 48 |   | (223 | ) |
| Total comprehensive loss                                                 |   | —                                                               |   | —                               |   | —                  |    | —          |   | —                                |   | —                                   |    | —             |   | —            |     | — |   | $ | (41,447 | ) |
| BALANCE - June 30, 2009                                             |   | 1,493                                                                |   | $                                    | 1      |                    | 7,697   |            | $      | 8                                     |   | $                                        | 23,679  |               | $      | (193,539          | )        | $ | (468 | ) | $ | (170,319 | ) | $ | 345 |   |   |   |
|                                                                     |   |                                                                 |   |                                 |   |                    |    |            |   |                                  |   |                                     |    |               |   |              |     |   |   |   |   |
| BALANCE - January 1, 2010                                           |   | —                                                               |   | $                                    | — |                    |    | 102,606         |   | $                                     | 103    |                                     | $       | 767,694            |   | $                 | (238,668 | ) | $ | (909 | ) | $ | 528,220 |   | $ | 110 |   |   |   |
| Stock-based compensation                                                 |   | —                                                               |   | —                               |   | —                  |    | —          |   | 5,133                                 |   | —                                   |    | —             |   | 5,133             |     | — |   |   |   |
| Issuance of common stock                                                 |   | —                                                               |   | —                               |   | 2,028                   |    | 2               |   | 8,854                                 |   | —                                   |    | —             |   | 8,856             |     | — |   |   |   |
| Comprehensive loss:                                                      |   |                                                                 |   |                                 |   |                    |    |            |   |                                  |   |                                     |    |               |   |              |     |   |   |   |   |
| Net loss                                                                 |   | —                                                               |   | —                               |   | —                  |    | —          |   | —                                |   | (63,243                                  | )       | —             |   | (63,243           | )        | (146 | ) | $ | (63,389 | ) |
| Foreign currency translation adjustment                                  |   | —                                                               |   | —                               |   | —                  |    | —          |   | —                                |   | —                                   |    | 255                |   | 255               |     | — |   | 255 |   |
| Total comprehensive loss                                                 |   | —                                                               |   | —                               |   | —                  |    | —          |   | —                                |   | —                                   |    | —             |   | —            |     | — |   | $ | (63,134 | ) |
| BALANCE - June 30, 2010                                             |   | —                                                               |   | $                                    | — |                    | 104,634 |            | $      | 105                                   |   | $                                        | 781,681 |               | $      | (301,911          | )        | $ | (654 | ) | $ | 479,221 |   | $ | (36 | ) |   |   |
|                                                                          |        |                                                                      |        |                                      |        |                         |         |                 |        |                                       |        |                                          |         |                    |        |                   |          |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

See notes to unauditedcondensed consolidated financial statements.

 

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**A123 Systems, Inc.**

**CondensedConsolidated Statements of Cash Flows**

**(in thousands)**

**(Unaudited)**

 
| ** **                                                                   | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                   | ** ** | **June 30,**    | ** ** |
| ** **                                                                   | ** ** | **2009**             | ** ** | **2010** | ** ** |
|                                                                         |       |                 |       |   |   |
| Cash flows from operating activities:                                        |       |                 |       |   |   |
| Net loss                                                                     |       | $                    | (41,224    | ) | $ | (63,389 | ) |
| Adjustments to reconcile net loss to net cash used  in operating activities: |       |                 |       |   |   |
| Depreciation and amortization                                                |       | 6,304                |       | 7,758 |   |
| Noncash rent                                                                 |       | 37                   |       | 656 |   |
| Noncash foreign exchange (gain) loss on  intercompany loan                   |       | (20                  | )          | 599 |   |
| Impairment of long-lived and intangible assets                               |       | —               |       | 530 |   |
| Unrealized loss on preferred stock warrant  liability                        |       | 70                   |       | — |   |
| Loss on disposal of property and equipment                                   |       | 9                    |       | 119 |   |
| Amortization of debt issuance costs and noncash interest  expense            |       | 42                   |       | — |   |
| Stock-based compensation                                                     |       | 4,034                |       | 5,133 |   |
| Changes in current assets and liabilities:                                   |       |                 |       |   |   |
| Accounts receivable                                                          |       | 839                  |       | (2,448 | ) |
| Inventory                                                                    |       | (6,093               | )          | (4,540 | ) |
| Prepaid expenses and other assets                                            |       | 2,291                |       | (1,735 | ) |
| Accounts payable                                                             |       | (8,699               | )          | 7,459 |   |
| Accrued expenses                                                             |       | 677                  |       | (2,369 | ) |
| Deferred revenue                                                             |       | (1,030               | )          | (4,459 | ) |
| Other liabilities                                                            |       | (11                  | )          | 963 |   |
| Net cash used in operating activities                                        |       | (42,774              | )          | (55,723 | ) |
|                                                                         |       |                 |       |   |   |
| Cash flows from investing activities:                                        |       |                 |       |   |   |
| (Increase) decrease in restricted cash                                       |       | (2,245               | )          | 58 |   |
| Purchases of property, plant and equipment                                   |       | (17,220              | )          | (60,987 | ) |
| Proceeds from sale of property and equipment                                 |       | 13                   |       | — |   |
| Proceeds from government grant                                               |       | —               |       | 26,319 |   |
| Purchase of investment                                                       |       | —               |       | (13,000 | ) |
| Net cash used in investing activities                                        |       | (19,452              | )          | (47,610 | ) |
|                                                                         |       |                 |       |   |   |
| Cash flows from financing activities:                                        |       |                 |       |   |   |
| Deferred offering costs                                                      |       | (756                 | )          | — |   |
| Proceeds from government grant                                               |       | 3,000                |       | 1,250 |   |
| Proceeds from exercise of stock options                                      |       | 24                   |       | 2,259 |   |
| Proceeds from issuance of long-term debt                                     |       | 7,585                |       | — |   |
| Payments on long-term debt                                                   |       | (2,648               | )          | (3,955 | ) |
| Payments on capital lease obligations                                        |       | (278                 | )          | (278 | ) |
| Net proceeds from issuance of redeemable  convertible preferred stock        |       | 99,590               |       | — |   |
| Net cash provided by (used in) financing  activities                         |       | 106,517              |       | (724 | ) |
|                                                                         |       |                 |       |   |   |
| Effect of foreign exchange rates on cash and cash  equivalents               |       | 76                   |       | 261 |   |
| Net increase (decrease) in cash and cash  equivalents                        |       | 44,367               |       | (103,796 | ) |
| Cash and cash equivalents at beginning of period                             |       | 70,510               |       | 457,122 |   |
| Cash and cash equivalents at end of period                                   |       | $                    | 114,877    |   | $ | 353,326 |   |
| Supplemental cash flow information - cash paid for  interest                 |       | $                    | 551        |   | $ | 485 |   |
| Noncash investing and financing activities:                                  |       |                 |       |   |   |
| Issuance of note for consulting services                                     |       | $                    | 830        |   | $ | — |   |
| Purchase of equipment under capital leases                                   |       | $                    | 423        |   | $ | 1,235 |   |
| Equipment purchases included in accounts payable  and accrued expenses       |       | $                    | 1,423      |   | $ | 28,088 |   |
| Issuance of common stock for investment                                      |       | $                    | —     |   | $ | 7,495 |   |

 

Seenotes to unaudited condensed consolidated financial statements.

 

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**A123 Systems, Inc.**

**Notes toCondensed Consolidated Financial Statements**

**(Unaudited)**

 

**1. Natureof the Business, Basis of Presentation, and Significant Accounting Policies**

 

A123 Systems, Inc. (the‘‘Company’’) was incorporated in Delaware on October 19, 2001 and has itscorporate offices in Watertown, Massachusetts. The Company designs, develops,manufactures and sells advanced rechargeable lithium-ion batteries and batterysystems and provides services to government agencies and commercial customers.

 

***Basis ofPresentation***—The accompanying condensed consolidated financialstatements and the related disclosures as of June 30, 2010 and for thethree and six months ended June 30, 2009 and 2010 are unaudited and havebeen prepared in accordance with accounting principles generally accepted inthe United States of America (“GAAP”) and the applicable rules andregulations of the Securities and Exchange Commission (‘‘SEC’’) for interimfinancial information. Accordingly, they do not include all of the informationand notes required by GAAP for complete financial statements.  These interim condensed consolidatedfinancial statements should be read in conjunction with the consolidatedfinancial statements and notes thereto contained in the Company’s Annual Reporton Form 10-K filed with the SEC on March 15, 2010.  The December 31, 2009 condensedconsolidated balance sheet included herein was derived from the auditedfinancial statements as of that date, but does not include all disclosures,including notes, required by GAAP for complete financial statements.

 

The unaudited interimcondensed consolidated financial statements have been prepared on the samebasis as the audited consolidated financial statements and, in the opinion ofmanagement, reflect all adjustments of a normal recurring nature considerednecessary to present fairly the Company’s financial position as ofJune 30, 2010 and results of its operations for the three and six monthsended June 30, 2009 and 2010, and its cash flows for the six months endedJune 30, 2009 and 2010. The interim results for the three and six monthsended June 30, 2010 are not necessarily indicative of the results that maybe expected for the year ending December 31, 2010.

 

***Principlesof Consolidation***—The accompanying condensed consolidated financialstatements include the accounts of the Company and its subsidiaries. Allinter-company balances and transactions have been eliminated in consolidation.The Company’s investment in a variable interest entity (‘‘VIE’’), of which theCompany is the primary beneficiary, is consolidated.

 

***Use ofEstimates***—The preparation of condensed consolidated financialstatements in conformity with GAAP requires management to make estimates andassumptions that affect the reported amounts of assets, liabilities, revenue,expense and related disclosures. The Company bases estimates and assumptions onhistorical experience and on various other factors that it believes to bereasonable under the circumstances. The Company evaluates its estimates andassumptions on an ongoing basis. The Company’s actual results may differ fromthese estimates under different assumptions or conditions.

 

***Revisions to Amounts Previously Presented***—Certain priorperiod amounts have been reclassified to conform to the current periodpresentation.  Production start-upexpenses for the three and six months ended June 30, 2009, relating to theCompany’s facility in Livonia, Michigan, have been reclassified from general and administrative expenses toproduction start-up expenses in the condensed consolidated statements ofoperations.

 

***Government Grants***—The Companyrecognizes government grants when there is reasonable assurance that theCompany will comply with the conditions attached to the grant arrangement andthe grant will be received. Government grants are recognized in the condensedconsolidated statements of operations on a systematic basis over the periods inwhich the Company recognizes the related costs for which the government grantis intended to compensate. Specifically, when government grants are related toreimbursements for cost of revenues or operating expenses, the governmentgrants are recognized as a reduction of the related expense in the condensedconsolidated statements of operations. For government grants related toreimbursements of capital expenditures, the government grants are recognized asa reduction of the basis of the asset and recognized in the condensedconsolidated statements of operations over the estimated useful life of thedepreciable asset as reduced depreciation expense.

 

The Company records government grants receivable in the condensedconsolidated balance sheets in prepaid expenses and other current assets or depositsand other assets, depending on when the amounts are expected to be receivedfrom the government agency. Proceeds received from government grants prior toexpenditures being incurred are recorded as restricted cash and other currentliabilities or other long-term liabilities, depending on when the Companyexpects to use the proceeds.

 

TheCompany classifies in the condensed consolidated statements of cash flows grantproceeds received in advance of spending for qualified expenditures as a cashflow from financing activities, as the proceeds are used to assist in fundingfuture expenditures. Grant proceeds received as reimbursements for capitalexpenditures previously incurred are classified in cash flows from investingactivities and grant proceeds received as reimbursements for operatingexpenditures previously incurred are classified in cash flows from operatingactivities.

 

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***Revenue Recognition***—The Companyrecognizes revenue from the sale of products and delivery of services,including governmental contracts. Revenue is recognized when all of thefollowing criteria are met: persuasive evidence of an arrangement exists,delivery has occurred or services have been provided, the price to the buyer isfixed or determinable, and collectability is reasonably assured. If salesarrangements contain multiple elements, the Company evaluates the agreements todetermine if separate units of accounting exist within the arrangement. Ifseparate units of accounting exist within an arrangement, the Company allocatesrevenue to each element based on the relative selling price of each of theelements.

 

EffectiveJanuary 1, 2010, the Company early adopted the new accounting standardsfor revenue recognition related to multiple-deliverable revenue arrangements.Under the new authoritative guidance, each deliverable within amultiple-element revenue arrangement is accounted for as a separate unit ofaccounting if both of the following criteria are met: (1) the delivereditem or items have value to the customer on a standalone basis and (2) foran arrangement that includes a general right of return relative to the delivereditem(s), delivery or performance of the undelivered item(s) is consideredprobable and substantially in the Company’s control. The Company considers adeliverable to have standalone value if the Company sells this item separatelyor if the item is sold by another vendor or could be resold by the customer.Further, the Company’s revenue arrangements generally do not include a generalright of return relative to delivered products. Deliverables not meeting thecriteria for being a separate unit of accounting are combined with adeliverable that does meet that criterion. The appropriate allocation ofarrangement consideration and recognition of revenue is then determined for thecombined unit of accounting.

 

In accordance with the new authoritative guidance, the Companyallocates arrangement consideration to each deliverable in an arrangement basedon its relative selling price. The Company determines selling price usingvendor-specific objective evidence (“VSOE”), if it exists; otherwise, theCompany uses third-party evidence (“TPE”). If neither VSOE nor TPE of sellingprice exists for a unit of accounting, the Company uses estimated selling price(“ESP”).

 

VSOEis generally limited to the price charged when the same or similar product issold separately. If a product or service is seldom sold separately, it isunlikely that the Company can determine VSOE for the product or service. Inmost cases, VSOE of selling price is an average price of recent actualtransactions that are priced within a reasonable range. TPE is determined basedon the prices charged by the Company’s competitors for a similar deliverablewhen sold separately. It may be difficult for the Company to obtain sufficientinformation on competitor pricing to substantiate TPE and, therefore, theCompany may not always be able to use TPE.

 

Ifthe Company is unable to establish selling price using VSOE or TPE, and the newor materially modified arrangement was entered into after the implementationdate of January 1, 2010, the Company will use ESP in the allocation ofarrangement consideration. The objective of ESP is to determine the price atwhich the Company would transact if the product or service were sold on astandalone basis. The Company’s determination of ESP involves a weighting ofseveral factors based on the specific facts and circumstances of thearrangement. Because of the nature of the business and history with providingservices and manufacturing products for various applications, the Companyperforms an initial assessment on the nature of the services that will beprovided by estimating the cost to provide those services plus an estimatedprofit margin. The Company performs the same assessment on new products byestimating the per unit cost to manufacture the product plus an estimatedprofit margin. The estimated profit margins initially used in the assessmentare based on the Company’s profit objectives which will be adjusted based onother considerations such as pricing of similar products and services,characteristics of the specific market, ongoing pricing strategy and policiesand value of any enhancements in functionality included in the deliverable.

 

TheCompany plans to analyze the selling prices used in the allocation ofarrangement consideration at a minimum on an annual basis. Selling prices willbe analyzed on a more frequent basis if a significant change in the businessnecessitates a more timely analysis or if the Company experiences significantvariances in selling prices.

 

*ProductRevenue*

 

Product revenue is generally recognized upon transfer of title and riskof loss, which is generally upon shipment, unless an acceptance period exists.In general, the Company’s customary shipping terms are FOB shipping point orfree carrier. In instances where customer acceptance of a product is required,revenue is either recognized (i) upon shipment when the Company is able todemonstrate that the customer specific objective criteria have been met or(ii) upon the earlier of customer acceptance or expiration of theacceptance period.

 

The Company provides warranties for its products and records theestimated costs as a cost of revenue in the period the revenue is recorded. TheCompany’s standard warranty period extends one to five years from the date ofdelivery, depending on the type of product purchased and its application. Thewarranties provide that the Company’s products will be free from defects inmaterial and workmanship and will, under normal use, conform to thespecifications for the product. The warranties further provide that the Companywill repair the product or provide replacement parts at no charge to thecustomer. When the Company is unable to reasonably determine its obligation forwarranty of new products, revenue from the sale of the products is deferreduntil expiration of the warranty period or until such time as the warrantyobligation can be reasonably estimated.

 

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*ServicesRevenue*

 

Revenue from services is recognized as the services are performedconsistent with the performance requirements of the contract using theproportional performance method. Where arrangements include milestones orgovernmental approval that impact the fees payable to the Company, revenue islimited to those amounts whereby collectability is reasonably assured. TheCompany recognizes revenue earned under time and materials contracts asservices are provided based upon actual costs incurred plus a contractuallyagreed-upon profit margin. The Company recognizes revenue from fixed-pricecontracts using the proportional performance method based on the ratio of costsincurred to estimates of total expected project costs in order to determine theamount of revenue earned to date. Project costs are based on the direct salaryand associated fringe benefits of the employees on the project plus all directexpenses incurred to complete the project that are not reimbursed by theclient. The proportional performance method is used since reasonably dependableestimates of the revenues and costs applicable to various stages of a contractcan be made. These estimates are based on historical experience anddeliverables identified in the contract and are indicative of the level ofbenefit provided to the Company’s clients. There are no costs that are deferredand amortized over the contract term.

 

Service revenue includes revenue derived from the execution ofcontracts awarded by the U.S. federal government, other government agencies andcommercial customers. The Company’s research and development arrangements withthe federal government or other government agencies typically require theCompany to provide pure research, in which the Company investigates designtechniques on new battery technologies. The Company’s arrangements withcommercial customers consist of arrangements where the Company is paid toenhance or modify an existing product or to develop or jointly develop a newproduct to meet a customer’s specifications.

 

***Pre-production costs related to long-term supplyarrangements***—Engineering, design and development costs forproducts sold under long-term supply arrangements are expensed as incurred inresearch, development and engineering expenses in the condensed consolidatedstatement of operations, unless the Company has a contractual guarantee forreimbursement from the customer.  Coststhat have a contractual guarantee for reimbursement are capitalized andamortized as a cost of sales over the applicable term.  For the three and six months ended June 30,2010, the Company expensed $0.2 million of pre-production costs related tolong-term supply arrangements as research, development and engineeringexpense.  As of June 30, 2010, theCompany capitalized $0.4 million of pre-production costs that have acontractual guarantee for reimbursement.

 

***Production start-up***—Productionstart-up expenses consist of salaries and personnel-related costs, siteselection costs, including legal and regulatory costs, rent and the cost ofoperating a production line before it has been qualified for full production,including the cost of raw materials run through the production line during thequalification phase.  The Company expectsto continue to incur production start-up expenses related to its facilities inLivonia and Romulus, Michigan. The Livonia facility is expected to beginqualification for production in the second half of 2010. The Romulus facilityis expected to begin qualification for production in the first half of 2011.  During the three and six months ended June 30,2010, the Company recorded production start-up expenses of $3.6 million and$5.4 million, of which $1.6 million related to materials, labor and overheadcosts incurred in the qualification of the prismatic cell production line.

 

***Fair Value of FinancialInstruments***—The carrying amount of cash, cash equivalents,restricted cash, accounts receivable, accounts payable and accrued expensesapproximates fair value due to the short-term nature of these items. Managementbelieves that the Company’s debt obligations bear interest at rates whichapproximate prevailing market rates for instruments with similarcharacteristics and, accordingly, the carrying values for these instrumentsapproximate fair value.

 

Fair value is an exit price,representing the amount that would be received from the sale of an asset orpaid to transfer a liability in an orderly transaction between marketparticipants. As such, fair value is a market-based measurement that should bedetermined based on assumptions that market participants would use in pricingan asset or liability. As a basis for considering such assumptions, GAAPestablishes a three-tier value hierarchy, which prioritizes the inputs used inmeasuring fair value as follows: (Level 1) observable inputs such as quotedprices in active markets; (Level 2) inputs other than the quoted prices inactive markets that are observable either directly or indirectly; and (Level 3)unobservable inputs in which there is little or no market data, which requiresthe Company to develop its own assumptions. This hierarchy requires the Companyto use observable market data, when available, and to minimize the use ofunobservable inputs when determining fair value. On a recurring basis, theCompany measures certain financial assets and liabilities at fair value,including the Company’s cash equivalents.

 

The Company did not have anymaterial items that are measured at fair value on a non-recurring basis underthis requirement as of December 31, 2009 or June 30, 2010.

 

The following tables showassets measured at fair value on a recurring basis and the input categoriesassociated with those assets (in thousands):

 

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| ** **         | ** ** | ** **                                | ** ** | **As of December 31, 2009**                                      | ** ** |
|--------------------|------------|-------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **         | ** ** | **Fair Value at  December 31, 2009** | ** ** | **Quoted Prices in  Active Markets for  Identical Assets  (Level 1)** | ** ** | **Significant Other  Observable  Inputs  (Level 2)** | ** ** | **Significant  Unobservable  Inputs  (Level 3)** | ** ** |
| Asset:             |       |                                      |       |                                                                  |       |   |   |   |   |
| Money market funds |       | $                                         | 447,368    |                                                                  | $          | 447,368 |   | $ | — |   | $ | — |   |
|                    |            |                                           |            |                                                                       |            |  |  |  |  |  |  |  |  |

 
| ** **         | ** ** | ** **                       | ** ** | **As of June 30, 2010**                                          | ** ** |
|--------------------|------------|----------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **         | ** ** | **Fair Value at June  30, 2010** | ** ** | **Quoted Prices in  Active Markets for  Identical Assets  (Level 1)** | ** ** | **Significant Other   Observable  Inputs  (Level 2)** | ** ** | **Significant  Unobservable  Inputs  (Level 3)** | ** ** |
| Asset:             |       |                             |       |                                                                  |       |   |   |   |   |
| Money market funds |       | $                                | 331,432    |                                                                  | $          | 331,432 |   | $ | — |   | $ | — |   |
|                    |            |                                  |            |                                                                       |            |  |  |  |  |  |  |  |  |

 

The Company’s cashequivalents consist of money market funds that approximate their face value.

 

***Stock-Based Compensation***—The Companyaccounts for all awards, including employee and director awards, by recognizingcompensation expense based on the fair value of share-based transactions in thecondensed consolidated financial statements. The Company recognizes compensation expense over the vesting periodusing a ratable method (providing the minimum amount of compensation recordedis equal to the vested portion of the award, requiring a ratable method whennecessary) and classifies these amounts in the condensed consolidatedstatements of operations based on the department to which the related employeereports. The Company uses the Black-Scholes valuation model to calculate thefair value of stock options, utilizing various assumptions.

 

The Company records equityinstruments issued to non-employees as expense at their fair value over therelated service period and periodically revalues the equity instruments as theyvest.

 

***Net Loss Per Share***—Basic net lossper share is computed by dividing net loss by the weighted-average number ofcommon shares outstanding during the relevant period. Diluted net loss pershare is computed by dividing net loss by the weighted-average number ofdilutive common shares outstanding during the relevant period. Dilutive sharesoutstanding are calculated by adding to the weighted shares outstanding anypotential (unissued) shares of common stock and warrants based on the treasurystock method.

 

The following potentiallydilutive securities were excluded from the calculation of diluted net loss pershare, as the effect would have been anti-dilutive (in thousands):

 
| ** **                                                   | ** ** | **June 30,** | ** ** |
|--------------------------------------------------------------|------------|-------------------|------------|
| ** **                                                   | ** ** | **2009**          | ** ** | **2010** | ** ** |
| Convertible preferred stock upon conversion to common  stock |       | 61,374            |       | — |   |
| Warrants to purchase redeemable convertible preferred  stock |       | 126               |       | — |   |
| Warrants to purchase common stock                            |       | 45                |       | 45 |   |
| Options to purchase common stock                             |       | 10,245            |       | 10,229 |   |
| Unvested restricted stock units                              |       | —            |       | 198 |   |
|                                                         |       | 71,790            |       | 10,472 |   |

 

***New AccountingPronouncements***—In June 2009, the FASB issued new accountingguidance which modifies the existing quantitative guidance used in determiningthe primary beneficiary of a VIE by requiring entities to qualitatively assesswhether an enterprise is a primary beneficiary, based on whether the entity has(i) power over the significant activities of the VIE, and (ii) anobligation to absorb losses or the right to receive benefits that could bepotentially significant to the VIE.  Thisguidance became effective for all new and existing VIE’s on January 1,2010.  There was no significant impact onthe Company’s condensed consolidated financial statements upon adopting thisguidance.

 

Duringthe second quarter of 2010, the Company elected to early adopt, as permitted bythe guidance, the new accounting standards for revenue recognition formultiple-deliverable revenue arrangements. The Company has prospectively (retroactive to January 1, 2010)applied the provisions of the new authoritative guidance to all revenuearrangements entered into or materially modified after January 1,2010.  The adoption had no impact onpreviously reported amounts for the three months ended March 31,2010.  This new authoritative guidanceamends previously issued guidance to eliminate the residual method ofallocation for multiple-deliverable revenue arrangements, and requires thatarrangement consideration be allocated at the inception of an arrangement toall deliverables using the relative selling price method. The new authoritativeguidance also establishes a selling price hierarchy for 

 

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determiningthe selling price of a deliverable, which includes (1) VSOE, if available,(2) TPE, if vendor-specific objective evidence is not available, and (3) ESP,if neither vendor-specific nor third-party evidence is available. Additionally,it expands the disclosure requirements related to a vendor’smultiple-deliverable revenue arrangements. Adopting the new standard will allow the Company to allocate thearrangement consideration to multiple deliverables in an arrangement. TheCompany’s multiple-deliverable revenue arrangements may include any combinationof engineering services, research and development services, prototypes, batterypacks, battery system components and battery cells.

 

Duringthe six months ended June 30, 2010, the adoption of this guidance had nomaterial impact. The new accounting standards for revenue recognition, ifapplied in the same manner to the year ended December 31, 2009, would nothave had a material impact on total net revenue for that fiscal year.

 

In January 2010, the FASB issued an update to the existingdisclosure requirements related to fair value measurements which requiresentities to make new disclosures about recurring or nonrecurring fair valuemeasurements including significant transfers into and out of Level 1 andLevel 2 fair value measurements and information on purchases, sales,issuances, and settlements on a gross basis in the reconciliation ofLevel 3 fair value measurements. This update is effective for annual andinterim periods beginning after December 15, 2009, except for Level 3reconciliation disclosures which are effective for annual periods beginningafter December 15, 2010.  There wasno significant impact on the Company’s condensed consolidated financial statementdisclosures for the adoption of this update as it relates to disclosures aboutrecurring or nonrecurring fair value measurements including significanttransfers into and out of Level 1 and Level 2.

 

In April 2010, the FASB issued an update to the accounting andreporting guidance for milestone based revenue arrangements.  This update provides guidance on defining amilestone and determining when it may be appropriate to apply the milestonemethod of revenue recognition for research or development transactions.Research or development arrangements frequently include payment provisionswhereby a portion or all of the consideration is contingent upon theachievement of milestone events. An entity may only recognize considerationthat is contingent upon the achievement of a milestone in its entirety in theperiod the milestone is achieved only if the milestone meets certain criteria.This update is effective prospectively for milestones achieved in fiscal yearsbeginning on or after June 15, 2010. While the Company is still evaluatingthe potential impact of this guidance, the Company does not expect that theadoption of this update will have a material impact on its financial position,results of operations, or cash flows.

 

**2.  GovernmentGrants and Incentives**

 

***Center of Energy and Excellence Grant***

 

In February 2009, the State of Michigan awarded the Company a$10.0 million Center of Energy and Excellence grant. Under the agreement,the State of Michigan will provide cost reimbursement for 100% of qualifiedexpenditures incurred through November 30, 2011. Other than certainstandard conditions, there are no conditions attached to this award that willrequire repayment of amounts received if those conditions are not met. TheCompany received $3.0 million of this grant in March 2009, with theremainder to be paid based on the achievement of certain milestones in thefacility development. The Company used $2.2 million of these funds in the yearended December 31, 2009.  TheCompany used $0 and $0.8 million of these funds during the three and sixmonths ended June 30, 2010, of which $0.7 million and $0.1 million wasrecorded as an offset to property, plant, and equipment and operating expenses,respectively, for the six months ended June 30, 2010.  In addition, the Company incurred allowablecosts of $31,000 and $1.5 million during the three and six months ended June 30,2010, respectively, which was recorded as a receivable in prepaid expense andother current assets and as an offset to property, plant, and equipment andoperating expenses.

 

***Michigan Economic Growth Authority***

 

In April 2009, Michigan Economic Growth Authority (“MEGA”) offeredthe Company certain tax incentives, which can be used to offset the MichiganBusiness Tax owed in a tax year, carried forward for the number of yearsspecified by the agreement, or be paid to the Company in cash at the timeclaimed to the extent the Company does not owe a tax. The terms and conditionsof the *High-Tech Credit* wereestablished in October 2009 and the *CellManufacturing Credit* in November 2009.

 

*High Tech Credit*—The *High-Tech Credit* agreement provides theCompany with a 15-year tax credit, beginning with the 2011 fiscal year. Thecredit will be calculated as qualified wages and benefits, multiplied by theMichigan personal income tax rate beginning in the tax year the credit issought. The proceeds to be received by the Company will be based on the numberof jobs created, qualified wages paid and tax rates in effect over the15 year period. The tax credit is subject to a repayment provision in theevent the Company relocates a substantial portion of the jobs outside the stateof Michigan within 15 years from the date the Company first receives thecredit. There is no impact to the condensed consolidated financial statementsas of June 30, 2010.

 

*Cell Manufacturing Credit*—The *Cell Manufacturing Credit* agreementauthorizes a credit for the Company equal to 50% of capital investment expensesrelated to the construction of the Company’s integrated battery cell manufacturingfacilities in Michigan, commencing January 1, 2009, up to a maximum of$100.0 million over a four year period. The credit shall not exceed$25.0 million per year and can be submitted for reimbursement beginning intax year 2012. The Company is required to create 300 jobs no later than 

 

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December 31,2016 for the tax credit to be non-refundable. The tax credit is subject to arepayment provision in the event the Company relocates 51% or more of the 300jobs outside of the state of Michigan within three years after the last yearthe tax credit is received. Through June 30, 2010, the Company hasincurred $60.4 million in expenses related to the construction of theLivonia and Romulus facilities. When the Company has met the filingrequirements for the tax year ending December 31, 2012, the Companyexpects to receive $30.2 million in refundable tax credits related tothese expenses. There is no impact to the condensed consolidated financialstatements as of June 30, 2010.  TheCompany will record the receivable when it is probable that it will comply withthe conditions of the grant and receipt of the grant.  At that time, the Company would reduce thebasis in the fixed assets acquired under the grant by $26.7 million and record$3.5 as reimbursement for expenses previously incurred.

 

***Michigan Economic Growth Authority Loan***

 

The State of Michigan also granted the Company a low interestforgivable loan of up to $4.0 million effective August 2009 with theobjective of conducting advance vehicle technology operations to promote andenhance job creation within the State of Michigan. To receive advances underthe loan, the Company is required to achieve certain key milestones related tothe development of the manufacturing facility. The note will accrue interest of1% per annum from the date of the initial advance, and the Company will have noobligation to pay any principal or interest until August 2012. If theCompany creates 350 full time jobs by August 2012 and maintains the jobsin the State of Michigan for three years after the end of the loan, the entiredebt will be forgiven. The Company has not yet met the first milestone requiredto receive the initial advance from the loan, and as such, there is no impactto the condensed consolidated financial statements as of June 30, 2010.

 

***U.S. Department of Energy Battery Initiative***

 

In December 2009, the Company entered into an agreementestablishing the terms and conditions of a $249.1 million grant awardedunder the Department of Energy (“DOE”) Battery Initiative to supportmanufacturing expansion of new lithium-ion battery manufacturing facilities inMichigan. Under the agreement, the DOE will provide cost reimbursement for 50%of qualified expenditures incurred from December 1, 2009 toNovember 30, 2012. The agreement also provides for reimbursement ofpre-award costs incurred from June 1, 2009 to November 30, 2009.Other than certain standard conditions, there are no conditions attached tothis award that will require repayment of amounts received if those conditionsare not met. For the three and six months ended June 30, 2010, the Companyreceived $0 million and $6.1 in reimbursement, respectively, for costs incurredin 2009, of which $5.7 million related to offsets to property, plant andequipment and $0.4 million related to offsets to operating expenses. For thethree and six months ended June 30, 2010, the Company received $22.3million in reimbursement for costs incurred in 2010, of which $20.6 millionrelated to offsets to property, plant and equipment and $1.7 million related tooperating expenses.  The Company hasincurred additional allowable costs in the six months ended June 30, 2010,entitling the Company to receive $1.7 million in reimbursement.  The Company recorded the $1.7 millionreceivable in prepaid expenses and other current assets in the consolidatedbalance sheets of which $1.2 million is an offset to deposits for purchases ofequipment, included in other long-term assets in the condensed consolidatedbalance sheets, and the remaining $0.5 million as an offset to operatingexpenses in the condensed consolidated statements of operations.

 

***Department of Energy, Labor and Economic Growth (“DELEG”)***

 

In December 2009, the State of Michigan awarded the Company$2.0 million to assist in funding the Company’s smart grid stabilizationproject, the purpose of which is to develop and improve the quality ofapplication of energy efficient technologies and to create or expand the marketfor such technologies. The Company received the initial advance of$0.9 million in December 2009, and through June 30, 2010, theCompany incurred $0.3 million in allowable costs which was recorded as anoffset to operating expenses.  TheCompany will receive the remainder of the grant upon expending 90% of theinitial advance.  As of June 30,2010, $0.6 million is included in short-term restricted cash and other currentliabilities.

 

***City of Livonia Personal Property Tax Exemption***

 

The Company entered into an agreement with the City of Livonia allowing100% exemption from personal property taxes by Livonia on all new personalproperty during the exemption period commencing on December 31, 2009 andcontinuing for fourteen years through December 31, 2023. The Company isrequired to invest at least $24.0 million in personal property and createor locate 350 new jobs in the eligible district to receive the exemption. Ifthe Company relocates operations, jobs or activities outside the City ofLivonia on or before May 31, 2016 such that employment is 175 jobs orless, the Company is required to repay all or a portion of the property taxesexempted. There is no impact to the condensed consolidated financial statementsas of June 30, 2010 as a result of this agreement.

 

***Michigan Strategic Fund Renaissance ZoneDevelopment***

 

In May 2010, the Company entered into a Renaissance ZoneDevelopment agreement with the Michigan Strategic Fund and the property ownersfor the site leased by the Company in Romulus, Michigan.  Under the terms of the agreement, the Companymay receive exemptions, deductions, credits or other benefits if it invests acertain amount of capital, creates a certain number of jobs and

 

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complieswith other standard conditions related to its facility in Romulus,Michigan.  As of June 30, 2010, theCompany has not yet met the conditions to be eligible to receive any of theRenaissance Zone benefits.  There is noimpact to the condensed consolidated financial statements as of June 30,2010 as a result of this agreement.

 

**3.  Inventory**

 

Inventory consists of thefollowing (in thousands):

** **
| ** **      | ** ** | **December 31, 2009** | ** ** | **June 30, 2010** | ** ** |
|-----------------|------------|----------------------------|------------|------------------------|------------|
| Raw materials   |       | $                          | 7,726      |                   | $          | 9,837 |   |
| Work-in-process |       | 25,139                     |       | 31,230                 |       |
| Finished goods  |       | 4,573                      |       | 621                    |       |
|            |       | $                          | 37,438     |                   | $          | 41,688 |   |

 

**4.  Property, Plant and Equipment**

 

For government grantsrelated to capital expenditures, the Company recognizes the reimbursement as areduction of the basis of the asset and a reduction to depreciation expenseover the useful life of the asset.  Property, plant and equipment consists of the following (in thousands):

 
| ** **                                                   | ** ** | **December 31, 2009** | ** ** | **June 30, 2010** | ** ** |
|--------------------------------------------------------------|------------|----------------------------|------------|------------------------|------------|
| Computer equipment and software                              |       | $                          | 7,005      |                   | $          | 9,608 |   |
| Furniture and fixtures                                       |       | 1,585                      |       | 2,791                  |       |
| Automobiles                                                  |       | 385                        |       | 400                    |       |
| Machinery and equipment                                      |       | 66,934                     |       | 71,578                 |       |
| Buildings                                                    |       | 6,900                      |       | 7,039                  |       |
| Leasehold improvements                                       |       | 9,224                      |       | 18,021                 |       |
| Assets in progress                                           |       | 9,126                      |       | 60,105                 |       |
| Property, plant and equipment, basis                         |       | 101,159                    |       | 169,542                |       |
| Less reduction for costs reimbursed under  government grants |       | 1,100                      |       | 19,080                 |       |
| Property, plant and equipment, carrying value                |       | 100,059                    |       | 150,462                |       |
| Less net accumulated depreciation and amortization           |       | 28,397                     |       | 33,891                 |       |
| Property, plant and equipment, net                           |       | $                          | 71,662     |                   | $          | 116,571 |   |

 

The Company has deposits forequipment not yet received of $17.0 million and $34.1 million at December 31,2009 and June 30, 2010, respectively, included within deposits and otherassets in the condensed consolidated balance sheets.  These deposits are reported net of contradeposit balances related to reimbursements under government grants of $6.7million and $12.7 million at December 31, 2009 and June 30, 2010,respectively.

 

Computerequipment under capital lease consists of the following (in thousands):

 
| ** **                               | ** ** | **December 31, 2009** | ** ** | **June 30, 2010** | ** ** |
|------------------------------------------|------------|----------------------------|------------|------------------------|------------|
| Computer equipment and software, at cost |       | $                          | 1,624      |                   | $          | 2,547 |   |
| Less accumulated depreciation            |       | (855                       | )          | (936                   | )          |
| Computer equipment and software, net     |       | $                          | 769        |                   | $          | 1,611 |   |

 

Net depreciation expense forthe three months ended June 30, 2009 and 2010 and for the six months endedJune 30, 2009 and 2010 was $2.9 million, $3.9 million, $5.3 million and$7.5 million, respectively.  For thethree and six months ended June 30, 2010, the Company recorded $0.1million as a reduction to depreciation expense related to reduced carryingvalue due to government grant reimbursements. There was no reduction to depreciation expense recorded for either thethree or six months ended June 30, 2009.

 

**5.**** Intangible Assets**

 

Intangible assets consist ofthe following (in thousands):

 

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| ** **                   | ** ** | ** **      | ** ** | **December 31, 2009** | ** ** | **June 30, 2010** | ** ** |
|------------------------------|------------|-----------------|------------|----------------------------|------------|------------------------|------------|
| ** **                   | ** ** | **Useful Life** | ** ** | ** **                 | ** ** | **Accumulated**        | ** ** | ** ** | ** ** | ** ** | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
| **Intangible Asset Class**   | ** ** | **(Years)**     | ** ** | **Gross**                  | ** ** | **Amortization**       | ** ** | **Net** | ** ** | **Gross** | ** ** | **Amortization** | ** ** | **Net** | ** ** |
| Contractual  backlogs        |       | 1-3             |       | $                          | 497        |                   | $          | 497 |   | $ | — |   | $ | 497 |   | $ | 497 |   | $ | — |   |
| Customer  relationships      |       | 5-17            |       | 640                        |       | 394                    |       | 246 |   | 629 |   | 396 |   | 233 |   |
| Patented  technology         |       | 4-5             |       | 2,473                      |       | 1,855                  |       | 618 |   | 2,394 |   | 2,008 |   | 386 |   |
| Specialty-trained  workforce |       | 4               |       | 60                         |       | 44                     |       | 16 |   | 60 |   | 51 |   | 9 |   |
| Trademarks  and trade names  |       | Indefinite      |       | 374                        |       | —                 |       | 374 |   | 102 |   | — |   | 102 |   |
|                         |       |            |       | $                          | 4,044      |                   | $          | 2,790 |   | $ | 1,254 |   | $ | 3,682 |   | $ | 2,952 |   | $ | 730 |   |

 

Amortization expense forintangible assets for the three months ended June 30, 2009 and 2010 andfor the six months ended June 30, 2009 and 2010 was $0.2 million, $0.1million, $0.4 million, and $0.2 million, respectively. The remaining net bookvalue of the intangible assets will be amortized over a weighted-average periodof approximately 2.97 years as of December 31, 2009.

 

**6.  Investment**

 

In January 2010, theCompany entered into an agreement to purchase preferred stock of a maker ofplug-in hybrid electric vehicles in the United States (the “Automaker”).  The Company agreed to invest cash of $13.0million and shares of the Company’s common stock, which, when transferred tothe Automaker, had a fair market value of $7.5 million.  As of June 30, 2010, all cash and stockconsideration had been transferred to the Automaker in return for preferredstock of the Automaker.  The Company isaccounting for its investment under the cost method.

 

In conjunction with the investment, the Companyentered into a supply agreement with the Automaker to supply battery systemsfor its plug-in hybrid electric vehicle programs. Through June 30, 2010,the Company has recorded $0.3 million of revenue related to shipments ofproducts to the Automaker.  The balancedue from the Automaker as of June 30, 2010, of $0.3 million, is includedwithin accounts receivable on the Company’s condensed consolidated balancesheet.

 

The Company recognizes revenue on product shipmentsto the Automaker, within the condensed consolidated statements of operations,when all revenue****recognition criteria are met.

 

**7****.  Commitments and Contingencies**

 

In June 2010, theCompany entered into a supply agreement for a raw material component whichincluded commitments to purchase minimum product volumes for each of the yearsending December 31, 2010 through December 31, 2013.  If the Company’s purchase volumes during anyyear fail to meet the minimum purchase commitments, it is required to pay theseller a variance payment for the difference between the amount actuallypurchased in that calendar year and the annual minimum purchase commitment forthat calendar year.  The Company willreceive a credit for the amount of the variance payment to be applied topurchases in the following year and will have until April 1, 2015 toreclaim any variance payments resulting from the minimum purchase commitmentsfor calendar years 2012 or 2013.  Thisarrangement qualifies as a normal purchase and normal sales contract.  For the three and six months ended June 30,2010, the Company has purchased $1.7 million and $2.1 million under this supplyagreement.  The amounts of purchasecommitments by year are as follows (in thousands):

 
| ** **                        | ** ** | **Purchase  Commitment** | ** ** |
|-----------------------------------|------------|--------------------------|------------|
|                              |       |                     |       |
| Remaining portion of 2010         |       | $                        | 4,584      |   |
| 2011                              |       | 12,950                   |       |
| 2012                              |       | 18,500                   |       |
| 2013                              |       | 18,500                   |       |
|                              |       |                     |       |
| Total future purchase commitments |       | $                        | 54,534     |   |

 

In May 2010, theCompany entered into a Lease Agreement (the “Waltham Lease”) for approximately97,000 square feet of office, research, lab and light manufacturing space inWaltham, Massachusetts for an initial term of ten years, expected to commenceon April 1, 2011, with the option to extend for an additional fiveyears.  The total cash obligation forbase rent over the initial term of the Waltham Lease is $25.3 million.  In addition to base rent, the Company is alsoresponsible for its share of electricity cost and its pro rata share ofincreases in operating expenses.  Thelandlord has agreed to provide the Company with an allowance for certainconstruction costs incurred. In connection with the Waltham Lease, the Companyprovided the landlord a security deposit of $1.0 million in the form of anirrevocable letter of credit.

 

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***Litigation***—In November 2005, the Company received a letter asserting that itwas infringing upon certain U.S. patents. In April 2006, the Companycommenced an action in the United States District Court for the District ofMassachusetts seeking a declaratory judgment that the patents in question werenot infringed by the Company’s products and that the patents claiming to beinfringed upon are invalid. On September 11, 2006, a countersuit was filedagainst the Company and two of its business partners in the United StatesDistrict Court for the Northern District of Texas alleging infringement ofthese patents. In October 2006 and January 2007, the U.S. Patent andTrademark Office (“PTO”) granted the Company’s request for reexamination of thetwo patents. In January and February 2007, the two suits were stayedpending the reexamination. The reexaminations of the two patents were concludedon April 15, 2008 and May 12, 2009, respectively. The Company filed amotion to re-open the litigation in the United States District Court for theDistrict of Massachusetts on June 11, 2009. On September 28, 2009,the Massachusetts court entered an order denying that motion, which the Companyappealed on October 27, 2009 to the United States Court of Appeals for theFederal Circuit.  On July 22, 2009,the Company was sent a proposed Second Amended Complaint which the complainantsintend to seek leave to file with the Texas court in light of the PTO’sreexaminations.  On August 27, 2009,Hydro-Quebec and UT filed a Motion for Leave to File Second Amended Complaintand Jury Demand in the United States District Court for the Northern Districtof Texas and the Company was granted several unopposed extensions to file itsresponse.  Hydro-Quebec and UT filed forleave to file an Amended Motion for Leave to File Second Amended Complaint andJury Demand on April 1, 2010 and the Company filed its opposition to thisapplication on April 22, 2010.  Thejudge held a status hearing with the parties on May 14, 2010 and hasentered a schedule for the case leading to a claim construction hearing in December 2010.  The Company has agreed to defend andindemnify the other named business partner for its legal costs in defendingthis litigation and any damages that may be awarded. The Company is unable topredict the outcome of this matter, and therefore no accrual has beenestablished for this contingency.

 

OnFebruary 3, 2010, the Company received notice that LG Chem, Ltd., orLG Chem, filed applications in the 50th division of Seoul District Court forpreliminary injunctions against six former employees who are now employedeither by the Company or its Enerland subsidiary. The applications allege thatthese former employees violated the two-year non-competition clause in theiremployment contracts with LG Chem and that there is a likelihood that they areinfringing LG Chem’s trade secrets by working for a competitor.  Aninitial court hearing was held on February 19, 2010 and a second hearingwas held on March 19, 2010.  Thecourt rendered a decision on this application on June 9, 2010, whichreduced the post-termination non-competition term from two years to eighteenmonths and prohibited four of the six defendants from working at Enerlandduring the applicable balance of their respective non-compete terms, rangingfrom four months to eleven months.  Thesix defendants were also prohibited from using the alleged trade secrets thatLG Chem submitted to the court.  LGChem has not commenced any additional legal action against these formeremployees, the Company or Enerland; however, should they do so, such legalaction could result in significant legal expenses and diversion of time by theCompany’s technical and management personnel.

 

**8.  Income Taxes**

 

TheCompany provides for income taxes at the end of each interim period based onthe estimated effective tax rate for the full fiscal year. Cumulativeadjustments to the Company’s estimate are recorded in the interim period inwhich a change in the estimated annual effective rate is determined.  The Company’s provision forincome taxes consists primarily of foreign taxes.

 

As of December 31,2009, the Company has provided a liability of $0.6 million for uncertain taxpositions related to various foreign income tax matters which are classified asother long-term liabilities in the Company’s condensed consolidated balancesheets. The uncertain tax positions as of December 31, 2009 excludeinterest and penalties of $0.2 million which are classified as other long-termliabilities on the Company’s condensed consolidated balance sheets. Theseuncertain tax positions would impact the Company’s effective tax rate, ifrecognized. The Company does not expect that the amounts of uncertain taxpositions will change significantly within the next 12 months.

 

The Company recognizesinterest and penalties accrued related to uncertain tax positions in theprovision for income taxes. During the three months ended June 30, 2009and 2010 and the six months ended June 30, 2009 and 2010, the Companyrecognized approximately $0, $14,000, $14,000 and $27,000 in penalties andinterest, respectively. The Company had approximately $0.2 million for thepayment of penalties and interest accrued at June 30, 2010.

 

**9.  Financing Arrangements**

 

**Long-TermDebt**—Long-term debt consists of the following (inthousands):

 

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| ** **                         | ** ** | **December 31, 2009** | ** ** | **June 30, 2010** | ** ** |
|------------------------------------|------------|----------------------------|------------|------------------------|------------|
| Term loan                          |       | $                          | 12,069     |                   | $          | 9,569 |   |
| Enerland debt                      |       |                       |       |                   |       |
| Term loan 2                        |       | 1,289                      |       | —                 |       |
| Technology funds loan              |       | 107                        |       | 69                     |       |
| Korean government loans            |       | 429                        |       | 312                    |       |
| Total                              |       | 13,894                     |       | 9,950                  |       |
| Less amounts classified as current |       | 6,456                      |       | 5,153                  |       |
| Long-term debt                     |       | $                          | 7,438      |                   | $          | 4,797 |   |

 

***Term Loan***—The Company has a term loanagreement with a financial institution that is also a common shareholder. TheCompany has a term loan facility under the term loan agreement for $15.0million.  The term loan facility is repayable over a 36-month period andaccrues interest at prime plus 0.75%.

 

Theterm loan agreement requires the Company to comply with certain financialcovenants, which include a minimum liquidity ratio calculation. The term loanagreement is collateralized by substantially all assets of the Company,excluding intellectual property, property and equipment owned as ofDecember 31, 2005 and certain equipment located in China.

 

***Enerland debt***—The Companyhas the following outstanding obligations for its Enerland subsidiary:

 

·*Term loan 2*—OnMarch 5, 2008, the Company entered into two loan agreements with afinancial institution in the amounts of $1.3 million and $0.3 million whichmatured in 2010. The loans had a variable interest rate.  Term loan 2 was paid off during February 2010.

 

·*Technologyfunds loan*—The Company has a technology funds loan agreementamounting to $0.1 million with a variable interest rate. The weighted averageinterest rate for the loan as of June 30, 2010 was 4.86%. The loan maturesin August 2011.

 

·*Koreangovernment loans*—As a part of the Korean government’s initiative topromote and encourage the development of start-up companies in certain hightechnology industries, high technology start-up companies with industry leadingtechnology or products are eligible for government loans.

 

**Revolving Credit Facilities**—The Companyentered into a line of credit (“LOC”) for $8.0 million with a financialinstitution that is also a common stockholder. The line of credit accruesinterest at prime (3.25% at December 31, 2009 and June 30,2010).  The outstanding balance atDecember 31, 2009 and June 30, 2010 was $8.0 million. The LOC has amaturity date of September 24, 2010, and the Company is required to complywith the same financial covenants required under the Term Loan mentioned above.

 

**10.  Stock-Based Compensation**

 

**Stock Incentive Plans and Stock-Based Compensation—**During 2009,the Company’s Board of Directors approved the 2009 Stock Incentive Plan (the “2009Plan”) which became effective on the closing of the Company’s initial publicoffering (“IPO”) on September 24, 2009. The 2009 Plan originally provided for the grant of qualified incentivestock options, nonqualified stock options, stock appreciation rights,restricted stock, restricted stock units, and other stock-based awards for thepurchase of shares of the Company’s common stock to the Company’s employees,officers, directors, and outside consultants. Up to an aggregate of 3,000,000 shares of Company’s common stock,subject to increase on an annual basis, are reserved for future issuance underthe 2009 Plan.  Shares of common stockreserved for issuance under the Company’s 2001 Stock Incentive Plan (the “2001Plan”) that remained available for issuance immediately prior to closing of theIPO and any shares of common stock subject to awards under the 2001 Plan thatexpired, terminated, or were otherwise forfeited, canceled or repurchased bythe Company prior to being fully exercised were added to the number of sharesavailable under the 2009 Plan, up to a maximum of 500,000 shares.  During the year ended December 31, 2009,and the six months ended June 30, 2010, 378,792 and 121,208 shares fromthe 2001 Plan were added to the number of shares available under the 2009 Plan,respectively.  No additional shares fromthe 2001 Plan will be added to the 2009 Plan. On January 1, 2010, 5,000,000 shares were added to the 2009 Plan inconnection with the annual increase.  AtJune 30, 2010, stock awards outstanding under the 2009 Plan included stockoptions and restricted stock units.  Asof June 30, 2010, the Company had 6,480,971 stock-based awards availablefor future grant under the 2009 Plan and no stock-based awards available forfuture grant under the 2001 Plan.

 

Stock-based compensationcost is measured at the grant date, based on the calculated fair value of theaward, and is recognized as an expense over the service period (generally thevesting period of the equity grant). The following table presents stock-basedcompensation expense included in the Company’s condensed consolidatedstatements of operations (in thousands):

 

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| ** **                            | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                            | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** |
| ** **                            | ** ** | **2009**               | ** ** | **2010**             | ** ** | **2009** | ** ** | **2010** | ** ** |
|                                  |       |                   |       |                 |       |   |   |   |   |
| Cost of revenue                       |       | $                      | 581        |                 | $          | 478 |   | $ | 747 |   | $ | 893 |   |
| Research, development and engineering |       | 1,339                  |       | 1,110                |       | 1,940 |   | 2,072 |   |
| Sales and marketing                   |       | 229                    |       | 97                   |       | 344 |   | 395 |   |
| General and administrative            |       | 676                    |       | 961                  |       | 1,003 |   | 1,773 |   |
| Total                                 |       | $                      | 2,825      |                 | $          | 2,646 |   | $ | 4,034 |   | $ | 5,133 |   |

 

The Company has capitalizedan immaterial amount of stock-based compensation as a component of inventory.

 

As of June 30, 2010,there was approximately $35.5 million of total unrecognized compensation costrelated to non-vested stock-based compensation arrangements granted under theplans, which is expected to be recognized over a weighted-average period of2.71 years.

 

**Stock Options—**Stock options generally vest over a four-yearperiod and expire 10 years from the date of grant. Upon option exercise, theCompany issues shares of common stock.

 

The following tablesummarizes stock option activity for the six months ended June 30, 2010:

 
| ** **                                      | ** ** | **Shares**         | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|-------------------------------------------------|------------|--------------------|------------|----------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------|------------|
| ** **                                      | ** ** | **(In thousands)** | ** ** | ** **                             | ** ** | ** **                                          | ** ** | **(In thousands)**              | ** ** |
| Outstanding - January 1, 2010              |       | 10,640             |       | $                                      | 5.98       |                                                | 7.40       |                            | $          | 175,122 |   |
| Granted                                         |       | 1,513              |       | 10.57                                  |       |                                                |       |                            |       |
| Exercised                                       |       | (1,596             | )          | 1.48                                   |       |                                                |       |                            |       |
| Forfeited                                       |       | (328               | )          | 8.39                                   |       |                                                |       |                            |       |
| Outstanding - June 30, 2010                |       | 10,229             |       | $                                      | 7.29       |                                                | 7.70       |                            | $          | 29,633 |   |
| Vested or expected to vest - June 30, 2010 |       | 9,824              |       | $                                      | 7.14       |                                                | 7.64       |                            | $          | 29,456 |   |
| Options exercisable - June 30, 2010        |       | 5,038              |       | $                                      | 4.75       |                                                | 6.63       |                            | $          | 24,662 |   |

 

The Company estimates the fair value of stock options granted using theBlack-Scholes option-pricing model and assumptions as to the fair value of thecommon stock on the grant date, expected term, expected volatility, risk-freerate of interest and an assumed dividend yield. Options are granted with an exercise price equal to the fair value ofthe common stock as of the date of grant. Prior to the Company’s IPO, fair value was determined by the Board ofDirectors.  For awards granted subsequentto the Company’s IPO, the fair value of the common stock is generallydetermined based on the closing price of the stock on the Nasdaq Global Marketon the grant date.  In addition, due tothe Company’s limited historical data, the Company estimated the expectedvolatility of its common stock at the date of grant based on the historicalvolatility of comparable public companies over the option’s expected term. TheCompany calculated the expected life of options using the simplified method asprescribed by the Stock Compensation Subtopic of the FASB Codification, due tothe Company’s limited historical data. The assumed dividend yield is based upon the Company’s expectation ofnot paying dividends in the foreseeable future. The risk-free rate is based onthe U.S. Treasury yield curve in effect at the time of grant for maturitiessimilar to the expected term. Compensation expense is amortized on astraight-line basis over the requisite service period of the options, which isgenerally four years.

 

TheBlack-Scholes model assumptions for the periods set forth below are as follows:

 
| ** **              | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------------|------------|------------------------|------------|----------------------|------------|
| ** **              | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** |
| ** **              | ** ** | **2009**               | ** ** | **2010**             | ** ** | **2009** | ** ** | **2010** | ** ** |
| Risk-free interest rate |       | 2.7 - 3.2              | %          | 2.8 - 3.3            | %          | 2.7 - 3.2 | % | 2.8 - 3.3 | % |
| Expected life           |       | 6.25 years             |       | 6.25 years           |       | 6.25 years |   | 6.25 years |   |
| Expected volatility     |       | 73                     | %          | 74                   | %          | 73 | % | 74 | % |
| Expected dividends      |       | 0                      | %          | 0                    | %          | 0 | % | 0 | % |

 

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The weighted average grantdate fair value of options granted during the three months ended June 30,2009 and 2010 and during the six months ended June 30, 2009 and 2010 was$6.37, $6.94,  $9.48, and $7.14,respectively. The intrinsic value of options exercised during the three monthsended June 30, 2009 and 2010 and during the six months ended June 30,2009 and 2010 was $0.1 million, $5.6 million, $4.7 million, and $22.8 million,respectively.

 

The Company received $13,000and $1.8 million in cash from option exercises during the three months endedJune 30, 2009 and 2010, respectively and $24,000 and $2.3 million in cashfrom option exercises during the six months ended June 30, 2009 and 2010,respectively.

 

**Restricted Stock Units—**During thethree months ended June 30, 2010, the Company granted restricted stockunit awards to certain executives.  Therestricted stock unit awards generally vest over a four-year period and uponvesting the Company issues shares of common stock.  The following table summarizes the Company’srestricted stock unit award activity for the six months ended June 30,2010:

 
| ** **                        | ** ** | **Shares**         | ** ** | **Weighted  Average Fair  Value** | ** ** |
|-----------------------------------|------------|--------------------|------------|-----------------------------------|------------|
| ** **                        | ** ** | **(In thousands)** | ** ** | ** **                        | ** ** |
| Non-vested - January 1, 2010 |       | —             |       | $                                 | —     |   |
| Granted                           |       | 198                |       | 10.11                             |       |
| Vested                            |       | —             |       | —                            |       |
| Forfeited                         |       | —             |       | —                            |       |
| Non-vested - June 30, 2010   |       | 198                |       | $                                 | 10.11      |   |

 

The fair value of restrictedstock unit awards is determined based on the closing price of the Company’scommon stock on the Nasdaq Global Market on the grant date.

 

**11.  Subsequent Events**

 

InJuly 2010, the Company entered into a Lease Agreement (the “Lease”) forapproximately 67,000 square feet of office, research and development, assembly,fabrication and warehouse space in Westborough, Massachusetts.  The lease term is from July 2010 throughJanuary 2021, and provides for the option to extend for one additionalterm of five years and the option for the Company to terminate the Lease in February 2016.  The total cash obligation for the base rentover the initial term of the Lease is approximately $4.4 million.  In addition to the base rent, the Company isalso responsible for its share of operating expenses and taxes, including, butnot limited to, insurance, real estate taxes, and common area maintenancecosts.  In connection with the Lease, theCompany provided a security deposit of approximately $156,000 to the landlordin the form of an irrevocable, unconditional, negotiable letter of credit.  The landlord has agreed to provide theCompany with allowances totaling approximately $0.6 million for certainupgrades and repairs to be made by the Company.

 

TheCompany has evaluated the period from June 30, 2010, the date of thefinancial statements, to the date of the issuance and filing, and hasdetermined that no material subsequent events have occurred, other than the eventdescribed above, that would affect the information presented in these financialstatements or require additional disclosure.

 

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**Item 2. Management’s Discussion andAnalysis of Financial Condition and Results of Operations**

 

*Thefollowing discussion and analysis of our financial condition and results ofoperations should be read in conjunction with the unaudited condensedconsolidated financial statements and the related notes thereto includedelsewhere in this Quarterly Report on Form 10-Q and the auditedconsolidated financial statements and notes thereto and management’s discussionand analysis of financial condition and results of operations for the yearended December 31, 2009 included in our Annual Report on Form 10-Kfiled with the Securities and Exchange Commission, or SEC, on March 15,2010. This Quarterly Report on Form 10-Q contains “forward-lookingstatements” within the meaning of Section 21E of the Securities ExchangeAct of 1934, as amended, or the Exchange Act. These statements are oftenidentified by the use of words such as “may,” “will,” “expect,” “believe,” “anticipate,”“intend,” “could,” “estimate,” or “continue,” and similar expressions orvariations. Such forward-looking statements are subject to risks, uncertaintiesand other factors that could cause actual results and the timing of certainevents to differ materially from future results expressed or implied by suchforward-looking statements. Factors that could cause or contribute to suchdifferences include, but are not limited to, those discussed in the sectiontitled “Risk Factors,” set forth in Part II, Item 1A of thisQuarterly Report on Form 10-Q and set forth in Part I, Item 1Aof our Annual Report on Form 10-K filed with the SEC on March 15,2010 and elsewhere in this Quarterly Report. The forward-looking statements inthis Quarterly Report on Form 10-Q represent our views as of the date ofthis Quarterly Report on Form 10-Q. We anticipate that subsequent eventsand developments will cause our views to change. However, while we may elect toupdate these forward-looking statements at some point in the future, we have nocurrent intention of doing so except to the extent required by applicable law.You should, therefore, not rely on these forward-looking statements asrepresenting our views as of any date subsequent to the date of this QuarterlyReport on Form 10-Q.*

 

**Overview**

 

We design, develop, manufacture and sell advanced, rechargeablelithium-ion batteries and battery systems. Our target markets are thetransportation, electric grid services and commercial markets.

 

We market and sell our products primarily through a direct sales force.In the transportation market, we are focusing sales of our batteries andbattery systems to automotive and heavy duty vehicle manufacturers eitherdirectly or through tier 1 suppliers. We work with automotive and heavyduty vehicle manufacturers directly to educate and inform them about thebenefits of our technology for use in hybrid electric vehicles, or HEVs,plug-in hybrid electric vehicles, or PHEVs and electric vehicles, or EVs, andare engaged in design and development efforts with several automotive and heavyduty vehicle manufacturers and tier 1 suppliers. At the same time, we workwith tier 1 suppliers who are developing integrated solutions using ourbatteries. In the electric grid services market, our agreements were initiateddirectly by our sales force. In the commercial market, our sales are made bothdirectly and indirectly through distributors with key accounts managed by oursales personnel. We have entered into an exclusive agreement to license certainof our technology in the field of commercial electronic devices (excludingpower tools and certain other consumer products) and expect to receive royaltyfees on net sales of licensed products that include our technology. We expectto continue to expand our sales presence in Europe and Asia as our business inthose regions continues to grow. We expect international markets to provideincreased opportunities for our products.

 

Our sales cycles vary by product and market segment. Most of ourbatteries and battery systems typically undergo a lengthy development andqualification period prior to commercial production. We expect that the totaltime from customer introduction to commercial production will range up to fiveyears depending on the specific product and market served. Our long andunpredictable sales cycles and the potential large size of battery supply anddevelopment contracts cause our period-to-period financial results to besusceptible to significant variability. Since most of our operating and capitalexpenses are incurred up-front based on the anticipated timing of estimateddesign wins and customer orders, the loss or delay of any such orders couldhave a material adverse effect on our results of operations for any particularperiod. The variability in our period-to-period results will also be driven bylikely period-to-period variations in product mix and by the seasonalityexperienced by some of the end markets into which we sell our products.  In the electric grid market, revenuerecognition will be volatile due to the timing of deployment, delivery, andsystem testing.  As such, the timing ofthese events will significantly affect the comparison of period-to-period revenues.

 

We have been expanding our manufacturing capacity since inception,including the current expansion of our Livonia and Romulus, Michiganfacilities, and we intend to further expand our manufacturing capacity byconstructing more manufacturing lines primarily in Michigan.  We are currently in transition as we are expandingcapacity in anticipation of increased demand for our prismatic cells as weexpect transportation product revenues to increase in future periods.  We intend to further accelerate the expansionof our manufacturing capacity subject to actual and anticipated future demandfor our products and the receipt of stimulus funds from the U.S. and stategovernments.  In the first quarter of2010, we began making investments against plans to further expand the finalassembly capacity of our Michigan facilities. Based on new design wins and our demand estimates, we have approvedplans to increase our capacity in Michigan, resulting in a worldwide capacityof over 760MWh.  We believe thatincreases in production capacity have had, and will continue to have, asignificant effect on our financial condition and results of operations. Wehave made and continue to make significant up-front investments in ourmanufacturing capacity, which negatively impact earnings and cash balances, butwe expect these investments will increase our revenue in the long term.

 

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Our research and development efforts are focused on developing newproducts and improving the performance of existing products. We fund ourresearch and development initiatives both from internal and external sources.As part of our development strategy, certain customers fund or partially fundresearch and development efforts to design and customize batteries and batterysystems for their specific application.

 

We have continued to experience significant losses since inception, aswe have continued to invest significantly to support the anticipated growth inour business. In particular, we have invested in product development and salesand marketing in order to meet product requirements of our target markets andto secure design wins that may lead to strong revenue growth and general andadministrative overhead to develop the infrastructure to support the business.We have also invested in the expansion of our manufacturing capacity to meetanticipated demand and our battery systems capabilities to provide batterysystems solutions to our customers. As our business grows, the key factors toimproving our financial performance will be revenue growth and revenuediversification into the transportation and electric grid services markets. Ourrevenue growth and revenue diversification will depend on our ability to securedesign wins in the transportation and electric grid services markets. Higherrevenue will also increase gross profit, as higher production volumes willprovide for increased absorption of manufacturing overhead and will reduce, ona percentage basis, the costs associated with increasing our productioncapacity.

 

In December 2009, we executed an agreement with the DOE regardingthe terms and conditions of the $249.1 million grant awarded under the DOE’sBattery Initiative to fund the construction of new lithium-ion batterymanufacturing facilities in Michigan. Under the DOE Battery Initiative, we arerequired to spend up to one dollar of our funds for every incentive dollarreceived. We are also negotiating a loan under the Advanced Technology VehiclesManufacturing Loan Program, or the ATVM Program, to support thismanufacturing expansion. Based on the amount of our grant award under the DOEBattery Initiative and the guidelines associated with the ATVM Program, webelieve we will be permitted to borrow up to $233 million under the ATVMProgram. We expect we will be required to spend one dollar of our own funds forevery four dollars we borrow under the ATVM Program. The timing and the amountof any loan we may receive under the ATVM Program are currently not known byus, and, once disclosed to us, are subject to change and negotiation with thefederal government.

 

In October 2009, we entered into a *High-Tech Credit* agreement with the Michigan Economic GrowthAuthority, or MEGA, pursuant to which we are eligible for a 15-year tax credit,beginning with the 2011 fiscal year. This credit has an estimated value of upto $25.3 million, depending on the number of jobs we create in Michigan.In November 2009, we entered into a *CellManufacturing Credit* agreement with MEGA pursuant to which we areeligible for a credit equal to 50% of our capital investment expensescommencing January 2009, up to a maximum of $100 million over afour-year period related to the construction of our integrated battery cellmanufacturing plant. The credit shall not exceed $25 million per yearbeginning with the tax year of 2012. We are required to create 300 jobs nolater than December 31, 2016 in order to receive the refundable taxcredit. The tax credit is subject to a repayment provision in the event werelocate 51% or more of the 300 jobs outside of the State of Michigan withinthree years after the last year we received the tax credit. Through June 30,2010 we have incurred expenses of $60.4 million related to the constructionof our facilities, and we are expecting to receive approximately$30.2 million in refundable tax credits related to these expenses.  We will record the receivable when it isprobable that we will comply with the conditions of the grant and the receiptof the grant.  At that time, we wouldreduce the basis in the assets acquired under the grant by $26.7 million andrecord $3.5 million as reimbursement for expenses previously incurred.

 

**Financial Operations Overview**

 

***Revenue***

 

We derive revenue from product sales and providing services.

 

*Product Revenue.*  Product revenue is derived from the sale ofour batteries and battery systems. For the six months ended June 30, 2009and 2010, product revenue represented 85% and 75% of our total revenue,respectively.

 

A significant portion of our revenue is generated from a limited numberof customers. Our two largest customers (BAE Systems and AES EnergyStorage, LLC) accounted for approximately 37% and 43% of our total revenueduring the six months ended June 30, 2009 and 2010, respectively, and weexpect that most of our revenue will continue to come from a relatively smallnumber of customers for the foreseeable future. As we increase our focus on thetransportation and electric grid markets, BAE Systems and AES Energy Storagewill continue to represent a significant portion of our 2010 revenue, and theloss of BAE Systems or AES Energy as a customer could have a material adverseeffect on our short-term revenue. Black & Decker has historicallyrepresented a significant portion of our revenue; however, we expect revenuefrom Black & Decker to continue to decline in future periods as weincrease our focus on the transportation and electric grid markets andBlack & Decker engages additional suppliers for its batteryrequirements. We expect the transportation market to be the largest portion ofour revenue in the near and long term.

 

*Services Revenue.*  Services revenue is primarily derived fromcontracts awarded by the U.S. federal government, other government agencies andcommercial customers. These activities range from pure research, in which weinvestigate design techniques on new battery technologies at the request of agovernment agency or commercial customer, to custom development projects inwhich

 

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weare paid to enhance or modify an existing product or develop a new product tomeet a customer’s specifications. We expect to continue to perform fundedresearch and development work and to use the technology developed to advanceour new product development efforts. We expect that revenue from services willvary period-to-period depending on the timing of cash payments received and, ifapplicable, the achievement of milestones. We expect that services revenue willdecrease as a percentage of our total revenue due to the expected increase inproduct revenue over the long-term.

 

*Deferred Revenue.*  We record deferred revenue for product salesand services in several different circumstances. These circumstances include(i) the products have been delivered or services have been performed butother revenue recognition criteria have not been satisfied (ii) paymentshave been received in advance of products being delivered or services beingperformed and (iii) when all other revenue recognition criteria have beenmet, but we are not able to reasonably estimate the warranty expense. Deferredrevenue includes customer deposits and up-front fees associated with servicearrangements. Deferred revenue expected to be recognized as revenue more thanone year subsequent to the balance sheet date is classified as long-termdeferred revenue. Deferred revenue will vary depending on the timing and amountof cash receipts from customers and can vary significantly depending onspecific contractual terms. As a result, deferred revenue is likely tofluctuate from period-to-period. During 2008, we received and recorded asdeferred revenue a $25.0 million up-front payment in connection with ourlicense agreement with Gillette. Under our exclusive license agreement withGillette, Gillette paid us an up-front fee of $22.5 million and a supportfee of $2.5 million. Gillette will also be required to pay us anadditional license fee following the completion of a support period. Inaddition, the agreement requires Gillette to pay us royalty fees on net salesof products that include our technology. We have agreed with Gillette that if,during a certain period following execution of the license agreement, we enterinto an agreement with a third party that materially restricts Gillette’slicense rights under the license agreement, then we may be required to refundto Gillette all license and support fees paid to us by Gillette under thelicense agreement, plus, in certain cases, an additional amount to coverGillette’s capital and other expenses paid and/or committed by Gillette inreliance upon its rights under the license agreement. Revenue recognition isexpected to commence two years from the date of the agreement, upon successfultransfer of technology know how to Gillette. The license and support fee willbe recognized on a straight-line basis over the longer of the patent term orthe expected customer relationship.

 

***Factorsthat May Affect Comparability***

 

*PublicCompany Expenses.* In September 2009,we completed an initial public offering of shares of our common stock.  As a result, we are subject to laws,regulations, and requirements that we were not required to comply with as aprivate company, including the Sarbanes-Oxley Act of 2002, other SECregulations and the requirements of the NASDAQ Global Market.  Compliance with these requirements requiresus to increase our general and administrative expenses in order to payconsultants, legal counsel and independent registered public accountants toassist us in, among other things, instituting and monitoring a morecomprehensive compliance and board governance function, establishing andmaintaining internal control over financial reporting in accordance withSection 404 of the Sarbanes-Oxley Act of 2002 and preparing anddistributing periodic public reports in compliance with our obligations underthe federal securities laws.  Inaddition, as a public company, it is more expensive for us to obtain andmaintain directors’ and officers’ liability insurance.

 

***Cost of Revenue and Gross Profit***

 

Cost of product revenue includes the cost of raw materials, labor andcomponents that are required for the production of our products, as well asmanufacturing overhead costs (including depreciation), inventory obsolescencecharges, and warranty costs.  Rawmaterial costs, which are our most significant cost item over the past twoyears, have historically been stable, but increasing energy costs for some ofour materials are expected to increase this cost. This increase may bepartially offset by process innovation, dual sourcing of materials andincreased volume if we achieve better economies of scale. We incur costsassociated with unabsorbed manufacturing expenses prior to a factory operatingat normal operating capacity. We expect these unabsorbed manufacturing costs,which include certain personnel, rent, utilities, materials, testing anddepreciation costs, to increase in absolute dollars and as a percentage ofrevenue in the near term.

 

Cost of services revenue includes the direct labor costs of engineeringresources committed to funded service contracts, as well as third-partyconsulting, and associated direct material and equipment costs. Additionally,we include overhead expenses such as occupancy costs associated with theproject resources, engineering tools and supplies and program managementexpense.

 

Our gross profit/(loss) is affected by a number of factors, includingthe mix of products sold, customer diversification, the mix between productrevenue and services revenue, average selling prices, foreign exchange rates,our actual manufacturing costs and costs associated with increasing productioncapacity until full production is achieved. As we continue to grow and buildout our manufacturing capacity, and as new product designs come intoproduction, our gross profit will continue to fluctuate from period-to-period.

 

***Operating Expenses***

 

Operating expenses consist of research, development and engineering,sales and marketing, general and administrative and production start-upexpenses. Personnel-related expenses comprise the most significant component ofthese expenses. We expect to

 

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hirea significant number of new employees in order to support our anticipatedgrowth. In any particular period, the timing of additional hires could materiallyaffect our operating expenses, both in absolute dollars and as a percentage ofrevenue.

 

*Research, Development and Engineering Expenses.*  Research, development and engineeringexpenses consist primarily of expenses for personnel engaged in the developmentof new products and the enhancement of existing products, as well as labmaterials, quality assurance activities and facilities costs and other relatedoverhead.  These expenses also includepre-production costs related to long-term supply agreements unlessreimbursement from the customer is contractually guaranteed.  Pre-production costs consist of engineering,design and development costs for products sold under long-term supplyarrangements.  We expense all of ourresearch, development and engineering costs as they are incurred. In the nearterm, we expect research, development and engineering expenses to increase inlarge part due to personnel-related expenses as we seek to hire additionalemployees, as well as contract-related expenses as we continue to invest in thedevelopment of our products.  Research,development and engineering expense is reported net of any funding receivedunder contracts with governmental agencies and commercial customers that areconsidered to be cost sharing arrangements with no contractually committeddeliverable. Accordingly, we expect that our research, development andengineering expenses will continue to increase in absolute dollars but decreaseas a percentage of revenue in the long term.

 

*Sales and Marketing Expenses.*  Sales and marketing expenses consistprimarily of personnel-related expenses, travel and other out-of-pocketexpenses for marketing programs, such as trade shows, industry conferences,marketing materials and corporate communications, and facilities costs andother related overhead. We intend to hire additional sales personnel, initiateadditional marketing programs and build additional relationships withresellers, systems integrators and strategic partners on a global basis.Accordingly, we expect that our sales and marketing expenses will continue toincrease in absolute dollars but decrease as a percentage of revenue in thelong term.

 

*General and Administrative Expenses.*  General and administrative expenses consistprimarily of personnel-related expenses related to our executive, legal,finance, human resource and information technology functions, as well as feesfor professional services and allocated facility overhead expenses.Professional services consist principally of external legal, accounting, tax,audit and other consulting services. We expect general and administrativeexpenses to increase as we incur additional costs related to operating as apublicly-traded company, including increased audit and legal fees, costs ofcompliance with securities, corporate governance and other regulations,investor relations expenses and higher insurance premiums, particularly thoserelated to director and officer insurance. In addition, we expect to incuradditional costs as we hire personnel and enhance our infrastructure to supportthe anticipated growth of our business. Accordingly, we expect that our generaland administrative expenses will continue to increase in absolute dollars butdecrease as a percentage of revenue in the long term.

 

*Production Start-up Expenses. *Production start-up expensesconsist of salaries and personnel-related costs, site selection costs,including legal and regulatory costs, rent and the cost of operating aproduction line before it has been qualified for full production, including thecost of raw materials run through the production line during the qualificationphase.  We expect to incur additionalproduction start-up expenses related to our facilities in Livonia and Romulus,Michigan in the near term. The Livonia facility is expected to beginqualification for production in the second half of 2010. The Romulus facilityis expected to begin qualification for production in the first half of 2011.

 

*Other Income (Expense), Net.*  Other income (expense), net consistsprimarily of interest income on cash balances, interest expense on borrowings,change in fair value of preferred stock warrants and foreign currency-relatedgains and losses. We have historically invested our cash in money marketinvestments. Our interest income will vary each reporting period depending onour average cash balances during the period and the current level of interestrates. Similarly, our foreign currency-related gains and losses will also varydepending upon movements in underlying exchange rates. Upon the closing of ourIPO, all preferred stock warrants were converted to common stock warrants andwe do not expect any gains or losses related to the change in the fair value ofpreferred stock warrants going forward.

 

*Provision for Income Taxes.*  Through June 30, 2010, we incurred netlosses since inception and have not recorded provisions for U.S. federal incometaxes since the tax benefits of our net losses have been offset by valuationallowances.

 

We have recorded a tax provision for foreign taxes associated with ourforeign subsidiaries and state income taxes where our net operating lossdeductions are limited by statutes.

 

**Watt Hours Operating Metric**

 

Wemeasure our product shipments in watt hours, or Wh, which refers to theaggregate amount of energy that could be delivered in a single completedischarge by a battery. We calculate Wh for each of our battery models bymultiplying the battery’s amp hour, or Ah, storage capacity by the battery’svoltage rating. For example, our 26650 battery is a 2.3 Ah battery thatoperates at 3.3 V, resulting in a 7.6 Wh rating. We determine a battery’s Ahstorage capacity at a specific discharge rate and a specific depth ofdischarge. We do this by charging the battery to its top voltage and bydischarging it to zero capacity (2 volt charge level). The Wh metric allows usand our investors to measure our manufacturing capacity and shipments,regardless of battery voltages and Ah specifications, utilizing a

 

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uniformand consistent metric.

 

**Certain Trends and Uncertainties**

 

The following represents asummary of certain trends and uncertainties, which could have a significantimpact on our financial condition and results of operations. This summary isnot intended to be a complete list of potential trends and uncertainties thatcould impact our business in the long or short term. The summary, however,should be considered along with the factors identified in the section titled “*Risk Factors*” set forth in Part II, Item 1Aof this Quarterly Report on Form 10-Q, and elsewhere in this report.

 

·                We believe that our future revenues dependon our ability to develop, manufacture and market products that improve uponexisting battery technology and gain market acceptance. If our batterytechnology is not adopted by our customers, or if our battery technology doesnot meet industry requirements for power and energy storage capacity in anefficient and safe design, our batteries will not gain market acceptance.

 

·                We build our manufacturing capacity based onour projection of future development and supply agreement wins. Increases inproduction capacity, have had, and will continue to have, an effect on ourfinancial condition and results of operations. Our business revenues andprofits will depend upon our ability to enter into and complete development andsupply agreements, successfully complete these capacity expansion projects,achieve competitive manufacturing yields and drive volume sales consistent withour demand expectations.

 

·                Our revenues are expected to continue tocome from a relatively small number of customers for the foreseeable future.The loss of one of our two most significant customers or several of our smallercustomers, could materially harm our business.

 

**CriticalAccounting Policies**

 

Our financial statements areprepared in accordance with accounting principles generally accepted in theUnited States of America. The preparation of our financial statements andrelated disclosures requires us to make estimates, assumptions and judgmentsthat affect the reported amount of assets, liabilities, revenue, costs andexpenses, and related disclosures. We base our estimates and assumptions onhistorical experience and other factors that we believe to be reasonable underthe circumstances. We evaluate our estimates and assumptions on an ongoingbasis. Our actual results may differ from these estimates under differentassumptions and conditions. Our most critical accounting policies are listedbelow.

 

·        Revenuerecognition;

 

·        Productwarranty obligations;

** **

·        Inventory;

 

·        Impairmentof goodwill and acquired intangible assets;

 

·        Impairmentof long-lived assets;

 

·        Governmentgrants;

 

·        Stock-basedcompensation;

 

·**       **Income taxes;

 

·        Investments in non-publiccompanies.

 

We updated our criticalaccounting policies during the three months ended June 30, 2010 asfollows:

 

*Grants to Non-Employees*.  Accounting for grants to non-employees is nolonger considered a critical accounting policy as non-employee stock-basedcompensation expense does not currently have a material impact on our condensedconsolidated financial statements.

 

*Investments in Non-PublicCompanies**.*  * *Our investments held in non-publiccompanies expose us to equity price risk. As of June 30, 2010,non-publicly traded investments of $20.5 million are accounted for using thecost method.  Strategicinvestments in third parties are subject to risk of changes in marketvalue, which if determined to be other-than-temporary, could result inrealized impairment losses, which could be material. We generally do notattempt to reduce or eliminate our market exposure in cost or equity

 

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methodinvestments. We regularly monitor these non-publicly traded investments forimpairment and record reductions in the carrying values when necessary.Circumstances that indicate an other-than-temporary decline include valuationascribed to the issuing company in subsequent financing rounds, decreases inquoted market price and declines in operations of the issuer. There can be noassurance that cost or equity method investments will not face risks of loss.

 

During the three and six monthsended June 30, 2010, there were no other significant changes in ourcritical accounting policies or estimates. See our Annual Report on Form 10-Kfor the year ended December 31, 2009, filed with the SEC on March 15,2010, for additional information about our critical accounting policies, aswell as a description of our other significant accounting policies.

 

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**Results ofConsolidated Operations**

 

The following table setsforth selected condensed consolidated statements of operations data for each ofthe periods (in thousands):

 
| ** **                                                         | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                         | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** |
| ** **                                                         | ** ** | **2009**               | ** ** | **2010**             | ** ** | **2009** | ** ** | **2010** | ** ** |
|                                                               |       |                   |       |                 |       |   |   |   |   |
| Revenue:                                                           |       |                   |       |                 |       |   |   |   |   |
| Product                                                            |       | $                      | 16,517     |                 | $          | 15,558 |   | $ | 36,638 |   | $ | 35,332 |   |
| Services                                                           |       | 3,185                  |       | 7,050                |       | 6,284 |   | 11,744 |   |
|                                                               |       |                   |       |                 |       |   |   |   |   |
| Total revenue                                                      |       | 19,702                 |       | 22,608               |       | 42,922 |   | 47,076 |   |
|                                                               |       |                   |       |                 |       |   |   |   |   |
| Cost of revenue:                                                   |       |                   |       |                 |       |   |   |   |   |
| Product                                                            |       | 19,616                 |       | 18,977               |       | 39,186 |   | 41,331 |   |
| Services                                                           |       | 2,661                  |       | 6,580                |       | 4,505 |   | 10,735 |   |
|                                                               |       |                   |       |                 |       |   |   |   |   |
| Total cost of revenue                                              |       | 22,277                 |       | 25,557               |       | 43,691 |   | 52,066 |   |
|                                                               |       |                   |       |                 |       |   |   |   |   |
| Gross loss                                                         |       | (2,575                 | )          | (2,949               | )          | (769 | ) | (4,990 | ) |
|                                                               |       |                   |       |                 |       |   |   |   |   |
| Operating expenses:                                                |       |                   |       |                 |       |   |   |   |   |
| Research, development and engineering                              |       | 11,587                 |       | 13,832               |       | 22,814 |   | 27,948 |   |
| Sales and marketing                                                |       | 2,245                  |       | 3,366                |       | 4,227 |   | 6,166 |   |
| General and administrative                                         |       | 5,990                  |       | 8,804                |       | 12,273 |   | 17,044 |   |
| Production start-up                                                |       | 179                    |       | 3,606                |       | 179 |   | 5,417 |   |
|                                                               |       |                   |       |                 |       |   |   |   |   |
| Total operating expenses                                           |       | 20,001                 |       | 29,608               |       | 39,493 |   | 56,575 |   |
|                                                               |       |                   |       |                 |       |   |   |   |   |
| Operating loss                                                     |       | (22,576                | )          | (32,557              | )          | (40,262 | ) | (61,565 | ) |
|                                                               |       |                   |       |                 |       |   |   |   |   |
| Other income (expense):                                            |       |                   |       |                 |       |   |   |   |   |
| Interest expense, net                                              |       | (292                   | )          | (372                 | )          | (510 | ) | (590 | ) |
| Gain (loss) on foreign exchange                                    |       | 673                    |       | (1,226               | )          | (115 | ) | (981 | ) |
| Unrealized loss on preferred stock warrant  liability              |       | (22                    | )          | —               |       | (70 | ) | — |   |
|                                                               |       |                   |       |                 |       |   |   |   |   |
| Other income (expense), net                                        |       | 359                    |       | (1,598               | )          | (695 | ) | (1,571 | ) |
|                                                               |       |                   |       |                 |       |   |   |   |   |
| Loss from operations, before tax                                   |       | (22,217                | )          | (34,155              | )          | (40,957 | ) | (63,136 | ) |
|                                                               |       |                   |       |                 |       |   |   |   |   |
| Provision for income taxes                                         |       | 123                    |       | 132                  |       | 267 |   | 253 |   |
|                                                               |       |                   |       |                 |       |   |   |   |   |
| Net loss                                                           |       | (22,340                | )          | (34,287              | )          | (41,224 | ) | (63,389 | ) |
| Less: Net loss attributable to the noncontrolling  interest        |       | 427                    |       | 69                   |       | 574 |   | 146 |   |
|                                                               |       |                   |       |                 |       |   |   |   |   |
| Net loss attributable to A123 Systems, Inc.                   |       | (21,913                | )          | (34,218              | )          | (40,650 | ) | (63,243 | ) |
|                                                               |       |                   |       |                 |       |   |   |   |   |
| Accretion to preferred stock                                       |       | (17                    | )          | —               |       | (28 | ) | — |   |
|                                                               |       |                   |       |                 |       |   |   |   |   |
| Net loss attributable A123 Systems, Inc.  common stockholders |       | $                      | (21,930    | )                    | $          | (34,218 | ) | $ | (40,678 | ) | $ | (63,243 | ) |
|                                                               |       |                   |       |                 |       |   |   |   |   |
| **Other Operating Data:**                                          |       |                   |       |                 |       |   |   |   |   |
| Shipments (in watt hours, or Wh) (in thousands)                    |       | 17,028                 |       | 14,563               |       | 27,663 |   | 30,815 |   |

 

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*ThreeMonths Ended June 30, 2009 and 2010*

 

**Revenue**

 
| ** **     | ** ** | **Three Months Ended June 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|----------------|------------|--------------------------------------|------------|------------|------------|-------------------|------------|
| ** **     | ** ** | **2009**                             | ** ** | **2010**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **     | ** ** | **(Dollars in thousands)**           | ** ** |
| **Revenue**    |       |                                 |       |       |       |              |       |   |   |
|           |       |                                 |       |       |       |              |       |   |   |
| Product        |       |                                 |       |       |       |              |       |   |   |
| Transportation |       | $                                    | 12,594     |       | $          | 10,457            |       | $ | (2,137 | ) | -17.0 | % |
| Commercial     |       | 3,923                                |       | 5,085      |       | 1,162             |       | 29.6 | % |
| Electric grid  |       | —                               |       | 16         |       | 16                |       | 100.0 | % |
|           |       |                                 |       |       |       |              |       |   |   |
| Total product  |       | 16,517                               |       | 15,558     |       | (959              | )          | -5.8 | % |
| Services       |       | 3,185                                |       | 7,050      |       | 3,865             |       | 121.4 | % |
|           |       |                                 |       |       |       |              |       |   |   |
| Total revenue  |       | $                                    | 19,702     |       | $          | 22,608            |       | $ | 2,906 |   | 14.7 | % |

 

*ProductRevenue.*The decrease in sales to customers in the transportationindustry of $2.1 million for the three months ended June 30, 2010compared to the three months ended June 30, 2009 was primarily due to adecrease in sales to BAE Systems of $2.4 million and a decrease in sales toMercedes-Benz HighPerformanceEngines of $2.2 million due to the cancellation ofthe Mercedes-Benz program in 2009.  Thesedecreases were partially offset by an increase of $2.5 million, primarily dueto sales to new transportation customers. Sales to customers in the commercial industry increased by $1.2million.  In the commercial industrysales to Black & Decker and its affiliates decreased by $0.4 millionand sales generated by our Enerland subsidiary decreased by $0.4 million.  Sales to other customers in the commercialindustry increased by $2.0 million.

 

*ServicesRevenue.*The increase in services revenue was related to theincrease in revenue from government agency research contracts, which wasprimarily due to a new project award granted.

 

**Cost of Revenue and Gross Profit(Loss)**

 
| ** **                | ** ** | **Three Months Ended June 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|---------------------------|------------|--------------------------------------|------------|------------|------------|-------------------|------------|
| ** **                | ** ** | **2009**                             | ** ** | **2010**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                | ** ** | **(Dollars in thousands)**           | ** ** |
| **Cost of revenue**       |       |                                 |       |       |       |              |       |   |   |
|                      |       |                                 |       |       |       |              |       |   |   |
| Product                   |       | $                                    | 19,616     |       | $          | 18,977            |       | $ | (639 | ) | -3.3 | % |
| Services                  |       | 2,661                                |       | 6,580      |       | 3,919             |       | 147.3 | % |
|                      |       |                                 |       |       |       |              |       |   |   |
| Total cost of revenue     |       | $                                    | 22,277     |       | $          | 25,557            |       | $ | 3,280 |   | 14.7 | % |
|                      |       |                                 |       |       |       |              |       |   |   |
| **Gross profit (loss)**   |       |                                 |       |       |       |              |       |   |   |
|                      |       |                                 |       |       |       |              |       |   |   |
| Product                   |       | $                                    | (3,099     | )          | $          | (3,419            | )          | $ | (320 | ) | 10.3 | % |
| Services                  |       | 524                                  |       | 470        |       | (54               | )          | -10.3 | % |
|                      |       |                                 |       |       |       |              |       |   |   |
| Total gross profit (loss) |       | $                                    | (2,575     | )          | $          | (2,949            | )          | $ | (374 | ) | 14.5 | % |

 

*Cost of Product Revenue*. The decreasein cost of product revenue was primarily due to a decrease in productrevenues.  In addition, due to lowfactory utilization, unabsorbed manufacturing expenses were $6.7 million forthe three months ended June 30, 2009, compared to $4.8 million for thethree months ended June 30, 2010, due to improved utilization of ourcoating and powder plants in support of the qualification of our prismatic cellproduction lines.

 

*Cost of Services Revenues*. The increasein costs of services revenue resulted from the increase in services revenues.

 

*Product Gross Profit (Loss).* We experienceda product gross loss during the three months ended June 30, 2010,primarily due to low factory utilization. Our future gross profit will beaffected by numerous factors, including the build-out of our manufacturingcapacity and the timing of the production of new product designs. For example,unabsorbed manufacturing expenses were $4.8 million during the three monthsended June 30, 2010. As a result, our gross profit or loss will varysignificantly from period-to period going forward.  In addition, gross profit decreased due to anunfavorable change in the mix of products sold in the three months ended June 30,2010, as the three months ended June 30, 2009 included the sale of highermargin products in comparison to the three months ended June 30, 2010.

 

*Services Gross Profit*. Servicesgross profit decreased due to the increase in the cost of services and thetiming of project milestones.   Inaddition, our services gross margin decreased due to the mix of government andcommercial contracts in the three months ended June 30, 2010, as the three

 

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months ended June 30,2009 included a greater percentage of higher margin contracts.

 

**Operating Expenses**

** **
| ** **                            | ** ** | **Three Months Ended June 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|---------------------------------------|------------|--------------------------------------|------------|------------|------------|-------------------|------------|
| ** **                            | ** ** | **2009**                             | ** ** | **2010**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                            | ** ** | **(Dollars in thousands)**           | ** ** |
| **Operating expenses**                |       |                                 |       |       |       |              |       |   |   |
|                                  |       |                                 |       |       |       |              |       |   |   |
| Research, development and engineering |       | $                                    | 11,587     |       | $          | 13,832            |       | $ | 2,245 |   | 19.4 | % |
| Sales and marketing                   |       | 2,245                                |       | 3,366      |       | 1,121             |       | 49.9 | % |
| General and administrative            |       | 5,990                                |       | 8,804      |       | 2,814             |       | 47.0 | % |
| Production start-up                   |       | 179                                  |       | 3,606      |       | 3,427             |       | 1914.5 | % |
|                                  |       |                                 |       |       |       |              |       |   |   |
| Total operating expenses              |       | $                                    | 20,001     |       | $          | 29,608            |       | $ | 9,607 |   | 48.0 | % |

 

*Research, Development andEngineering Expenses.* A portion of research, development andengineering expenses was offset primarily by cost-sharing funding. Ourresearch, development and engineering expenditures are summarized as follows:

 
| ** **                                                     | ** ** | **Three Months Ended June 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|----------------------------------------------------------------|------------|--------------------------------------|------------|------------|------------|-------------------|------------|
| ** **                                                     | ** ** | **2009**                             | ** ** | **2010**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                                                     | ** ** | **(Dollars in thousands)**           | ** ** |
| **Research, development and engineering  expenditures**        |       |                                 |       |       |       |              |       |   |   |
|                                                           |       |                                 |       |       |       |              |       |   |   |
| Aggregated research, development and engineering  expenditures |       | $                                    | 12,431     |       | $          | 15,257            |       | $ | 2,826 |   | 22.7 | % |
| Research, development and engineering  reimbursements          |       | 844                                  |       | 1,425      |       | 581               |       | 68.8 | % |
|                                                           |       |                                 |       |       |       |              |       |   |   |
| Research, development and engineering expenses                 |       | $                                    | 11,587     |       | $          | 13,832            |       | $ | 2,245 |   | 19.4 | % |

 

The increase in research,development and engineering expenses for the three months ended June 30,2010 compared to the three months ended June 30, 2009 was primarilyattributable to an increase of $2.6 million in personnel-related expensesassociated with an increase in research, development and engineering personnelwho primarily focus on manufacturing process improvement, material sciencechemistry and battery and battery systems technology.  This increase was partially offset by adecrease in general product development and other research, development andengineering expenses of $0.4 million. Research, development and engineering expense was 59% of revenue for thethree months ended June 30, 2009, compared to 61% for the three monthsended  June 30, 2010.

 

*Sales and Marketing Expenses.* The increasein sales and marketing expenses for the three months ended June 30, 2010compared to the three months ended June 30, 2009 was primarilyattributable to an increase of $0.6 million in personnel-related expensesassociated with an increase in sales and marketing headcount, in addition to anincrease in marketing expenses related to trade shows, public relations,advertising, and other sales and marketing related expenses of $0.5million.  Sales and marketing expense was11% of revenue for the three months ended June 30, 2009, compared to 15%for the three months ended June 30, 2010.

 

*General and AdministrativeExpenses*. The increase in general and administrative expensesfor the three months ended June 30, 2010 compared to the three monthsended June 30, 2009 was primarily due to an increase in personnel-relatedexpenses of $1.7 million, associated with an increase in general andadministrative headcount, and an increase in other general and administrativeexpenses of $1.1 million.  General andadministrative expense was 30% of revenue for the three months endedJune 30, 2009, compared to 39% for the three months ended June 30,2010.

 

*Production Start-up Expenses.  *Theincrease in production start-up expenses for the three months ended June 30,2010 compared to the three months ended June 30, 2009 was primarily due toincreased costs incurred related to our manufacturing expansion at our Livoniaand Romulus, Michigan facilities.  Inaddition, during the three months ended June 30, 2010, we incurred $1.6million of production start-up expenses related to materials, laborand overhead costs incurred in the qualification of the prismatic cellproduction line.  Production start-upexpenses were offset by approximately $1.2 million of government grant fundingduring the three months ended June 30, 2010.  There was no offset to production start-upexpenses during the three months ended June 30, 2009.  Production start-up expense was 1% of revenuefor the three months ended June 30, 2009, compared to 16% of revenue forthe three months ended June 30, 2010.

 

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**Other Income (Expense), Net**

 
| ** **                                            | ** ** | **Three Months Ended June 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|-------------------------------------------------------|------------|--------------------------------------|------------|------------|------------|-------------------|------------|
| ** **                                            | ** ** | **2009**                             | ** ** | **2010**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                                            | ** ** | **(Dollars in thousands)**           | ** ** |
| **Other  income (expense), net**                      |       |                                 |       |       |       |              |       |   |   |
|                                                  |       |                                 |       |       |       |              |       |   |   |
| Interest expense, net                                 |       | $                                    | (292       | )          | $          | (372              | )          | $ | (80 | ) | 27.4 | % |
| Gain (loss) on foreign exchange                       |       | 673                                  |       | (1,226     | )          | (1,899            | )          | 282.2 | % |
| Unrealized loss on preferred stock warrant  liability |       | (22                                  | )          | —     |       | 22                |       | -100.0 | % |
|                                                  |       |                                 |       |       |       |              |       |   |   |
| Total other income (expense), net                     |       | $                                    | 359        |       | $          | (1,598            | )          | $ | (1,957 | ) | -545.1 | % |

 

Thechange in interest, net for the three months ended June 30, 2010 was dueto an increase in interest expense due on the total debt outstanding. Thedecrease in net foreign exchange gains for the three months ended June 30,2010 is due to the effect of currency exchange rate changes, in particularchanges in the U.S. Dollar - Korean Won exchange rate, on transactions that arenon U.S. dollar denominated and charged or credited to earnings. The decreasein unrealized loss on preferred stock warrant liability was due to the conversionof the preferred stock warrants to common stock warrants in connection with ourIPO.

 

*Provision for Income Taxes.* The provisionfor income taxes for the three months ended June 30, 2009 and 2010 wasprimarily related to foreign and state income taxes. We did not report abenefit for federal income taxes in the condensed consolidated financialstatements as the deferred tax asset generated from our net operating loss hasbeen offset by a full valuation allowance because it is more likely than notthat the tax benefits of the net operating loss carry forward may not berealized.

 

*SixMonths Ended June 30, 2009 and 2010*

 

**Revenue**

** **
| ** **     | ** ** | **Six Months  Ended June 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|----------------|------------|-------------------------------------|------------|------------|------------|-------------------|------------|
| ** **     | ** ** | **2009**                            | ** ** | **2010**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **     | ** ** | **(Dollars  in thousands)**         | ** ** |
| **Revenue**    |       |                                |       |       |       |              |       |   |   |
|           |       |                                |       |       |       |              |       |   |   |
| Product        |       |                                |       |       |       |              |       |   |   |
| Transportation |       | $                                   | 25,673     |       | $          | 20,707            |       | $ | (4,966 | ) | -19.3 | % |
| Commercial     |       | 10,965                              |       | 9,369      |       | (1,596            | )          | -14.6 | % |
| Electric grid  |       | —                              |       | 5,256      |       | 5,256             |       | 100.0 | % |
|           |       |                                |       |       |       |              |       |   |   |
| Total Product  |       | 36,638                              |       | 35,332     |       | (1,306            | )          | -3.6 | % |
| Services       |       | 6,284                               |       | 11,744     |       | 5,460             |       | 86.9 | % |
|           |       |                                |       |       |       |              |       |   |   |
| Total revenue  |       | $                                   | 42,922     |       | $          | 47,076            |       | $ | 4,154 |   | 9.7 | % |

 

*Product Revenue.*Thedecrease in sales to customers in the transportation industry of $5.0 millionfor the six months ended June 30, 2010 compared to the six months ended June 30,2009 was primarily due to a decrease of sales to Mercedes-BenzHighPerformanceEngines of $6.9 million due to the cancellation of theMercedes-Benz program in 2009.  Thisdecrease was partially offset by an increase of $1.9 million, primarily due tosales to new transportation customers.  The decrease in sales to customers in the commercial industry of $1.6million is due to a decrease of sales to Black & Decker and itsaffiliates of $4.9 million and a decrease in sales generated by our Enerlandsubsidiary of $0.7 million, which was attributable to the decline in demand forour radio controlled products.  Sales toother commercial customers increased by $4.0 million.

 

*ServicesRevenue.*The increase in services revenue was related to theincrease in revenue from government agency research contracts, which wasprimarily due to a new project award granted.

 

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**Cost of Revenue and Gross Profit(Loss)**

 
| ** **               | ** ** | **Six Months  Ended June 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|--------------------------|------------|-------------------------------------|------------|------------|------------|-------------------|------------|
| ** **               | ** ** | **2009**                            | ** ** | **2010**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **               | ** ** | **(Dollars  in thousands)**         | ** ** |
| **Cost of revenue**      |       |                                |       |       |       |              |       |   |   |
|                     |       |                                |       |       |       |              |       |   |   |
| Product                  |       | $                                   | 39,186     |       | $          | 41,331            |       | $ | 2,145 |   | 5.5 | % |
| Services                 |       | 4,505                               |       | 10,735     |       | 6,230             |       | 138.3 | % |
|                     |       |                                |       |       |       |              |       |   |   |
| Total cost of revenue    |       | $                                   | 43,691     |       | $          | 52,066            |       | $ | 8,375 |   | 19.2 | % |
|                     |       |                                |       |       |       |              |       |   |   |
| **Gross  profit (loss)** |       |                                |       |       |       |              |       |   |   |
|                     |       |                                |       |       |       |              |       |   |   |
| Product                  |       | $                                   | (2,548     | )          | $          | (5,999            | )          | $ | (3,451 | ) | 135.4 | % |
| Services                 |       | 1,779                               |       | 1,009      |       | (770              | )          | -43.3 | % |
|                     |       |                                |       |       |       |              |       |   |   |
| Total gross loss         |       | $                                   | (769       | )          | $          | (4,990            | )          | $ | (4,221 | ) | 548.9 | % |

 

*Cost of Product Revenue*. The increasein cost of product revenue was primarily due to an unfavorable change in themix of products sold in the six months ended June 30, 2010. In addition,due to low factory utilization, unabsorbed manufacturing expenses were $11.5million for the six months ended June 30, 2010, compared to $9.7 millionfor the six months ended June 30, 2010, due to improved utilization of ourcoating and powder plants in support of the qualification of our prismatic cellproduction lines.

 

*Cost of Services Revenues*. The increasein costs of services revenue resulted from the increase in services revenues.

 

*Product Gross Profit (Loss).* We experienceda product gross loss during the six months ended June 30, 2010, primarilydue to low factory utilization. Our future gross profit will be affected bynumerous factors, including the build-out of our manufacturing capacity and thetiming of the production of new product designs. For example, unabsorbedmanufacturing expenses were $9.7 million during the six months endedJune 30, 2010. As a result, our gross profit or loss will varysignificantly from period-to period going forward.  In addition, gross profit decreased due to anunfavorable change in the mix of products sold in the six months ended June 30,2010, as the six months ended June 30, 2009 included the sale of highermargin products in comparison to the six months ended June 30, 2010.

 

*Services Gross Profit*. Servicesgross profit decreased due to the increase in the cost of services and thetiming of project milestones.  Inaddition, our services gross margin decreased due to the mix of government andcommercial contracts in the six months ended June 30, 2010, as the six monthsended June 30, 2009 included a greater percentage of higher margincontracts.

 

**Operating Expenses**

** **
| ** **                            | ** ** | **Six Months Ended June 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|---------------------------------------|------------|------------------------------------|------------|------------|------------|-------------------|------------|
| ** **                            | ** ** | **2009**                           | ** ** | **2010**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                            | ** ** | **(Dollars in thousands)**         | ** ** |
| **Operating expenses**                |       |                               |       |       |       |              |       |   |   |
|                                  |       |                               |       |       |       |              |       |   |   |
| Research, development and engineering |       | $                                  | 22,814     |       | $          | 27,948            |       | $ | 5,134 |   | 22.5 | % |
| Sales and marketing                   |       | 4,227                              |       | 6,166      |       | 1,939             |       | 45.9 | % |
| General and administrative            |       | 12,273                             |       | 17,044     |       | 4,771             |       | 38.9 | % |
| Production start-up                   |       | 179                                |       | 5,417      |       | 5,238             |       | 2926.3 | % |
|                                  |       |                               |       |       |       |              |       |   |   |
| Total operating expenses              |       | $                                  | 39,493     |       | $          | 56,575            |       | $ | 17,082 |   | 43.3 | % |

 

*Research, Development andEngineering Expenses.* A portion of research, development andengineering expenses was offset primarily by cost-sharing funding. Ourresearch, development and engineering expenditures are summarized as follows:

 
|                                                           |   | **Six Months  Ended June 30,** | ** ** | ** ** | ** ** | ** **        |       |
|----------------------------------------------------------------|--------|-------------------------------------|------------|------------|------------|-------------------|------------|
|                                                           |   | **2009**                            | ** ** | **2010**   | ** ** | **$ Change** | ** ** | **% Change** |   |
|                                                           |   | **(Dollars  in thousands)**         |       |
| **Research, development expenditures**                         |   |                                |       |       |       |              |       |   |   |
|                                                           |   |                                |       |       |       |              |       |   |   |
| Aggregated research,  development and engineering expenditures |   | $                                   | 24,441     |       | $          | 29,923            |       | $ | 5,482 |   | 22.4 | % |
| Research, development and  engineering reimbursements          |   | 1,627                               |       | 1,975      |       | 348               |       | 21.4 | % |
|                                                           |   |                                |       |       |       |              |       |   |   |
| Research, development and  engineering expenses                |   | $                                   | 22,814     |       | $          | 27,948            |       | $ | 5,134 |   | 22.5 | % |

 

The increase in research,development and engineering expenses for the six months ended June 30,2010 compared to the six months ended June 30, 2009 was primarilyattributable to an increase of $3.7 million in personnel-related expensesassociated with an increase in research, development and engineering personnelwho primarily focus on manufacturing process improvement, material sciencechemistry and battery and battery systems technology, in addition to anincrease in general product development and other research, development andengineering expenses of $1.4 million. Research, development and engineeringexpense as a percentage of

 

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revenue was 53% in the sixmonths ended June 30, 2009, compared to 59% in the six months endedJune 30, 2010.

 

*Sales and Marketing Expenses.* The increasein sales and marketing expenses for the six months ended June 30, 2010compared to the six months ended June 30, 2009 was primarily attributableto an increase of $0.9 million in personnel-related expenses associated with anincrease in sales and marketing personnel, in addition to an increase inmarketing expenses related to trade shows, public relations, advertising, andother sales and marketing related expenses of $1.0 million.  Sales and marketing expense was 10% ofrevenue for the six months ended June 30, 2009, compared to 13% for thesix months ended June 30, 2010.

 

*General and AdministrativeExpenses*. The increase in general and administrativeexpenses for the six months ended June 30, 2010 compared to the six monthsended June 30, 2009 was primarily due to an increase in personnel-relatedexpenses of $3.1 million associated with an increase in general andadministrative personnel, and an increase in other general and administrativeexpenses of $1.7 million.  General andadministrative expense was 29% of revenue for the six months endedJune 30, 2009, compared to 36% for the six months ended June 30,2010.

 

*Production Start-up Expenses. *Theincrease in production start-up expenses for the six months ended June 30,2010 compared to the six months ended June 30, 2009 was primarily due toincreased costs incurred related to our manufacturing expansion at our Livoniaand Romulus, Michigan facilities.  Inaddition, during the six months ended June 30, 2010, we incurred $1.6million of production start-up expenses related to materials, laborand overhead costs incurred in the qualification of the prismatic cellproduction line.  The production start-upexpenses were offset by approximately $1.5 million of government grant fundingduring the six months ended June 30, 2010. There was no offset to production start-up expenses during the sixmonths ended June 30, 2009. Production start-up expense was 0% of revenue for the six months ended June 30,2009, compared to 12% of revenue for the six months ended June 30, 2010.

 

**Other Income (Expense), Net**

** **
| ** **                                            | ** ** | **Six Months  Ended June 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|-------------------------------------------------------|------------|-------------------------------------|------------|------------|------------|-------------------|------------|
| ** **                                            | ** ** | **2009**                            | ** ** | **2010**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                                            | ** ** | **(Dollars  in thousands)**         | ** ** |
| **Other  income (expense), net**                      |       |                                |       |       |       |              |       |   |   |
|                                                  |       |                                |       |       |       |              |       |   |   |
| Interest expense, net                                 |       | $                                   | (510       | )          | $          | (590              | )          | (80 | ) | 15.7 | % |
| Loss on foreign exchange                              |       | (115                                | )          | (981       | )          | (866              | )          | 753.0 | % |
| Unrealized loss on  preferred stock warrant liability |       | (70                                 | )          | —     |       | 70                |       | -100.0 | % |
|                                                  |       |                                |       |       |       |              |       |   |   |
| Total other income  (expense), net                    |       | $                                   | (695       | )          | $          | (1,571            | )          | $ | (876 | ) | 126.0 | % |
|                                                       |            |                                     |            |            |            |                   |            |  |  |  |  |  |

 

Thechange in interest, net for the six months ended June 30, 2010 was due toan increase in interest expense due on the total debt outstanding. The increasein net foreign exchange losses for the six months ended June 30, 2010 isdue to the effect of currency exchange rate changes, in particular changes inthe U.S. Dollar - Korean Won exchange rate, on transactions that are non U.S.dollar denominated and charged or credited to earnings. The decrease inunrealized loss on preferred stock warrant liability was due to the conversionof the preferred stock warrants to common stock warrants in connection with ourIPO.

 

*Provision for Income Taxes.* The provisionfor income taxes for the six months ended June 30, 2009 and 2010 wasprimarily related to foreign and state income taxes. We did not report abenefit for federal income taxes in the condensed consolidated financialstatements as the deferred tax asset generated from our net operating loss hasbeen offset by a full valuation allowance because it is more likely than notthat the tax benefits of the net operating loss carry forward may not berealized.

 

**Liquidity and Capital Resources**

 

The following table setsforth the major sources and uses of cash for each of the periods set forthbelow (in thousands):

 
| ** **                                                     | ** ** | **Six Months Ended June 30,** | ** ** |
|----------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                     | ** ** | **2009**                           | ** ** | **2010** | ** ** |
| ** **                                                     | ** ** | ** **                         | ** ** | ** ** | ** ** |
| Net cash used in operating activities                          |       | $                                  | (42,774    | ) | $ | (55,723 | ) |
| Net cash used in investing activities                          |       | (19,452                            | )          | (47,610 | ) |
| Net cash provided by (used in) financing  activities           |       | 106,517                            |       | (724 | ) |
| Effect of foreign exchange rates on cash and cash  equivalents |       | 76                                 |       | 261 |   |
| ** **                                                     | ** ** | ** **                         | ** ** | ** ** | ** ** |
| Net increase (decrease) in cash and cash  equivalents          |       | $                                  | 44,367     |   | $ | (103,796 | ) |

 

As of June 30, 2010, we had cash and cash equivalents of $353.3million and accounts receivable of $18.3 million.  During the six months ended June 30,2010, we received proceeds from government grants of $29.6 million.  In 2010 and beyond, we expect to use asignificant portion of our cash for capital expenditures to increasemanufacturing capacity in anticipation of increased demand for our products,including the current expansion of our manufacturing facilities in Michigan.

 

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***Cash Flows From Operating Activities***

 

Operating activities used $55.7million of net cash during the six months ended June 30, 2010. We incurreda net loss of $63.4 million in the six months ended June 30, 2010, whichincluded non-cash share-based compensation expense of $5.1 million anddepreciation and amortization of $7.8 million. Changes in asset and liabilityaccounts used $7.1 million of net cash during the six months endedJune 30, 2010.

 

Operating activities used$42.8 million of net cash during the six months ended June 30, 2009.We incurred a net loss of $41.2 million in the six months endedJune 30, 2009, which included non-cash share-based compensation expense of$4.0 million and depreciation and amortization of $6.3 million.Changes in asset and liability accounts used $12.0 million of net cashduring the six months ended June 30, 2009.

 

Weanticipate negative cash flow from operations in the near future as we continueto support the anticipated growth of our business.

 

***Cash Flows From Investing Activities***

 

Cash flows from investingactivities primarily relate to capital expenditures to support our growth.

 

Cash used in investingactivities totaled $47.6 million during the six months ended June 30, 2010and consisted of capital expenditures of $61.0 million primarily related to thepurchase of manufacturing equipment, expenditures of $13.0 million related tothe purchase of a long-term investment, a decrease in restricted cash of $0.1million and receipt of government grant proceeds of $26.3 million.

 

Cash used in investingactivities totaled $19.5 million during the six months ended June 30,2009 and consisted of capital expenditures of $17.2 million primarilyrelated to the purchase of manufacturing equipment and an increase inrestricted cash of $2.2 million.

 

We anticipate higher capital expenditure levels in future periods as wecontinue to fund the expansion of our facilities to support the anticipatedgrowth of our business.  As of June 30,2010, we have contractual obligations, which include agreements or purchaseorders to purchase goods, related to capital expenditure purchases of $109.4million.  Additionally, in futureperiods, we anticipate investing cash in joint ventures and other equityinvestments in order to establish strategic relationships.

 

***Cash Flows From Financing Activities***

 

Cash used in financingactivities totaled $0.7 million during the six months ended June 30, 2010and included proceeds from government grants of $1.3 million and proceeds fromexercise of stock options of $2.3 million. These proceeds were partially offsetby repayments on long-term debt of $4.0 million, and repayments on capitallease obligations of $0.3 million. In future periods, we expect financingactivities such as proceeds from grants, equity offerings and debt issuances tobe a significant source of cash.

 

Cashflows from financing activities totaled $106.5 million during the sixmonths ended June 30, 2009 and included proceeds of $99.6 millionfrom the issuance of series F convertible preferred stock, proceeds fromgovernment grants of $3.0 million and proceeds from issuance of long-termdebt of $7.6 million. These proceeds were partially offset by repayments onlong-term debt of $2.6 million and $0.8 million of deferred offeringcosts.

 

**Off-BalanceSheet Arrangements**

 

In June 2010, weentered into a supply agreement under which we committed to minimum purchasevolumes for each of the years ending December 31, 2010 through December 31,2013 for a raw material component.  Ifour purchase volumes during any year fail to meet the minimum purchasecommitments, we are required to pay the seller a variance payment for thedifference between the amount actually purchased in that calendar year and theannual minimum purchase commitment for that calendar year.  We will receive a credit for the amount ofthe variance payment to be applied to purchases in the following year and wewill have until April 1, 2015 to reclaim any variance payment resulting fromthe minimum purchase commitments for calendar years 2012 or 2013.  The table shown below in the next sectiontitled “Contractual Obligations” shows the amount of our purchase commitmentspayable by year inclusive of our commitment under the supply agreementdescribed above.  For the three and sixmonths ended June 30, 2010, we have purchased $1.7 million and $2.1million under this supply agreement.

 

During the periodspresented, we did not have and do not currently have, any off-balance sheetarrangements, as defined under SEC rules, such as relationships withunconsolidated entities or financial partnerships, which are often referred toas structured finance or special purpose entities, established for the purposeof facilitating financing transactions that are not required to be reflected onour balance sheet, other than the arrangement described above.

 

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**ContractualObligations**

 

Our contractual obligationsrelate primarily to borrowings under long-term debt obligations, capitalleases, operating leases, and purchase obligations which include agreements orpurchase orders to purchase goods or services that are enforceable and legallybinding.  A table summarizing the amountsand estimated timing of these future cash payments was provided in our AnnualReport on Form 10-K for the year ended December 31,2009.  During the six months ended June 30, 2010, there were nomaterial changes outside the ordinary course of business in our contractualobligations or the estimated timing of the future cash payments, except asrelated to our operating lease obligations and our purchase obligations.

 

The following is a summaryof our contractual obligations related to operating lease obligations andpurchase obligations as of June 30, 2010:

 
| ** **                  | ** ** | ** **         | ** ** | **Payments Due in**   | ** ** |
|-----------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                  | ** ** | **Total**          | ** ** | **Less than  1 Year** | ** ** | **1-3 Years** | ** ** | **3-5 Years** | ** ** | **More than  5 Years** | ** ** |
| ** **                  | ** ** | **(in thousands)** | ** ** |
| ** **                  | ** ** | ** **         | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Operating lease obligations |       | $                  | 57,563     |                  | $          | 5,393 |   | $ | 13,033 |   | $ | 11,455 |   | $ | 27,682 |   |
| Purchase obligations (1)    |       | 169,461            |       | 119,511               |       | 31,450 |   | 18,500 |   | — |   |
|                        |       |               |       |                  |       |   |   |   |   |   |   |
|                        |       | $                  | 227,024    |                  | $          | 124,904 |   | $ | 44,483 |   | $ | 29,955 |   | $ | 27,682 |   |

 

----

(1) Purchaseobligations include agreements or purchase orders to purchase goods or servicesthat are enforceable and legally binding and specify all significant terms.Purchase obligations exclude agreements that are cancelable without penalty.

 

**ITEM****3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

*Foreign Currency Exchange Risk.*  As a result of our foreign operations, wehave significant expenses, assets and liabilities that are denominated inforeign currencies. A significant number of our employees are located in Asia.Therefore, a substantial portion of our payroll as well as certain otheroperating expenses are paid in the China RMB and South Korean Won.Additionally, we purchase materials and components from suppliers in Asia.While we pay these suppliers in U.S. dollars, their costs are typically basedupon the local currency of the country in which they operate. All of ourrevenues are received in U.S. dollars because our customer contracts generallyprovide that our customers will pay us in U.S. dollars.

 

As a consequence, our gross profit, operating results, profitabilityand cash flows are adversely impacted when the dollar depreciates relative toother foreign currencies. We have a particularly significant currency rateexposure to changes in the exchange rate between the RMB and South Korean Wonto the U.S. dollar. For example, to the extent that we need to convert U.S.dollars for our operations, appreciation of the RMB or South Korean Won againstthe U.S. dollar would have an adverse effect on the amount we receive from theconversion.

 

We have not used any forward contracts or currency borrowings to hedgeour exposure to foreign currency exchange risk.

 

*Interest Rate Sensitivity.*  We had cash and cash equivalents totaling$353.3 million as of June 30, 2010, and $457.1 million as ofDecember 31, 2009. Our exposure to interest rate risk primarily relates tothe interest income generated by excess cash invested in highly liquidinvestments with maturities of three months or less from the original dates ofpurchase. The cash and cash equivalents are held for working capital purposes.We have not used derivative financial instruments in our investment portfolio.We have not been exposed, nor do we anticipate being exposed, to material risksdue to changes in market interest rates. Declines in interest rates, however,will reduce future investment income. If overall interest rates had declined byup to 100 basis points during the year ended December 31, 2009 and the sixmonths ended June 30, 2010, our interest income would have decreased byapproximately $0.2 million and $0.1 million, respectively, assumingconsistent investment levels.

 

Interest rate risk also refers to our exposure to movements in interestrates associated with our interest bearing liabilities. The interest bearingliabilities are denominated in U.S. dollars and the interest expense is basedon the prime interest rate plus an additional margin, depending on therespective lending institutions. If the prime rate had increased by 100 basispoints during the year ended December 31, 2009 and the six months ended June 30,2010, our interest expense would have increased by approximately$0.2 million and $0.1 million, respectively, assuming consistent borrowinglevels.

 

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**ITEM 4T. CONTROLS AND PROCEDURES**

 

*Evaluationof Disclosure Controls and Procedures.* Our management, with theparticipation of our chief executive officer and chief financial officer,evaluated the effectiveness of our disclosure controls and procedures as ofJune 30, 2010. The term “disclosure controls and procedures,” as definedin Rules 13a-15(e) and 15d-15(e) under the Exchange Act, meanscontrols and other procedures of a company that are designed to ensure thatinformation required to be disclosed by a company in the reports that it filesor submits under the Exchange Act is recorded, processed, summarized andreported, within the time periods specified in the SEC’s rules and forms.Disclosure controls and procedures include, without limitation, controls andprocedures designed to ensure that information required to be disclosed by acompany in the reports that it files or submits under the Exchange Act isaccumulated and communicated to the company’s management, including itsprincipal executive and principal financial officers, as appropriate to allowtimely decisions regarding required disclosure. Management recognizes that anycontrols and procedures, no matter how well designed and operated, can provideonly reasonable assurance of achieving their objectives and managementnecessarily applies its judgment in evaluating the cost-benefit relationship ofpossible controls and procedures. Based on the evaluation of our disclosurecontrols and procedures as of June 30, 2010, our chief executive officerand chief financial officer concluded that, as of such date, our disclosurecontrols and procedures were not effective at the reasonable assurance level.

 

*Changes in Internal Controls*. No changes in our internalcontrol over financial reporting (as defined in Rules 13a-15(f) and15d-15(f) under the Exchange Act) occurred during the quarterly periodended June 30, 2010 that have materially affected, or are reasonablylikely to materially affect, our internal control over financial reporting.

 

AtDecember 31, 2010, Section 404 of the Sarbanes-Oxley Act will requireour management to provide an assessment of the effectiveness of our internalcontrol over financial reporting, and our independent registered publicaccounting firm will be required to provide an attestation on the effectivenessof our internal controls over financial reporting. We are in the process ofperforming the system and process documentation, evaluation and testingrequired for management to make this assessment and for its independentauditors to provide its attestation report. We have not completed this processor its assessment, and this process will require significant amounts of managementtime and resources. In the course of evaluation and testing, management mayidentify deficiencies that will need to be addressed and remediated.

 

Asdisclosed in our Annual Report on Form 10-K for the year ended December 31,2009, filed with the SEC on March 15, 2010, we identified materialweaknesses in our internal control over financial reporting. Although we havemade enhancements to our control procedure, the material weaknesses will not beconsidered remediated until our controls are operational for a period of time,tested, and management concludes that these controls are operating effectively.

 

**PART II. OTHER INFORMATION**

 

**Item 1. Legal Proceedings**

 

In 2005 and 2006, we received communications from Hydro-Quebec, aCanadian utility company, alleging that the cathode material of our batteriesinfringes U.S. Patent No. 5,910,382 and U.S. Patent No. 6,514,640that had been granted to The University of Texas, or UT, and that relate tocertain electrode materials used in lithium-ion batteries. We refer to thesepatents by the last three digits of the patent number. The ‘382 and ‘640patents include claims that claim to cover battery cathode material having aparticular crystal structure and chemical formula. We contend that our cathodematerial has a different crystal structure and chemical formula.

 

We believe that UT subsequently licensed the patents to Hydro-Quebec,which in turn licensed the technology to companies that make and sell electrodematerials for batteries. On April 7, 2006, we commenced an action in theUnited States District Court for the District of Massachusetts seeking adeclaratory judgment that our products do not infringe these patents and thatthe patents are invalid. On September 8, 2006, we also requested ex partereexamination of the two patents by the U.S. Patent & TrademarkOffice, or PTO, to determine whether the subject matter they claim ispatentable. The reexamination process does not result in findings ofinfringement. In order to have a patent reexamined, the party of interest mustsubmit prior art that raises a “substantial new question of patentability”. Ifthe PTO determines that there is a substantial new question of patentability,it will order a reexamination. In an ex parte reexamination, a third partyrequesting reexamination does not participate further in the reexaminationproceedings. Once a reexamination is ordered, a new examiner is assigned to thecase and the patent goes through another examination similar in procedure tothe examination it received leading up to the issuance of the patent in thefirst instance. If any claims are rejected in light of the new questionsraised, then the patent owner can narrow or cancel the rejected claims to tryto avoid rejection of the claims. The patent owner can also submit new claims,provided they are not broader than the claims in the original patent. Once thereexamination has been concluded and if any claims are considered patentable, a“Certificate of Reexamination” is issued.

 

On September 11, 2006, Hydro-Quebec and UT commenced an action inthe United States District Court for the Northern District of Texas against us,one of our customers, Black & Decker, whom we have agreed toindemnify, and one of our suppliers (which has since been dropped from the action)alleging infringement of the two patents and, in a later amended complaint,false advertising. The plaintiffs’ complaint alleges infringement of variousclaims of the ‘382 Patent and various claims of the ‘640 Patent and that we andBlack & Decker have engaged in false advertising by makingrepresentations about the source and nature of our technology. The

 

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complaintseeks injunctive relief, including against making, using or selling any productcontaining the patented technology, actual damages in an unspecified amount,increased and/or treble damages, interest, costs and attorney fees.

 

In October 2006 and January 2007, the PTO granted ourrequests for reexamination of the two patents. In January and February 2007,the two litigations in Massachusetts and Texas were stayed pending the PTOreexaminations. Various motions to dismiss, filed by parties on both sides ofthe dispute, remain undecided.

 

During the reexamination, the PTO rejected all of the original claimsof the ‘382 Patent as unpatentable. UT then amended the claims of the ‘382Patent to make them narrower than the original claims in order to distinguishthe claimed invention from the prior art and added two new and narrower claims.The PTO determined that the narrower amended and new claims of the ‘382 Patentsubmitted during reexamination are patentable and concluded the reexaminationof the ‘382 Patent. On April 15, 2008, the PTO issued a reexaminationcertificate with the amended claims and the two new claims. During thereexamination of the ‘640 Patent, the PTO rejected all of the original claimsof the ‘640 Patent as unpatentable. UT then amended the claims of the ‘640Patent to make them narrower than the original claims in order to distinguishthe claimed invention from the prior art.

 

On December 22, 2008, the parties jointly requested that the stayof the litigation continue pending resolution of the reexamination of the ‘640Patent. On May 12, 2009, the PTO issued a Reexamination Certificate forthe ‘640 Patent with the amended narrower claims, thus removing the lastcondition for staying this litigation. As a result, while Hydro-Quebec and UT may assert the narrower claims ofthe reexamination certificate against any alleged infringer, including us, theyare unable to continue to assert the original claims of the ‘382 Patent and the‘640 Patent against us. On June 11, 2009, we filed a motion to reopen thelawsuit in Massachusetts pursuant to the court’s deadline to file within30 days of the conclusion of the PTO’s reexamination. OnSeptember 28, 2009, the Massachusetts court entered an order denying thatmotion, which we appealed on October 27, 2009 to the United States Courtof Appeals for the Federal Circuit. On July 22, 2009, Hydro-Quebec and UTsent us a proposed Second Amended Complaint in the Texas litigation that theysaid they intend to seek leave to file in light of the PTO’sreexaminations.  On August 27, 2009, Hydro-Quebec and UT filed a Motion for Leave toFile Second Amended Complaint and Jury Demand in the United States DistrictCourt for the Northern District of Texas and we were granted several unopposedextensions to file our response.  Hydro-Quebecand UT filed for leave to file an Amended Motion for Leave to File SecondAmended Complaint and Jury Demand on April 1, 2010 and we filed ouropposition to this application on April 22, 2010.  The judge held a status hearing with theparties on May 14, 2010 and has entered a schedule for the case leading toa claim construction hearing in December 2010.

 

If either or both of the lawsuits go forward, we expect that they couldtake as much as two years or more to reach trial, if at all. We believe that wedo not infringe either UT patent, including the ‘382 Patent and the ‘640 Patentfollowing reexamination, and that we have other meritorious defenses, and weintend to continue to vigorously defend our products and intellectual propertyrights. The ‘382 and ‘640 Patents include claims that claim to cover batterycathode material having a particular crystal structure and chemical formula,which Hydro-Quebec and UT claim our cathode material infringes. We believe, andcontend in the lawsuits, that our cathode material has a different crystalstructure and chemical formula that is not covered by the ‘382 and ‘640patents. However, due to the nature of the litigation, we cannot determine thetotal expense or possible loss, if any, that may ultimately be incurred eitherin the context of a trial or as a result of a negotiated settlement. AlthoughHydro-Quebec and UT have not specified in their complaint the nature or extentof their damages, they have asked for injunctive relief and we believe thatthey would likely seek substantial damages that could involve both one-timepayments and on-going amounts. Regardless of the ultimate outcome of thelitigation, it could result in significant legal expenses and diversion of timeby our technical and managerial personnel. The results of these proceedings areuncertain, and there can be no assurance that they will not have a materialadverse effect on our business, operating results, and financial condition.

 

OnFebruary 3, 2010, we received notice that LG Chem, Ltd., or LG Chem,filed applications in the 50th division of Seoul District Court for preliminary injunctionsagainst six former employees who are now employed either by our Enerlandsubsidiary or by us. The applications allege that these former employees violatedthe two-year non-competition clause in their employment contracts with LG Chemand that there is a likelihood that they are infringing LG Chem’s trade secretsby working for a competitor.  An initial court hearing was held on February 19,2010 and a second hearing was held on March 19, 2010.  The court rendered a decision on thisapplication on June 9, 2010, which reduced the post-terminationnon-competition term from two years to eighteen months and prohibited four ofthe six defendants from working at Enerland during the applicable balance oftheir respective non-compete terms, ranging from four months to elevenmonths.  The six defendants were alsoprohibited from using the alleged trade secrets that LG Chem submitted to thecourt.  LG Chem has not commencedany additional legal action against these former employees, us or Enerland;however, should they do so, such legal action could result in significant legalexpenses and diversion of time by our technical and management personnel.

 

**Item 1A. Risk Factors**

 

*Our business is subject to numerous risks. We cautionyou that the following important factors, among others, could cause our actualresults to differ materially from those expressed in forward-looking statementsmade by us or on our behalf in filings with the SEC, press releases,communications with investors and oral statements. Any or all of ourforward-looking statements in this Quarterly Report on**Form 10-Q**and in any other public statements we make may turn out to be wrong.They can be affected by*

 

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*inaccurate assumptions we might make or by known or unknownrisks and uncertainties. Many factors mentioned in the discussion below will beimportant in determining future results. Consequently, no forward-lookingstatement can be guaranteed. Actual future results may differ materially fromthose anticipated in forward-looking statements. We undertake no obligation toupdate any forward-looking statements, whether as a result of new information,future events or otherwise. You are advised, however, to consult any furtherdisclosure we make in our reports filed with the SEC.*

 

**Risks Related to Our Business**

 

***We have had a history of losses, andwe may be unable to achieve or sustain profitability.***

 

We have never been profitable. We experienced net losses of$80.5 million for 2008, $86.6 million for 2009 and $63.4 million forthe six months ended June 30, 2010. We expect we will continue to incurnet losses in 2010. We expect to incur significant future expenses as wedevelop and expand our business and our manufacturing capacity. In addition, asa public company, we incur additional significant legal, accounting and otherexpenses that we did not incur as a private company. These increasedexpenditures will make it harder for us to achieve and maintain futureprofitability. We may incur significant losses in the future for a number ofreasons, including the other risks described in this section, and we mayencounter unforeseen expenses, difficulties, complications, delays and otherunknown events. Accordingly, we may not be able to achieve or maintainprofitability.

 

***We have yet to achieve positive cashflow, and our ability to generate positive cash flow is uncertain.***

 

To rapidly develop and expand our business, we have made significantup-front investments in our manufacturing capacity and incurred research,development and engineering, sales and marketing, general and administrativeand production start-up expenses. In addition, our growth has required asignificant investment in working capital over the last several years. We havehad negative cash flow before financing activities of $76.0 million for2008, $114.7 million for 2009 and $103.3 million for the six months ended June 30,2010. We anticipate that we will continue to have negative cash flow for theforeseeable future as we continue to make significant future capitalexpenditures to expand our manufacturing capacity and incur increased research,development and engineering, sales and marketing, general and administrativeand production start-up expenses. Our business will also require significantamounts of working capital to support our growth. Therefore, we may need toraise additional capital from investors to achieve our expected growth, and wemay not achieve sufficient revenue growth to generate positive future cashflow. An inability to generate positive cash flow for the foreseeable future orraise additional capital on reasonable terms may decrease our long-termviability.

 

***Our limited operating history makesit difficult to evaluate our current business and future prospects.***

 

We have been in existence since 2001, but much of our growth hasoccurred in recent periods. Our limited operating history may make it difficultto evaluate our current business and our future prospects. We have encounteredand will continue to encounter risks and difficulties frequently experienced bygrowing companies in rapidly changing industries, including increasing expensesas we continue to grow our business. If we do not manage these riskssuccessfully, our business will be harmed.

 

In addition, we are targeting new and emerging markets for ourbatteries and battery systems. However, historically, a significant portion ofthe products that we have sold are designed for the consumer tool market, whichis a more mature market with different growth prospects than our other targetmarkets. Several of our products are still under development, including abattery in prismatic form designed for use in the automotive industry, and thetiming of the ultimate release, if any, of new production quality products isnot determinable. Our efforts to expand beyond our existing markets may neverresult in new products that achieve market acceptance, create additionalrevenue or become profitable. Therefore, our recent historical growthtrajectory may not provide an accurate representation of the market dynamics wemay be exposed to in the future, making it difficult to evaluate our futureprospects.

 

***The demand for batteries in thetransportation and other markets depends on the continuation of current trendsresulting from dependence on fossil fuels. Extended periods of low gasolineprices could adversely affect demand for electric and hybrid electric vehicles.***

 

We believe that much of the present and projected demand for advancedbatteries in the transportation and other markets results from recent increasesin the cost of oil, the dependency of the United States on oil from unstable orhostile countries, government regulations and economic incentives promotingfuel efficiency and alternate forms of energy, as well as the belief thatclimate change results in part from the burning of fossil fuels. If the cost ofoil decreased significantly, the outlook for the long-term supply of oil to theUnited States improved, the government eliminated or modified its regulationsor economic incentives related to fuel efficiency and alternate forms of energy,or if there is a change in the perception that the burning of fossil fuelsnegatively impacts the environment, the demand for our batteries could bereduced, and our business and revenue may be harmed.

 

Gasoline prices have been extremely volatile, and this continuingvolatility is expected to persist. Lower gasoline prices over extended periodsof time may lower the perception in government and the private sector thatcheaper, more readily available energy

 

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alternativesshould be developed and produced. If gasoline prices remain at deflated levelsfor extended periods of time, the demand for hybrid and electric vehicles maydecrease, which would have a material adverse effect on our business.

 

***If we are unable to develop,manufacture and market products that improve upon existing battery technologyand gain market acceptance, our business may be adversely affected. Inaddition, many factors outside of our control may affect the demand for ourbatteries and battery systems.***

 

We are researching, developing, manufacturing and selling lithium-ionbatteries and battery systems. The market for advanced rechargeable batteriesis at a relatively early stage of development, and the extent to which ourlithium-ion batteries will be able to meet our customers’ requirements andachieve significant market acceptance is uncertain. Rapid and ongoing changesin technology and product standards could quickly render our products lesscompetitive, or even obsolete if we fail to continue to improve the performanceof our battery chemistry and systems. Other companies that are seeking toenhance traditional battery technologies have recently introduced or aredeveloping batteries based on nickel metal-hydride, liquid lithium-ion andother emerging and potential technologies. These competitors are engaged insignificant development work on these various battery systems. One or more new,higher energy rechargeable battery technologies could be introduced which couldbe directly competitive with, or superior to, our technology. The capabilitiesof many of these competing technologies have improved over the past severalyears. Competing technologies that outperform our batteries could be developedand successfully introduced, and as a result, our products may not competeeffectively in our target markets. If our battery technology is not adopted byour customers, or if our battery technology does not meet industry requirementsfor power and energy storage capacity in an efficient and safe design, ourbatteries will not gain market acceptance.

 

In addition, the market for our products depends upon third partiescreating or expanding markets for their end-user products that utilize ourbatteries and battery systems. If such end-user products are not developed, ifwe are unable to have our products designed into these end user products, ifthe cost of these end-user products is too high, or the market for suchend-user products contracts or fails to develop, the market for our batteriesand battery systems would be expected similarly to contract or collapse. Ourcustomers operate in extremely competitive industries, and competition tosupply their needs focuses on delivering sufficient power and capacity in acost, size and weight efficient package. The ability of our customers to adoptnew battery technologies will depend on many factors outside of our control.For example, in the automotive industry, we depend on our customers’ ability todevelop HEV, PHEV and EV platforms that gain broad appeal among end users.

 

Many other factors outside of our control may also affect the demandfor our batteries and battery systems and the viability of widespread adoptionof advanced battery applications, including:

 

·          performance and reliability of batterypower products compared to conventional and other non-battery energy sourcesand products;

 

·          success of alternative batterychemistries, such as nickel-based batteries, lead-acid batteries andconventional lithium-ion batteries and the success of other alternative energytechnologies, such as fuel cells and ultra capacitors;

 

·          end-users’ perceptions of advancedbatteries as relatively safe and reliable energy storage solutions, which couldchange over time if alternative battery chemistries prove unsafe or become thesubject of significant product liability claims and negative publicity isgenerated on the battery industry as a whole;

 

·          cost-effectiveness of our productscompared to products powered by conventional energy sources and alternativebattery chemistries;

 

·          availability of government subsidiesand incentives to support the development of the battery power industry;

 

·          fluctuations in economic and marketconditions that affect the cost of energy stored by batteries, such asincreases or decreases in the prices of electricity;

 

·          continued investment by the federalgovernment and our customers in the development of battery poweredapplications;

 

·          heightened awareness of environmentalissues and concern about global warming and climate change; and

 

·          regulation of energy industries.

 

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***Adverse business or financial conditionsaffecting the automobile industry may have a material adverse effect on ourdevelopment and marketing partners and our battery business.***

 

Much of our business depends on and is directly affected by the generaleconomic state of the United States and global automobile industry. The effectof the continued economic difficulties of the major automobile manufacturers onour business is unclear. Two major auto manufacturers have gone throughbankruptcy, and one of our existing customers has entered into a debtrestructuring process, and it is possible that more of these companies mayencounter financial difficulties. The impact of any such financial difficultieson the automobile industry and its suppliers is unclear and difficult topredict. Possible effects could include reduced spending on alternative energysystems for automobiles, a delay in the introduction of new, or thecancellation of new and existing, hybrid and electric vehicles and programs,and a delay in the conversion of existing batteries to lithium-ion batteries,each of which would have a material adverse effect on our business.

 

We have entered into agreements relating to joint design anddevelopment efforts with several automotive manufacturers and tier 1suppliers regarding their HEV, PHEV and EV development efforts. Certain ofthese manufacturers and suppliers have in recent years experienced static orreduced revenues, increased costs, net losses, loss of market share,bankruptcy, labor issues and other business and financial challenges. As aresult, these or other automotive manufacturers may discontinue or delay theirplanned introduction of HEVs, PHEVs or EVs as a result of adverse changes intheir financial condition or other factors. Automotive manufacturers may alsoseek alternative battery systems from other suppliers which may be morecost-effective or require fewer modifications in standard manufacturingprocesses than our products. We may also experience delays or losses withrespect to the collection of payments due from customers in the automotiveindustry experiencing financial difficulties. 

 

***We have experienced rapid growth inrecent periods. If we fail to manage our growth effectively, we may be unableto execute our business plan, maintain high levels of service or addresscompetitive challenges adequately.***

 

We increased our number of full-time employees from 227 atJanuary 1, 2007 to 1,784 at June 30, 2010, and our revenue increasedfrom $41.3 million in 2007 to $91.0 million in 2009. Our growth hasplaced, and may continue to place, a significant strain on our managerial,administrative, operational, financial, information technology and otherresources. We intend to further expand our overall business, customer base,headcount and operations both domestically and internationally. Expanding aglobal organization and managing a geographically dispersed workforce willrequire substantial management effort and significant additional investment inour infrastructure. We will be required to continue to improve our operational,financial and management controls and our reporting procedures and we may notbe able to do so effectively. As such, we may be unable to manage our expenseseffectively in the future, which may negatively impact our operating results inany particular quarter.

 

***Because we build our manufacturingcapacity based on our projection of future design wins and supply agreements,our business revenue and profits will depend upon our ability to enter into andcomplete these agreements, successfully complete these expansion projects,achieve competitive manufacturing yields and drive volume sales consistent withour demand expectations.***

 

In order to fulfill the anticipated demand for our products, we investin capital expenditures in advance of actual customer orders, based onestimates of future demand. We plan to continue the expansion of ourmanufacturing capacity across multiple product lines. The build-up of ourinternal manufacturing capabilities, such as the current expansions in Livoniaand Romulus, Michigan, exposes us to significant up-front fixed costs. Ifmarket demand for our products does not increase as quickly as we haveanticipated and align with our expanded manufacturing capacity, or if we failto enter into and complete projected development and supply agreements, we maybe unable to offset these costs and to achieve economies of scale, and ouroperating results may be adversely affected as a result of high operatingexpenses, reduced margins, underutilization of capacity and asset impairmentcharges. Alternatively, if we experience demand for our products in excess ofour estimates, our installed capital equipment may be insufficient to supporthigher production volumes, which could harm our customer relationships andoverall reputation. In addition, we may not be able to expand our workforce andoperations in a timely manner, procure adequate resources, or locate suitablethird-party suppliers, to respond effectively to changes in demand for ourexisting products or to the demand for new products requested by our customers,and our current or future business could be materially and adversely affected.Our ability to meet such excess customer demand could also depend on ourability to raise additional capital and effectively scale our manufacturing operations.

 

We utilize standard manufacturing equipment that we modify andcustomize in order to meet our production needs. While this equipment may beavailable from various suppliers, its procurement requires long lead times.Therefore, we may experience delays, additional or unexpected costs and otheradverse events in connection with our capacity expansion projects, includingthose associated with potential delays in the procurement and customization ofmanufacturing equipment and various components required for our products.

 

If we are unable to achieve and maintain satisfactory production yieldsand quality as we expand our manufacturing capabilities, our relationships withcertain customers and overall reputation may be harmed, and our sales coulddecrease.

 

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***We may not be able to obtain, or toagree on acceptable terms and conditions for, all or a significant portion ofthe government grants, loans and other incentives for which we have applied andmay in the future apply. Our customers and potential customers applying forgovernment grants, loans and other incentives may condition purchases of ourproducts upon their receipt of these funds or delay purchases of our productsuntil their receipt of these funds.***

 

We have applied for federal and state grants, loans and tax incentivesunder government programs designed to stimulate the economy and support theproduction of electric vehicles and advanced battery technologies. Much of ourplanned domestic manufacturing capacity expansion depends on receipt of thesefunds and other incentives, and the failure to obtain these funds or otherincentives could materially and adversely affect our ability to expand ourmanufacturing capacity and meet planned production levels. We anticipate thatin the future there will be new opportunities for us to apply for grants, loansand other incentives from the United States, state and foreign governments. Ourability to obtain funds or incentives from government sources is subject to theavailability and continued availability of funds under applicable governmentprograms and approval of our applications to participate in such programs. Theapplication process for these funds and other incentives is and will be highlycompetitive. While we have received a grant under the DOE Battery Initiativeand have received some state incentives, we cannot assure you that we will besuccessful in obtaining additional grants, loans and other incentives.Moreover, we may not be able to satisfy or continue to satisfy the requirementsand milestones imposed by the granting authority as conditions to receipt ofthe funds or other incentives, the timing of the receipt of the funds may notmeet our needs and we nevertheless may be unable to successfully execute on ourbusiness plan. Moreover, not all of the terms and conditions associated withthese incentive funds have been disclosed to us, and once disclosed, there maybe terms and conditions with which we are unable to comply or which arecommercially unacceptable to us. In addition, the DOE Battery initiative grantand any other federal government programs which may make additional awards tous will require us to spend a portion of our own funds for every incentivedollar we receive or are permitted to borrow from the government and willimpose time limits during which we must use the funds awarded to us. If we areunable to raise sufficient additional capital so that we are able to receiveall of the amounts which have and may be awarded to us in a timely manner, ourability to expand our manufacturing capacity could be materially adverselyaffected. In addition, less than expected actual and anticipated future demandfor our products may cause us to slow the pace of the expansion of ourmanufacturing capacity such that we are not able to use the governmentincentive funds awarded or made available to us in the time periods required bythe granting authorities.

 

Our customers and potential customers applying for these governmentgrants, loans and other incentives may condition purchases of our products uponreceipt of these funds or delay purchases of our products until receipt ofthese funds, and if our customers and potential customers do not receive thesefunds or the receipt of these funds is significantly delayed, our results ofoperations could suffer.

 

***We rely on a limited number ofcustomers for a significant portion of our revenue, and the loss of one of ourtwo most significant customers, or several of our smaller customers, couldmaterially harm our business.***

 

A significant portion of our revenue is generated from a limited numberof customers. During each of the years ended December 31, 2008 and 2009and the six months ended June 30, 2010, Black & Decker, togetherwith its affiliates, represented 44%, 14% and 7% of our revenue, respectively.We expect revenue from Black & Decker will continue to decline in 2010and therefore represent a smaller percentage of our revenue in future periods.For the year ended December 31, 2009 and the six months ended June 30,2010, revenue from BAE Systems represented 35% and 32% of our revenue,respectively. For the year ended December 31, 2009 and the six months endedJune 30, 2010, revenue from AES Energy accounted for 9% and 11% ofour revenue, respectively. Although the composition of our significantcustomers will vary from period to period, we expect that most of our revenuewill continue, for the foreseeable future, to come from a relatively smallnumber of customers. In addition, our contracts with our customers generally donot include long-term commitments or minimum volumes that ensure future salesof our products. Consequently, our financial results may fluctuatesignificantly from period-to-period based on the actions of one or moresignificant customers. A customer may take actions that affect us for reasonsthat we cannot anticipate or control, such as reasons related to the customer’sfinancial condition, changes in the customer’s business strategy or operations,the introduction of alternative competing products, or as the result of theperceived quality or cost-effectiveness of our products. Our agreements withthese customers may be cancelled if we fail to meet certain productspecifications or materially breach the agreement or for other reasons outsideof our control. In addition, our customers may seek to renegotiate the terms ofcurrent agreements or renewals. The loss of or a reduction in sales or anticipatedsales to our most significant or several of our smaller customers could have amaterial adverse effect on our business, financial condition and results ofoperations.

 

***Our financial results may varysignificantly from period-to-period due to the long and unpredictable salescycles for some of our products, the seasonality of certain end markets intowhich we sell our products, and changes in the mix of products we sell during aperiod, which may lead to volatility in our stock price.***

 

The size and timing of our revenue from sales to our customers isdifficult to predict and is market dependent. Our sales efforts often requireus to educate our customers about the use and benefits of our products,including their technical and performance characteristics. Customers typicallyundertake a significant evaluation process that has in the past resulted in alengthy sales cycle for us, typically many months. In some markets such as thetransportation market, there is usually a significant lag time between the

 

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designphase and commercial production. We spend substantial amounts of time and moneyon our sales efforts and there is no assurance that these investments willproduce any sales within expected time frames or at all. Given the potentiallylarge size of battery development and supply contracts, the loss of or delay inthe signing of a contract or a customer order could significantly reduce ourrevenue in any period. Since most of our operating and capital expenses areincurred based on the estimated number of design wins and their timing, theyare difficult to adjust in the short term. As a result, if our revenue fallsbelow our expectations or is delayed in any period, we may not be able toreduce proportionately our operating expenses or manufacturing costs for thatperiod, and any reduction of manufacturing capacity could have long-termimplications on our ability to accommodate future demand.

 

Our profitability from period-to-period may also vary significantly dueto the mix of products that we sell in different periods. While we have soldmost of our products to date into the commercial market, as we expand ourbusiness we expect to sell new battery and battery system products into othermarkets and for other applications. These products are likely to have differentcost profiles and will be sold into markets governed by different businessdynamics. Consequently, sales of individual products may not necessarily beconsistent across periods, which could affect product mix and cause gross andoperating profits to vary significantly.

 

In addition, since our batteries and battery systems are incorporatedinto our customers’ products for sale into their respective end markets, ourbusiness is exposed to the seasonal demand that may characterize some of ourcustomers’ own product sales. Because many of our expenses are based onanticipated levels of annual revenue, our business and operating results couldalso suffer if we do not achieve revenue consistent with our expectations forthis seasonal demand.

 

As a result of these factors, we believe that quarter-to-quartercomparisons of our operating results are not necessarily meaningful and thatthese comparisons cannot be relied upon as indicators of future performance.Moreover, our operating results may not meet expectations of equity researchanalysts or investors. If this occurs, the trading price of our common stockcould fall substantially either suddenly or over time.

 

***Our principal competitors have, andany future competitors may have, greater financial and marketing resources thanwe do, and they may therefore develop batteries or other technologies similaror superior to ours or otherwise compete more successfully than we do.***

 

Competition in the battery industry is intense. The industry consistsof major domestic and international companies, most of which have existingrelationships in the markets into which we sell as well as financial,technical, marketing, sales, manufacturing, scaling capacity, distribution andother resources and name recognition substantially greater than ours. Thesecompanies may develop batteries or other technologies that perform as well asor better than our batteries. We believe that our primary competitors areexisting suppliers of cylindrical lithium-ion, nickel cadmium, nickelmetal-hydride and in some cases, non-starting/lighting/ignition lead-acidbatteries. A number of our competitors have existing and evolving relationshipswith our target customers. For example, Bosch and Samsung formed SB LiMotive tofocus on the development, production and marketing of lithium-ion batterysystems for application in hybrid and other electric vehicles, and Dow Chemicalhas entered into a joint venture with Kokam America and others, pending receiptof government incentive funding, to build a facility in Michigan for themanufacture of lithium polymer batteries for use in HEVs and EVs. In addition,NEC and Nissan entered into a joint venture to develop lithium-ion batteries inprismatic form, Sanyo and Volkswagen agreed to develop lithium-ion batteriesfor HEVs, Sanyo already provides nickel metal hydride batteries for Ford andHonda, and Toyota and Panasonic are engaged in a joint venture to makebatteries for HEVs and EVs. In addition, we expect new competitors will enterthe markets for our products in the future. Potential customers may choose todo business with our more established competitors, because of their perceptionthat our competitors are more stable, are more likely to complete variousprojects, can scale operations more quickly, have greater manufacturingcapacity, are more likely to continue as a going concern and lend greater credibilityto any joint venture. If we are unable to compete successfully againstmanufacturers of other batteries or technologies in any of our targetedapplications, our business could suffer, and we could lose or be unable to gainmarket share.

 

***If our products fail to perform asexpected, we could lose existing and future business, and our ability todevelop, market and sell our batteries and battery systems could be harmed.***

 

Our products are complex and could have unknown defects or errors,which may give rise to claims against us, diminish our brand or divert ourresources from other purposes. Despite testing, new and existing products havecontained defects and errors and may in the future contain manufacturing ordesign defects, errors or performance problems when first introduced, when newversions or enhancements are released, or even after these products have beenused by our customers for a period of time. These problems could result inexpensive and time-consuming design modifications or warranty charges, delaysin the introduction of new products or enhancements, significant increases inour service and maintenance costs, exposure to liability for damages, damagedcustomer relationships and harm to our reputation, any of which may adverselyaffect our business and our operating results.

 

Our success in the transportation market depends, in part, on ourability to design, develop and commercially manufacture lithium-ion batteriesin prismatic form for use in HEVs, PHEVs and EVs currently being developed andthat may be developed in the future. The design and development of alithium-ion battery in prismatic form for use in the automotive industry iscomplex, expensive, time-consuming and subject to rigorous quality andperformance requirements. If we are unable to design, develop and commercially

 

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manufacturelithium-ion batteries in prismatic form in a timely fashion and that areaccepted for use in the automotive industry, our business and operating resultsmay be adversely affected.

 

***We entered into a strategicinvestment agreement with an early stage entity with which we have a commercialrelationship.***

 

In January 2010, we entered into an agreement with FiskerAutomotive, Inc., or Fisker, a privately-held company, to invest$13.0 million in cash and shares of our common stock, which whentransferred to Fisker had a value of approximately $7.5 million.   In exchange, we received shares ofconvertible preferred stock in Fisker which are not liquid, and we do notexpect that they will be liquid for some time. Our investment in Fisker exposesus to equity price risk; if Fisker does not execute on its strategic plan, ourinvestment may not be recovered. In addition, this would have an adverse impact on ourfuture product revenues from Fisker. This investment is subjectto risk of changes in fair value, which could result in a material realizedimpairment loss.

 

***In the past, we have identifiedmaterial weaknesses in our internal control over financial reporting which areunremediated and if we fail to remediate these weaknesses and maintain properand effective internal controls, our ability to produce accurate and timelyfinancial statements could be impaired, which could harm our operating results,our ability to operate our business and investors’ views of us.***

 

Ensuring that we have adequate internal financial and accountingcontrols and procedures in place so that we can produce accurate financialstatements on a timely basis is a costly and time-consuming effort that needsto be evaluated frequently. In connection with our financial audits, weidentified material weaknesses in our internal control over financial reporting.A material weakness is defined as a deficiency, or combination of deficiencies,in internal control over financial reporting, such that there is a reasonablepossibility that a material misstatement of the company’s annual or interimfinancial statements will not be prevented or detected on a timely basis by thecompany’s internal controls. These material weaknesses were as follows:

 

· we did not have anadequate number of personnel in our accounting and finance department withsufficient technical accounting expertise and, as a result, we could notevaluate in a timely manner the accounting implications of our businesstransactions; and

 

· we did not design ormaintain effective operating and information technology controls over thefinancial statement close and reporting process in order to ensure the accurateand timely preparation of financial statements in accordance with accountingprinciples generally accepted in the United States, or GAAP.

 

We are in the process of taking the necessary steps to remediate thematerial weaknesses that we identified and have made enhancements to ourcontrol procedures; however, the material weaknesses will not be remediateduntil the necessary controls have been implemented and are operatingeffectively. We do not know the specific time frame needed to fully remediatethe material weaknesses identified.

 

We cannot assure you that our efforts to fully remediate these internalcontrol weaknesses will be successful or that similar material weaknesses willnot recur.

 

Implementing any appropriate changes to our internal controls maydistract our officers and employees, entail substantial costs to implement newprocesses and modify our existing processes and take significant time tocomplete. Moreover, these changes do not guarantee that we will be effective inmaintaining the adequacy of our internal controls, and any failure to maintainthat adequacy, or consequent inability to produce accurate financial statementson a timely basis, could increase our operating costs and harm our business. Inaddition, investors’ perceptions that our internal controls are inadequate orthat we are unable to produce accurate financial statements on a timely basismay harm our stock price and make it more difficult for us to effectivelymarket and sell our products to new and existing customers. For a more detaileddiscussion of our material weaknesses, see Item 9A, “*Controls and Procedures”*of our Annual Report on Form 10-K forthe year ended December 31, 2009, which was filed with the SEC on March 15,2010.

 

***If our warranty expense estimatesdiffer materially from our actual claims, or if we are unable to estimatefuture warranty expense for new products, our business and financial resultscould be harmed.***

 

Our warranty for our products ranges from one to five years from thedate of sale, depending on the type of product and its application. We expectthat in the future some of our warranties will extend beyond five years. In thecommercial market, we typically provide a warranty against certain potentialmanufacturing defects, which may cause high rates of self-discharge, inaccuratevoltage, and other product irregularities. In the electric grid services andtransportation markets, we may also provide a warranty against a certainpercentage decline in the initial power and energy density specifications of aparticular product. Since we began selling our first products in the commercialmarket in the first quarter of 2006, in the transportation market in the firstquarter of 2007 and in the electric grid services market in the third quarterof 2009, we have a limited product history on which to base our warrantyestimates. Because of the limited operating history of our batteries andbattery systems, our management is required to make assumptions and to applyjudgment regarding a number of factors, including anticipated rate of warrantyclaims, the durability

 

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andreliability of our products, and service delivery costs. Our assumptions couldprove to be materially different from the actual performance of our batteries andbattery systems, which could cause us to incur substantial expense to repair orreplace defective products in the future and may exceed expected levels againstwhich we have reserved. If our estimates prove incorrect, we could be requiredto accrue additional expenses from the time we realize our estimates areincorrect and also face a significant unplanned cash burden at the time ourcustomers make a warranty claim, which could harm our operating results.

 

In addition, with our new products and products that remain underdevelopment, we will be required to base our warranty estimates on historicalexperience of similar products testing of our batteries and performanceinformation learned during our development activities with the customer. If weare unable to estimate future warranty costs for any new product, we will berequired to defer recognizing revenue for that product until we are reasonablyable to estimate the associated warranty expense. As a result, our financialresults could vary significantly from period-to-period.

 

***Product liability or other claimscould cause us to incur losses or damage our reputation.***

 

The risk of product liability claims and associated adverse publicityis inherent in the development, manufacturing, marketing and sale of batteriesand battery systems. Certain materials we use in our batteries, as well as ourbatteries and battery systems, could, if used improperly, cause injuries toothers. Improperly charging or discharging our batteries could cause fires. Anyaccident involving our batteries or other products could decrease or eveneliminate demand for our products. Because some of our batteries are designedto be used in vehicles, and because vehicle accidents can cause injury topersons and damage to property, we are subject to a risk of claims for suchinjuries and damages. In addition, we could be harmed by adverse publicityresulting from problems or accidents caused by third party products thatincorporate our batteries. For example, our business and operating resultscould be harmed by adverse publicity resulting from injury to persons or damageto property caused by a defective electronic system on a battery systemmanufactured by a third party that incorporates our batteries.

 

Although we have product liability insurance for our products of up toan annual aggregate limit of $102 million, this may be inadequate to coverall potential product liability claims. In addition, while we often seek tolimit our product liability in our contracts, such limits may not be enforceableor may be subject to exceptions. Any product recall or lawsuit seekingsignificant monetary damages either in excess of our coverage, or outside ofour coverage, may have a material adverse affect on our business and financialcondition. We may not be able to secure additional product liability insurancecoverage on acceptable terms or at reasonable costs when needed. If we were toexperience a large insured loss, it might exceed our coverage limits, or ourinsurance carriers could decline to further cover us or raise our insurancerates to unacceptable levels, any of which could impair our financial positionand results of operations. A successful product liability claim against uscould require us to pay a substantial monetary award. We cannot assure you thatsuch claims will not be made in the future.

 

***We are subject to financial andreputational risks due to product recalls resulting from product quality andliability issues.***

 

The risk of product recalls, and associated adverse publicity, is inherentin the development, manufacturing, marketing, and sale of batteries and batterysystems. Our products and the products of third parties in which our productsare a component are becoming increasingly sophisticated and complicated asrapid advancements in technologies occur, and as demand increases for lighterand more powerful rechargeable batteries. At the same time, product quality andliability issues present significant risks. Product quality and liabilityissues may affect not only our own products but also the third-party productsin which our batteries and battery systems are a component. Our efforts and theefforts of our development partners to maintain product quality may not besuccessful, and if they are not, we may incur expenses in connection with, forexample, product recalls and lawsuits, and our brand image and reputation as aproducer of high-quality products may suffer. Any product recall or lawsuitseeking significant monetary damages could have a material adverse effect onour business and financial condition. A product recall could generatesubstantial negative publicity about our products and business, interfere withour manufacturing plans and product delivery obligations as we seek to replaceor repair affected products, and inhibit or prevent commercialization of otherfuture product candidates. Although we do have product liability insurance, wedo not have insurance to cover the costs associated with a product recall andthe expenses we would incur in connection with a product recall could have amaterial adverse affect on our operating results.

 

***We depend on third parties todeliver raw materials, parts, components and services in adequate quality andquantity in a timely manner and at a reasonable price.***

 

Our manufacturing operations depend on obtaining raw materials, partsand components, manufacturing equipment and other supplies including servicesfrom reliable suppliers in adequate quality and quantity in a timely manner. Itmay be difficult for us to substitute one supplier for another, increase thenumber of suppliers or change one component for another in a timely manner orat all due to the interruption of supply or increased industry demand. This mayadversely affect our operations. The prices of raw materials, parts andcomponents and manufacturing equipment may increase due to changes in supplyand demand. In addition, currency fluctuations and a weakening of theU.S. dollar against foreign currencies may adversely affect our purchasingpower for raw materials, parts and components and manufacturing equipment fromforeign suppliers.

 

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We depend on sole source suppliers or a limited number of suppliers forcertain key raw materials and component parts used in manufacturing anddeveloping our products. We generally purchase raw materials pursuant topurchase orders placed from time to time and if we deem necessary, we will enterinto long-term contracts or other guaranteed supply arrangements with our soleor limited source suppliers. Therefore, our operating margins may be impactedby price fluctuations in the commodities we use as raw materials in ourbatteries. As a result, our suppliers may not be able to meet our requirementsrelative to specifications and volumes for key raw materials, and we may not beable to locate alternative sources of supply at an acceptable cost. In thepast, we have experienced delays in product development due to the delivery ofraw materials from our suppliers that do not meet our specifications. Inaddition, if a sole source supplier ceased to continue to produce a componentwith little or no notice to us, our business could be harmed. Any future inabilityto obtain high quality raw materials or manufacturing equipment in sufficientquantities on competitive pricing terms and on a timely basis, due to globalsupply and demand or a dispute with a supplier, may delay battery production,impede our ability to fulfill existing or future purchase orders and harm ourreputation and profitability.

 

***Our failure to raise additionalcapital necessary to expand our operations and invest in our products andmanufacturing facilities could reduce our ability to compete successfully.***

 

We may require additional capital in the future and we may not be ableto obtain additional debt or equity financing on favorable terms, if at all. Ifwe raise additional equity financing, our stockholders may experiencesignificant dilution of their ownership interests, and the per-share value ofour common stock could decline. If we engage in debt financing, we may berequired to accept terms that restrict our ability to incur additionalindebtedness and force us to maintain specified liquidity or other ratios. Weare also seeking federal and state grants, loans and tax incentives some ofwhich we intend to use to expand our operations. We may not be successful inobtaining these funds or incentives. If we need additional capital and cannotraise or otherwise obtain it on acceptable terms, we may not be able to, amongother things:

 

· developor enhance our products or introduce new products;

 

· continueto expand our development, sales and marketing and general and administrativeorganizations and manufacturing operations;

 

· attracttop-tier companies as customers or as our technology and product developmentpartners;

 

· acquirecomplementary technologies, products or businesses;

 

· expandour operations, in the United States or internationally;

 

· expandand maintain our manufacturing capacity;

 

· hire,train and retain employees; or

 

· respondto competitive pressures or unanticipated working capital requirements.

 

***Our inability to obtain federal andstate government environmental permits and approvals for our plannedU.S. manufacturing facilities could negatively impact our ability toobtain federal and state incentive funding and materially harm our business.***

 

Pursuant to applicable environmental and safety laws and regulations,we are required to obtain and maintain certain governmental permits andapprovals and to comply with applicable federal and state environmental lawsand regulations.  There is no guaranteethat required determinations, permits and approvals will ultimately beobtained; the failure to obtain required federal and state environmentalpermits could have an adverse effect on our financial results and could alsodelay or prevent us from obtaining matching fund reimbursement from the$249.1 million grant we were awarded under the DOE Battery Initiative, aswell as funding under the DOE ATVM loan program.

 

If obtained, permits and approvals may be subject to revocation,modification or denial under certain circumstances. Our operations oractivities could result in administrative or private actions, revocation ofrequired permits or licenses, or fines, penalties or damages, which could havean adverse effect on us. In addition, environmental laws will likely becomemore stringent over time, thereby requiring new capital expenditures andincreases in operating costs.

 

***Our working capital requirementsinvolve estimates based on demand expectations and may decrease or increasebeyond those currently anticipated, which could harm our operating results andfinancial condition.***

 

In order to fulfill the product delivery requirements of our customers,we plan for working capital needs in advance of customer orders. As a result,we base our funding and inventory decisions on estimates of future demand. Ifdemand for our products does not increase as quickly as we have estimated ordrops off sharply, our inventory and expenses could rise, and our business andoperating

 

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resultscould suffer. Alternatively, if we experience sales in excess of our estimates,our working capital needs may be higher than those currently anticipated. Ourability to meet this excess customer demand depends on our ability to arrangefor additional financing for any ongoing working capital shortages, since it islikely that cash flow from sales will lag behind these investment requirements.

 

***Credit market volatility andilliquidity may affect our ability to raise capital to finance our operations,plant expansion and growth.***

 

The credit markets have experienced extreme volatility in recent years,and worldwide credit markets have remained illiquid despite injections ofcapital by the federal government and foreign governments. Despite the capitalinjections and government actions, banks and other lenders, such as equipmentleasing companies, have significantly increased credit requirements and reducedthe amounts available to borrowers. Companies with low credit ratings may nothave access to the debt markets until the liquidity improves, if at all. Ifcurrent credit market conditions do not improve, we may not be able to accessdebt or leasing markets to finance our plant expansion plans.

 

***We may be unable to successfullyimplement or manage our planned expansion of our domestic manufacturingcapability or realize the expected benefits of our planned expansion.***

 

We expect to aggressively expand our battery manufacturing capacity inthe United States to meet expected demand for our product. Much of our planneddomestic expansion, such as our current expansion in Livonia and Romulus,Michigan, depends upon our receipt of sufficient federal and state incentivefunding and ourability to successfully ramp our manufacturing operations, particularly in theproduction of prismatic batteries. We may not receive the federaland state funding necessary for our planned expansion at all or on a timelybasis. In addition, such funding could be subject to conditions that arecommercially unacceptable to us or for which we are unable to comply. Even ifwe succeed in aggressively expanding our domestic manufacturing capacity, wemay not have enough demand for our products to justify the increased capacity.

 

Any such expansion will place a significant strain on our seniormanagement team and our financial and other resources. Our proposed expansionwill expose us to greater overhead and support costs and other risks associatedwith the manufacture and commercialization of new products. Our ability tomanage our growth effectively will require us to continue to improve ouroperations and our financial and management information systems and to train,motivate and manage our employees. Difficulties in effectively managing thebudgeting, forecasting and other process control issues presented by such arapid expansion could harm our business, prospects, results of operations andfinancial condition.

 

***We may not be able to successfullyrecruit and retain skilled employees, particularly scientific, technical andmanagement professionals.***

 

We believe that our future success will depend in large part on ourability to attract and retain highly skilled technical, managerial andmarketing personnel who are familiar with our key customers and experienced inthe battery industry. We plan to continue to expand our work force bothdomestically and internationally. Industry demand for such employees,especially employees with experience in battery chemistry and batterymanufacturing processes, however, exceeds the number of personnel available,and the competition for attracting and retaining these employees is intense.This competition will intensify if the advanced battery market continues togrow, possibly requiring increases in compensation for current employees overtime. We compete in the market for personnel against numerous companies,including larger, more established competitors who have significantly greaterfinancial resources than we do and may be in a better financial position tooffer higher compensation packages to attract and retain human capital. Wecannot be certain that we will be successful in attracting and retaining theskilled personnel necessary to operate our business effectively in the future.Because of the highly technical nature of our batteries and battery systems,the loss of any significant number of our existing engineering and projectmanagement personnel could have a material adverse effect on our business andoperating results.

 

***Our future success depends on ourability to retain key personnel.***

 

Our success will depend to a significant extent on the continuedservices of our senior management team, and in particular David Vieau, ourchief executive officer, and Gilbert N. Riley, Jr., our chieftechnical officer. The loss or unavailability of either of these individualscould harm our ability to execute our business plan, maintain importantbusiness relationships and complete certain product development initiatives,which could harm our business. We do not have agreements requiring any of oursenior management team to remain with our company. In addition, each of theseindividuals could terminate his or her relationship with us at any time, and wemay be unable to enforce any applicable employment or non-compete agreements.

 

***If we do not continue to form andmaintain economic arrangements with original equipment manufacturers, or OEMs,to commercialize our products, our profitability could be impaired.***

 

Our business strategy requires us to integrate the design of ourproducts into products being developed by OEMs, and therefore to identifyacceptable OEMs and enter into agreements with them. In addition, we will needto meet their requirements and specifications by developing and introducing newproducts and enhanced or modified versions of our existing products on a timelybasis. OEMs

 

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oftenrequire unique configurations or custom designs for batteries or batterysystems which must be developed and integrated into a product well before the productis launched. This development process requires not only substantial lead timebetween the commencement of design efforts for a customized battery system andthe commencement of volume shipments of the battery systems to the customer,but also the cooperation and assistance of the OEMs in order to determine therequirements for each specific application. Technical problems may arise thataffect the acceptance of our product by OEMs. If we are unable to designand develop products that meet OEMs’ requirements, we may lose opportunities toobtain purchase orders, and our reputation may be damaged. In addition, we maynot receive adequate assistance from OEMs to successfully commercialize ourproducts, which could impair our profitability.

 

***Declines in product prices mayadversely affect our financial results.***

 

Our business is subject to intense price competition worldwide, whichmakes it difficult for us to maintain product prices and achieve adequateprofits. Such intense price competition may adversely affect our ability toachieve profitability, especially during periods of decreases in demand. Inaddition, because of their purchasing size, our larger automotive customers caninfluence market participants to compete on price terms. If we are not able tooffset pricing reductions resulting from these pressures by improved operatingefficiencies and reduced expenditures, those pricing reductions may have anadverse impact on our business.

 

***Implementations of new softwareplatforms or modifications to existing platforms may disrupt our business andoperations and could harm our operating results.***

 

The implementation of new software management platforms and theaddition of these platforms at new locations, especially overseas, requiresignificant management time, support and cost. As our business continues todevelop, we expect to add and enhance existing management platforms in theareas of financial, inventory control, engineering, and customer support andwarranty management. We cannot be sure that these platforms will be fully oreffectively implemented on a timely basis, if at all. If we do not successfullyimplement or modify these platforms, our operations may be disrupted and ouroperating expenses could be harmed. In addition, the new systems may not operateas we expect them to, and we may be required to expend significant resources tocorrect problems or find alternative sources for performing these functions.

 

***Our inability to effectively andquickly transfer, replicate and scale our new product manufacturing processesfrom low volume prototype production to high volume manufacturing facilities,could adversely affect our results of operations.***

 

Under our manufacturing model, we develop and establish manufacturingprocesses and systems for the low volume prototype production of our newproducts. As demand increases for a product, we transfer these processes andsystems to, and replicate and scale these processes and systems in our highvolume manufacturing facilities. If we are unable to effectively and quicklytransfer, replicate and scale these manufacturing processes and systems, suchas replicating our prismatic pilot facility in Korea to our new facilities inLivonia and Romulus, Michigan, we may be unable to meet our customers’ productquality and quantity requirements and lower our costs of goods sold and ourresults of operations could be adversely affected.

 

In addition, our costs of goods sold for some of our new productsexceed the purchase price for that product paid to us by our customers. If weare unable to decrease unit production costs for these products by increasingvolumes, improving the manufacturing process, reducing transportation andhandling costs or obtaining lower cost raw materials or component parts, wewill not realize a profit from these products and our business will be harmed.

 

***Problems in our manufacturing andassembly processes could limit our ability to produce sufficient batteries tomeet the demands of our customers.***

 

Regardless of the process technology used, the manufacturing andassembly of safe, high-power batteries and battery systems is a highly complexprocess that requires extreme precision and quality control throughout a numberof production stages. Any defects in battery packaging, impurities in theelectrode materials used, contamination of the manufacturing environment,incorrect welding, excess moisture, equipment failure or other difficulties inthe manufacturing process could cause batteries to be rejected, therebyreducing yields and affecting our ability to meet customer expectations.

 

As we have scaled up our production capacity, we have experiencedproduction problems that limited our ability to produce a sufficient number ofbatteries to meet the demands of certain customers. If these or other productionproblems recur and we are unable to resolve them in a timely fashion, ourbusiness could suffer and our reputation may be harmed.

 

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***Our failure to cost-effectivelymanufacture our batteries and battery systems in quantities which satisfy ourcustomers’ demand and product specifications and their expectations for productquality and reliable delivery could damage our customer relationships andresult in significant lost business opportunities for us.***

 

We manufacture a substantial percentage of our products rather thanrelying upon third-party outsourcing. To be successful, we mustcost-effectively manufacture commercial quantities of our complex batteries andbattery systems that meet our customer specifications for quality and timelydelivery. To facilitate the commercialization of our products, we will need tofurther reduce our manufacturing costs, which we intend to do by working withmanufacturing partners and by improving our manufacturing and developmentoperations in our wholly-owned operations in China. We manufacture ourbatteries and assemble our products in China, Korea, Massachusetts andMichigan. We depend on the performance of our manufacturing partners, as wellas our own manufacturing operations, to manufacture and deliver our products toour customers. If we or any of our manufacturing partners are unable tomanufacture products in commercial quantities on a timely and cost-effectivebasis, we could lose our customers and be unable to attract future customers.

 

In addition, we are shifting most of our battery assembly and all ofour battery system manufacturing from contract manufacturing to in-housemanufacturing, so our in-house experience with battery assembly and batterysystem manufacturing is limited.

 

***We may be unable to complete orintegrate acquisitions effectively, which may adversely affect our growth,profitability and results of operations.***

 

We may pursue acquisitions as part of our business strategy. However,we cannot be certain that we will be able to identify attractive acquisitiontargets, obtain financing for acquisitions on satisfactory terms orsuccessfully acquire identified targets. Additionally, we may not be successfulin integrating acquired businesses into our existing operations and achievingprojected synergies. Competition for acquisition opportunities in the variousindustries in which we operate may rise, thereby increasing our costs of makingacquisitions or causing us to refrain from making further acquisitions. Theseand other acquisition-related factors could negatively and adversely impact ourgrowth, profitability and results of operations.

 

***We entered into a joint venture inChina that, if not successful, could adversely impact our business, businessprospects and operating results.***

 

In December 2009, we formed a joint venture with SAICMotor Co. Ltd., or SAIC, a leading automaker in China. We will have a49 percent minority interest in the joint venture, Shanghai AdvancedTraction Battery Systems Co., Ltd., or ATBS, which is domiciled inShanghai, China. Pursuant to the joint venture agreements, we will supply ATBSwith battery cells and, as requested by ATBS, we have granted necessaryadvanced technology licenses to ATBS for the development, manufacture andservice of battery systems. As of June 30, 2010, we have not yet made anycapital contributions to ATBS and operations of ATBS have not yet commenced.

 

The business of ATBS is subject to all the operational risks thatnormally arise for a technology company with global operations pertaining toresearch and development, manufacturing, sales, service, marketing andcorporate functions. In addition, there could be disagreements between us andSAIC with respect to important strategic and operational decisions. Operating abusiness as a joint venture often requires additional organizationalformalities as well as time-consuming procedures for sharing information and makingdecisions. We may be required to pay more attention to our relationship withSAIC, as the co-owner of ATBS, and if SAIC ceases to be the co-owner of ATBS,our relationship with ATBS may be adversely affected. Additionally, as we aresharing intellectual property with ATBS we face the risks that we may not beable to maintain or enforce the rights to our intellectual property.

 

If the joint venture terminates, the joint venture could retaintechnical know how relating to battery systems transferred by us as part of theagreement. Additionally, we would have to find new partners or separatelypursue market opportunities in China which could cause us to incur additionaltime and expense.

 

***Laws regulating the manufacture ortransportation of batteries may be enacted which could result in a delay in theproduction of our batteries or the imposition of additional costs that couldharm our ability to be profitable.***

 

Laws and regulations exist today, and additional laws and regulationsmay be enacted in the future, which impose environmental, health and safetycontrols on the storage, use and disposal of certain chemicals and metals usedin the manufacture of lithium-ion batteries. Complying with any laws orregulations could require significant time and resources from our technicalstaff and possible redesign of one or more of our products, which may result insubstantial expenditures and delays in the production of one or more of ourproducts, all of which could harm our business and reduce our future profitability.The transportation of lithium and lithium-ion batteries is regulated bothdomestically and internationally. Compliance with these regulations, whenapplicable, increases the cost of producing and delivering our products.

 

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***We depend on contracts with theU.S. government and its agencies or on subcontracts with theU.S. government’s prime contractors for revenue and research grants tofund or partially fund our research and development programs, and our failureto retain current or obtain additional contracts could preclude us fromachieving our anticipated levels of revenue growth and profitability, increaseour research, development and engineering expenses and delay or halt certainresearch and development programs.***

 

Our ability to develop and market some of our products depends uponmaintaining our U.S. government contract revenue and research grantsobtained, which are recorded as incremental revenue and an offset to ourresearch, development and engineering expenses, respectively. Many of ourU.S. government contracts are funded incrementally, with funding decisionsmade on an annual basis. Approximately 3.6% of our total revenue and 18.3% ofour research, development and engineering expenses during the year endedDecember 31, 2009 were derived from government contracts and subcontracts.Changes in government policies, priorities or programs that result in budgetreductions could cause the government to cancel existing contracts or eliminatefollow-on phases in the future which would severely inhibit our ability tosuccessfully complete the development and commercialization of some of ourproducts. In addition, there can be no assurance that, once a governmentcontract is completed, it will lead to follow-on contracts for additionalresearch and development, prototype build and test or production. Furthermore,there can be no assurance that our U.S. government contracts orsubcontracts will not be terminated or suspended in the future. A reduction orcancellation of these contracts, or of our participation in these programs,would increase our research, development and engineering expenses, which couldmaterially and adversely affect our results of operations and could delay orimpair our ability to develop new technologies and products.

 

***If we are unable to developmanufacturing facilities for our products in the United States, we may losebusiness opportunities and our customer relationships may suffer.***

 

We believe that developing manufacturing facilities for our products inthe United States is important, in order to address national economicimperatives, such as job creation, as well as to more efficiently address theneeds of our U.S.-based customers. This expansion depends upon our receivingfederal and state financial incentives, primarily in the form of direct grantsand loans, to provide the necessary capital for facilities and equipment. If weare unable to obtain this government assistance on a timely basis and in theamounts requested, we will not be able to scale our capacity meet current andfuture customer demand for our products.

 

***Because of the funding we receivefrom U.S. government entities and our government business initiatives, weare subject to U.S. federal government audits and other regulation, andour failure to satisfy audit requirements or comply with applicable regulationscould subject us to material adjustments or penalties that could negativelyimpact our business.***

 

The accuracy and appropriateness of our direct and indirect costs andexpenses under our contracts with the U.S. government are subject toextensive regulation and audit by appropriate agencies of theU.S. government. These agencies have the right to challenge our costestimates or allocations with respect to any such contract. Additionally,substantial portions of the payments to us under U.S. government contractsare provisional payments that are subject to potential adjustment upon audit bysuch agencies. Adjustments that result from inquiries or audits of ourcontracts could have a material adverse impact on our financial condition orresults of operations. Since our inception, we have not experienced anymaterial adjustments as a result of any inquiries or audits, but there can beno assurance that our contracts will not be subject to material adjustments inthe future.

 

As we grow our government business, we may also need to comply withU.S. laws regulating the export of our products, particularly in ourgovernment business. We cannot be certain of our ability to obtain any licensesrequired to export our products or to receive authorization from theU.S. federal government for international sales or domestic sales toforeign persons. Moreover, the export regimes and the governing policiesapplicable to our business are subject to change. Our failure to comply withthese and other applicable regulations, rules and approvals could resultin the imposition of penalties, the loss of our government contracts or oursuspension or debarment from contracting with the federal government generally,any of which would harm our business, financial condition and results ofoperations.

 

***Our ability to sell our products toour direct, OEM and tier 1 supplier customers depends in part on thequality of our engineering and customization capabilities, and our failure tooffer high quality engineering support and services could have a materialadverse effect on our sales and operating results.***

 

A high level of support is critical for the successful marketing andsale of our products. The sale of our batteries and battery systems ischaracterized by significant co-development and customization work in certainapplications. This development process requires not only substantial lead timebetween the commencement of design efforts for a customized battery system andthe commencement of volume shipments of the battery systems to the customer,but also the cooperation and assistance of the OEMs to determine therequirements for each specific application. Once our products are designed intoan OEM or tier 1 supplier customer’s products or systems, the OEM ortier 1 supplier customer depends on us to resolve issues relating to ourproducts. If we do not effectively assist our OEM or tier 1 suppliercustomers in customizing, integrating and deploying our products in their ownsystems or products, or if we do not succeed in helping them quickly resolvepost-deployment issues and provide effective ongoing technical support, ourability to sell our products would be adversely affected.

 

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In addition, while we have supply and co-development agreements withcustomers located in different regions of the world, we do not have a globallydistributed engineering support and services organization. Currently, any issueresolution related to our products, system deployment or integration ischanneled back to our energy solutions group in Hopkinton, Massachusetts andMichigan, from which engineers and support personnel are deployed. As we growour business with our existing customers and beyond the markets into which wecurrently sell our battery technologies, we may need to increase the size ofour engineering support teams and deploy them closer to our customers. Ourinability to deliver a consistent level of engineering support and overallservice as we expand our operations could have a material adverse effect on ourbusiness and operating results. Moreover, despite our internal quality testing,our products may contain manufacturing or design defects or exhibit performanceproblems at any stage of their lifecycle. These problems could result inexpensive and time-consuming design modifications and impose additional needsfor engineering support and maintenance services as well as significantwarranty charges.

 

***Our past and future operations maylead to substantial environmental liability.***

 

The handling and use of some of the materials used in the developmentand manufacture of our products are subject to federal, state and localenvironmental laws, as well as environmental laws in other jurisdictions inwhich we operate. Under applicable environmental laws, we may be jointly andseverally liable with prior property owners for the treatment, cleanup,remediation and/or removal of any hazardous substances discovered at anyproperty we use. In addition, courts or government agencies may imposeliability for, among other things, the improper release, discharge, storage,use, disposal or transportation of hazardous substances. If we incur anysignificant environmental liabilities, our ability to execute our business planand our financial condition would be harmed. Our facilities or operations couldbe damaged or adversely affected as a result of disasters or unpredictableevents, including widespread public health problems.

 

Our headquarters, including sales offices and research and developmentcenters, is located in Massachusetts. We also operate manufacturing, logistics,sales and research and development facilities in Michigan, Missouri, China,Korea, Germany and Canada. If major disasters such as earthquakes, fires,floods, hurricanes, wars, terrorist attacks, computer viruses, pandemics orother events occur, or our information system or communications network breaksdown or operates improperly, our facilities may be seriously damaged, or we mayhave to stop or delay production and shipment of our products. We may incurexpenses relating to such damages. In addition, a renewed outbreak of SARS,avian flu, swine flu or another widespread public health problem in China orthe United States could have a negative effect on our operations.

 

**Risks Related to Intellectual Property**

 

***Third parties have asserted thatthey own or control patents that are infringed by our products.***

 

We are presently involved in two related patent litigations withHydro-Québec involving certain patents it has licensed from The University ofTexas, or UT, related to electrode materials used in lithium-ion batteries.After discussions with Hydro-Québec about the relevance of two of these patentsto our products, we brought an action in the Federal District Court of Massachusettsseeking a declaratory judgment that our products do not infringe these two UTpatents. In response, Hydro-Québec and the UT countersued us in the FederalCourts in Texas. Both cases are currently stayed pending re-examination ofthese patents by the U.S. Patent Office. The re-examination of thesepatents is complete, but the stay continues, although the litigation couldresume at any time. For a more detailed discussion of our patent litigation,see Item 1 of Part II: “Legal Proceedings.”

 

We believe that we have valid non-infringement defenses against both ofthese patents and that at least one of the patents is invalid. If we were tochallenge the validity of any issued United States patent in court, we wouldneed to overcome a presumption of validity that attaches to every patent. Thisburden is high and would require us to present clear and convincing evidence asto the invalidity of the patent’s claims. There is no assurance that a courtwould find in our favor on infringement or validity and, if this case is notresolved in our favor, we may be required to pay substantial damages. Inaddition, an adverse ruling could cause us, and our customers, developmentpartners and licensees, to stop, modify or delay activities in the UnitedStates such as research, development, manufacturing and sales of products basedon technologies covered by these patents. We would need to develop products andtechnologies that design around these patents or obtain a license to theappropriate patent. There is no certainty that such design-arounds exist or ifthey exist that they would be commercially competitive, and there is nocertainty that a license from the appropriate parties could be obtained. Also,the mere existence, and the uncertainty with respect to the ultimate outcome,of this patent litigation or any other patent litigation that we may becomeinvolved with, could cause our current and potential customers, developmentpartners, the federal or state governments and licensees to stop, delay oravoid doing business with us or modify the extent to which they are willing todo business with us, and this loss or delay of business could harm ouroperating results and our ability to execute on our business plan.

 

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***Other parties may also bringintellectual property infringement claims against us which would betime-consuming and expensive to defend, and if any of our products or processesis found to be infringing, we may not be able to procure licenses to usepatents necessary to our business at reasonable terms, if at all.***

 

Our success depends in part on avoiding the infringement of otherparties’ patents and proprietary rights. We may inadvertently infringe existingthird-party patents or third-party patents issued on existing patentapplications. In the United States and most other countries, patentapplications are published 18 months after filing. As a result, there may bethird-party pending patent applications of which we are unaware, and which wemay infringe once they issue. These third parties could bring claims against usthat, even if resolved in our favor, could cause us to incur substantialexpenses and, if resolved against us, could cause us to pay substantialdamages. Under some circumstances in the United States, these damages could betriple the actual damages the patent holder incurs. If we have suppliedinfringing products to third parties for marketing or licensed third parties tomanufacture, use or market infringing products, we may be obligated toindemnify these third parties for any damages they may be required to pay tothe patent holder and for any losses the third parties may sustain themselvesas the result of lost sales or damages paid to the patent holder. In addition,we may have, and may be required to, make representations as to our right tosupply and/or license intellectual property and to our compliance with laws.Such representations are usually supported by indemnification provisionsrequiring us to defend our customers and otherwise make them whole if welicense or supply products that infringe on third party technologies or violategovernment regulations. Further, if a patent infringement suit were broughtagainst us, we and our customers, development partners and licensees could beforced to stop or delay research, development, manufacturing or sales ofproducts based on our technologies in the country or countries covered by thepatent we infringe, unless we can obtain a license from the patent holder. Sucha license may not be available on acceptable terms, or at all, particularly ifthe third party is developing or marketing a product competitive with productsbased on our technologies. Even if we were able to obtain a license, the rightsmay be nonexclusive, which would give our competitors access to the sameintellectual property.

 

Any successful infringement action brought against us may alsoadversely affect marketing of products based on our technologies in othermarkets not covered by the infringement action. Furthermore, we may sufferadverse consequences from a successful infringement action against us even ifthe action is subsequently reversed on appeal, nullified through another actionor resolved by settlement with the patent holder. As a result, any infringementaction against us would likely harm our competitive position, be costly andrequire significant time and attention of our key management and technicalpersonnel.

 

***We may be involved in lawsuits toprotect or enforce our patents, which could be expensive and time consuming.***

 

Competitors or others may infringe our patents. To counter infringementor unauthorized use, we may be required to file patent infringement claims, whichcan be expensive and time-consuming. In addition, in an infringementproceeding, a court may decide that a patent of ours is not valid or isunenforceable, or may refuse to stop the other party from using the technologyat issue on the grounds that our patents do not cover that technology. Anadverse determination of any litigation or defense proceedings could put one ormore of our patents at risk of being invalidated or interpreted narrowly andcould put our patent applications at risk of not issuing.

 

Interference proceedings brought by the United States Patent andTrademark Office may be necessary to determine the priority of inventions withrespect to our patent applications. Litigation or interference proceedings mayfail and, even if successful, may result in substantial costs and be adistraction to our management. We may not be able to prevent misappropriationof our proprietary rights, particularly in countries where the laws may notprotect such rights as fully as in the United States.

 

Furthermore, because of the substantial amount of discovery required inconnection with intellectual property litigation, there is a risk that some ofour confidential information could be compromised by disclosure. In addition,during the course of this litigation, there could be public announcements ofthe results of hearings, motions or other interim proceedings or developments.If securities analysts or investors perceive these results to be negative, itcould have a substantial adverse effect on the price of our common stock.

 

We may not prevail in any litigation or interference proceeding inwhich we are involved. Even if we do prevail, these proceedings can beexpensive and distract our management.

 

***Our patent applications may notresult in issued patents, which may have a material adverse effect on ourability to prevent others from commercially exploiting products similar toours.***

 

Patent applications in the United States are maintained in secrecyuntil the patents are published or are issued. Since publication of discoveriesin the scientific or patent literature tends to lag behind actual discoveriesby several months, we cannot be certain that we are the first creator ofinventions covered by pending patent applications or the first to file patentapplications on these inventions. We also cannot be certain that our pendingpatent applications will result in issued patents or that any of our issuedpatents will afford protection against a competitor. In addition, patentapplications filed in foreign countries are subject to laws, rules andprocedures that differ from those of the United States, and thus we cannot becertain that foreign patent applications related to issued U.S. patentswill be issued. Furthermore, if these patent applications issue, some foreigncountries provide significantly less effective patent enforcement than in theUnited States.

 

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The status of patents involves complex legal and factual questions andthe breadth of claims allowed is uncertain. Accordingly, we cannot be certainthat the patent applications that we file will result in patents being issued,or that our patents and any patents that may be issued to us in the near futurewill afford protection against competitors with similar technology. Inaddition, patents issued to us may be infringed upon or designed around byothers and others may obtain patents that we need to license or design around,either of which would increase costs and may adversely affect our operations.

 

***Our patents and other protectivemeasures may not adequately protect our proprietary intellectual property.***

 

We regard our intellectual property, particularly our proprietaryrights in our battery and battery system technology, as critical to oursuccess. We have received a number of patents, and filed other patentapplications, for various applications and aspects of our technology orprocesses and other intellectual property. In addition, we generally enter intoconfidentiality and invention agreements with our employees and consultants.Such patents and agreements and various other measures we take to protect ourintellectual property from use by others may not be effective for variousreasons, including the following:

 

·                        our pendingpatent applications may not be granted for various reasons, including theexistence of conflicting patents or defects in our applications;

 

·                        the patents wehave been granted may be challenged, invalidated or circumvented because of thepre-existence of similar patented or unpatented intellectual property rights orfor other reasons;

 

·                        parties to theconfidentiality and invention agreements may have such agreements declaredunenforceable or, even if the agreements are enforceable, may breach suchagreements;

 

·                        the costsassociated with enforcing patents, confidentiality and invention agreements orother intellectual property rights may make aggressive enforcement prohibitive;

 

·                        even if weenforce our rights aggressively, injunctions, fines and other penalties may beinsufficient to deter violations of our intellectual property rights; and

 

·                        other personsmay independently develop proprietary information and techniques that arefunctionally equivalent or superior to our intellectual proprietary informationand techniques but do not breach our patented or unpatented proprietary rights.

 

***We may be unable to adequatelyprevent disclosure of trade secrets and other proprietary information.***

 

We rely on trade secrets to protect our proprietary technologies,especially where we do not believe patent protection is appropriate orobtainable. However, trade secrets are difficult to protect. We rely in part onconfidentiality agreements with our employees, contractors, consultants,outside scientific collaborators and other advisors to protect our tradesecrets and other proprietary information. These agreements may not effectivelyprevent disclosure of confidential information and may not provide an adequateremedy in the event of unauthorized disclosure of confidential information. Inaddition, others may independently discover our trade secrets or independentlydevelop processes or products that are similar or identical to our tradesecrets, and courts outside the United States may be less willing to protecttrade secrets. Costly and time-consuming litigation could be necessary toenforce and determine the scope of our proprietary rights, and failure toobtain or maintain trade secret protection could adversely affect ourcompetitive business position.

 

**Risks Associated With Doing Business Internationallyand Specifically in China and Korea**

 

***Our substantial internationaloperations subject us to a number of risks, including unfavorable political,regulatory, labor and tax conditions.***

 

We have significant manufacturing facilities and operations in Chinaand Korea that are subject to the legal, political, regulatory and socialrequirements and economic conditions in these jurisdictions. In addition, we expectto sell a significant portion of our products to customers located outside theUnited States. Risks inherent to international operations and sales, include,but are not limited to, the following:

 

· difficultyin enforcing agreements, judgments and arbitration awards in foreign legalsystems;

 

· fluctuationsin exchange rates may affect product demand and may adversely affect ourprofitability in U.S. dollars to the extent the cost of raw materials andlabor is denominated in a foreign currency;

 

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· impedimentsto the flow of foreign exchange capital payments and receipts due to exchangecontrols instituted by certain foreign governments and the fact that the localcurrencies of these countries are not freely convertible;

 

· inabilityto obtain, maintain or enforce intellectual property rights;

 

· changesin general economic and political conditions;

 

· changesin foreign government regulations and technical standards, including additionalregulation of rechargeable batteries, power technology, or the transport oflithium or phosphate, which may reduce or eliminate our ability to sell orlicense in certain markets;

 

· requirementsor preferences of foreign nations for domestic products could reduce demand forour products;

 

· tradebarriers such as export requirements, tariffs, taxes and other restrictions andexpenses, which could increase the prices of our products and make us lesscompetitive; and

 

· longerpayment cycles typically associated with international sales and potentialdifficulties in collecting accounts receivable, which may reduce the futureprofitability of foreign sales.

 

Our business in foreign jurisdictions requires us to respond to rapidchanges in market conditions in these countries. Our overall success as aglobal business depends on our ability to succeed in different legal,regulatory, economic, social and political situations and conditions. We maynot be able to develop and implement effective policies and strategies in eachforeign jurisdiction where we do business. Also, each of the foregoing riskswill likely take on increased significance as we implement plans to expandforeign manufacturing operations.

 

***Since many of our products aremanufactured in China, we own and lease manufacturing facilities in China andthe Chinese market is of growing importance for our products, we face risks ifChina loses normal trade relations status with the United States or if US-Chinatrade relations are otherwise adversely impacted.***

 

We manufacture and export our products from China and own and leasemanufacturing facilities in China. We may also sell our products in China inthe future. Our products sold in the United States have normal trade relationsstatus and are currently not subject to United States import duties. As aresult of opposition to certain policies of the Chinese government and China’sgrowing trade surpluses with the United States, there has been, and in thefuture may be, opposition to normal trade relations status with China. TheUnited States Congress may also introduce China trade legislation targetingcurrency manipulation, which may adversely affect our business in China. Theloss of normal trade relations status for China, changes in current tariffstructures or adoption in the United States of other trade policies adverse toChina, and any retaliatory measures that impact our products in the Chinesemarket, could have an adverse effect on our business.

 

A change in exchange rates mandated by legislation could negativelyimpact the cost of imported raw materials and products.

 

Furthermore, our business and operations may be adversely affected bydeterioration of the diplomatic and political relationships between the UnitedStates and China. If the relationship between the United States and China wereto materially deteriorate, it could negatively impact our ability to controlour operations and relationships in China, enforce any agreements we have withChinese partners or otherwise deal with any assets or investments we may havein China.

 

***Our ongoing manufacturing operationsin China are complex and having these remote operations may divert management’sattention, lead to disruptions in operations, delay implementation of ourbusiness strategy and make it difficult to establish adequate management andfinancial controls in China. Our plans to grow our business to include sales toChinese customers may necessitate additional management attention toestablishing and maintaining one or more joint venture relationships withChinese parties.***

 

Currently, we have most of our manufacturing operations in China. Wemay not be able to find or retain suitable employees in China and we may haveto train personnel to perform necessary functions for our manufacturing, seniormanagement and development operations. This may divert management’s attention,lead to disruptions in operations and delay implementation of our businessstrategy, all of which could negatively impact our profitability.

 

China has only recently begun to adopt management and financialreporting concepts and practices like those with which investors in the UnitedStates are familiar. We may have difficulty in hiring and retaining employeesin China who have the experience necessary to implement the kind of managementand financial controls that are expected of a United States public company. Ifwe cannot establish and implement such controls, we may experience difficultyin collecting financial data and preparing financial statements, books ofaccount and corporate records and instituting business practices that meet U.S.standards.

 

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In order to grow our business and sales to Chinese customers we haveentered into a Chinese-foreign joint venture with a Chinese partner. AChinese-foreign joint venture can be a complex business arrangement requiringsubstantial management attention to the joint venture relationship. The jointventure will also require capital contributions and due to China’s foreignexchange controls, uncertainty as to the ability to repatriate profits andprincipal out of China.

 

***Because of the relative weakness ofthe Chinese legal system in general, and the intellectual property regime inparticular, we may not be able to enforce intellectual property rights inChina.***

 

The legal regime protecting intellectual property rights in China isweak. Because the Chinese legal system in general, and the intellectualproperty regime in particular, are relatively weak, it is often difficult tocreate and enforce intellectual property rights in China. Accordingly, we maynot be able to effectively protect our intellectual property rights in China.

 

***Enforcing agreements and laws inChina is difficult and may be impossible because China does not have acomprehensive system of laws.***

 

We depend on our relationships with our Chinese manufacturing partners.In China, enforcement of contractual agreements may be sporadic, andimplementation and interpretation of laws may be inconsistent. The Chinesejudiciary is relatively inexperienced in interpreting agreements and enforcingChina’s laws, leading to a higher than usual degree of uncertainty as to theoutcome of any litigation. Even where adequate law exists in China, it may notbe possible to obtain swift and equitable enforcement of such law, or to obtainenforcement of a judgment or an arbitration award by a court of anotherjurisdiction.

 

***The government of China may changeor even reverse its policies of promoting private industry and foreigninvestment, in which case our assets and operations may be at risk.***

 

Our existing and planned operations in China are subject to risksrelated to the business, economic and political conditions in China, whichinclude the possibility that the central government of China will change oreven reverse its policies of promoting private industry and foreign investmentin China. The government of China has exercised and continues to exercisesubstantial control over virtually every section of the Chinese economy throughregulation and state ownership. Many of the current reforms which supportprivate business in China are of recent origin or provisional in nature. Otherpolitical, economic and social factors, such as political changes, changes inthe rates of economic growth, unemployment or inflation, or in the disparitiesof per capita wealth among citizens of China and between regions within China,could also lead to further readjustment of the government’s reform measures. Itis not possible to predict whether the Chinese government will continue to beas supportive of private business in China, nor is it possible to predict howany future reforms will affect our business. For example, if the governmentwere to limit the number of foreign personnel who could work in the country,substantially increase taxes on foreign businesses, eliminate export processingzones, restrict the transportation of goods in and out of the country, adoptpolicies favoring competitors or impose other restrictions on our operations,the impact may be significant.

 

Significantly, a reversal of current liberalizations of foreignexchange controls by the Chinese government could be disruptive and costly toour cross-border operations and our business as a whole.

 

***Business practices in China andKorea may entail greater risk and dependence upon the personal relationships ofsenior management than is common in North America, and therefore some of ouragreements with other parties in China and Korea could be difficult orimpossible to enforce.***

 

The business cultures of China and Korea are, in some respects,different from the business cultures in Western countries and may present somedifficulty for Western investors reviewing contractual relationships amongcompanies in China and Korea and evaluating the merits of an investment.Personal relationships among business principals of companies and businessentities in China and Korea are very significant in their business cultures. Insome cases, because so much reliance is based upon personal relationships,written contracts among businesses in China and Korea may be less detailed andspecific than is commonly accepted for similar written agreements in Westerncountries. In some cases, material terms of an understanding are not containedin the written agreement but exist as oral agreements only. In other cases, theterms of transactions which may involve material amounts of money are notdocumented at all. In addition, in contrast to Western business practices wherea written agreement specifically defines the terms, rights and obligations ofthe parties in a legally-binding and enforceable manner, the parties to awritten agreement in China or Korea may view that agreement more as a startingpoint for an ongoing business relationship which will evolve and requireongoing modification. As a result, written agreements in China or Korea mayappear to the Western reader to look more like outline agreements that precedea formal written agreement. While these documents may appear incomplete orunenforceable to a Western reader, the parties to the agreement in China orKorea may feel that they have a more complete understanding than is apparent tosomeone who is only reading the written agreement without having attended thenegotiations. As a result, contractual arrangements in China and Korea may bemore difficult to review and understand.

 

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***China has introduced sweepingreforms to its income tax, turnover tax and other tax laws and regulations.Some of the changes increase the taxes for foreign-invested and otherbusinesses in China will incur on specific types of transactions as well asarising from operations generally in China. Our earnings may be affected by taxadjustments to reflect such changes in the law.***

 

Pursuant to a comprehensive reform of China’s tax system that tookeffect on January 1, 2008, income tax incentives granted toforeign-invested enterprises, and geographically-based incentives, have largelybeen eliminated and have been replaced with incentives designed to encourageenterprises, domestic and foreign-invested alike, in selected industries. Forexample, dividends paid by foreign-invested enterprises to foreign shareholdersare no longer exempt from withholding tax. A 10% withholding tax applies todividends, although the rate is reduced to 5% by certain tax treaties. The taxholidays and tax reduction periods and the reduced national income tax ratethat foreign-invested enterprises engaged in production used to enjoy have alsobeen removed. The tax incentives promised to our wholly foreign-ownedsubsidiaries located in export processing zones at the time of inception willbe phased-out by the end of 2012. At that time, these subsidiaries and any newforeign-invested enterprises we might establish as part of our strategy toexpand the market for our products will no longer have income tax advantagesover Chinese domestic businesses.

 

China’s turnover tax system consists of VAT, consumption tax andbusiness tax. VAT is primarily imposed on import and sales of goods and certainservices, such as repairing, processing and replacement. Export sales areexempt under VAT rules, and an exporter who incurs VAT on the purchase ormanufacture of goods should be able to claim a refund from Chinese taxauthorities. Depending on whether VAT export refund rates are raised or reducedfor relevant goods, exporters might bear part of the VAT they incurred inconjunction with producing the exported goods. To mitigate the effects of theglobal economic downturn on China’s export industry, the PRC Ministry ofFinance and the State Administration of Taxation have raised VAT rebates onnumerous exported labor-intensive and high-value-added products. However, theChinese government may also lower rebate rates in future in response todifferent economic and policy objectives.

 

China has also introduced sweeping VAT policy reforms with effect fromJanuary 1, 2009, which facilitate China’s shift from a production-basedVAT scheme to a consumption-based system. Generally, the new system reduces thetotal output VAT of production enterprises as fixed-asset investment costsrelated to VAT-eligible output are no longer subject to VAT. However, our VATcosts will depend on our ability to pass on input VAT to our local suppliersand customers. As the relevant VAT law and implementing regulations are new,there may be a period of adjustment before any cost-savings are realized.

 

Business tax is usually a fee of 3-5 percent levied on services—suchas transport, construction, education, finance, and insurance—transfer ofintangible assets, and sales of fixed assets, none of which are generallyeligible for VAT. New business tax regulations, which took effectJanuary 1, 2009, may impose business on services exchanged among China-and foreign-based entities which previously were not subject to business tax,and the potential overall impact is to increase the tax burden of cross-borderservice transactions.

 

Frequent changes to China’s tax laws can result in uncertainty andunpredictability in financial results of our operations in China. China’s taxlaws are supplemented with detailed implementation rules and circulars.However, the interpretation of the rules may vary among local tax authorities.

 

**Risks Related to Ownership of Our Common Stock**

 

***We are incurring increased costs anddemands upon management as a result of complying with the laws and regulationsaffecting public companies, which could harm our operating results.***

 

As a public company, we are incurring significant additional legal,accounting and other expenses that we did not incur as a private company,including costs associated with public company reporting requirements. We alsohave incurred and will incur costs associated with current corporate governancerequirements, including requirements under Section 404 and otherprovisions of the Sarbanes-Oxley Act, as well as rules implemented by theSecurities and Exchange Commission, or SEC, and the Nasdaq Global Market. Theexpenses incurred by public companies for reporting and corporate governancepurposes have increased dramatically in recent years. We expect these rules andregulations to substantially increase our legal and financial compliance costsand to make some activities more time-consuming and costly. We also expectthese new rules and regulations may make it more difficult and moreexpensive for us to obtain and maintain director and officer liabilityinsurance, and we may be required to accept reduced policy limits and coverageor incur substantially higher costs to obtain the same or similar coveragepreviously available. As a result, it may be more difficult for us to attractand retain qualified individuals to serve on our board of directors or as ourexecutive officers.

 

***An active trading market for ourcommon stock may not develop or be sustained, and you may not be able to resellyour shares at or above the price at which you purchased them.***

 

We have a limited history as a public company. An active trading marketfor our shares may never develop or be sustained. In the absence of an activetrading market for our common stock, investors may not be able to sell theircommon stock at or above the price they paid or at the time that they wouldlike to sell.

 

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***Our stock price may be volatile.***

 

The market price of our common stock could be subject to significantfluctuations, and it may decline below the price at which you purchased it.Market prices for securities of early stage companies have historically beenparticularly volatile. As a result of this volatility, you may not be able tosell your common stock at or above the price you paid. Some of the factors thatmay cause the market price of our common stock to fluctuate include:

 

· fluctuationsin our quarterly financial results or the quarterly financial results ofcompanies perceived to be similar to us;

 

· fluctuationsin our recorded revenue, even during periods of significant sales orderactivity;

 

· changesin estimates of our financial results or recommendations by securitiesanalysts;

 

· failureof any of our products to achieve or maintain market acceptance;

 

· productliability issues involving our products or our competitors’ products;

 

· changesin market valuations of similar companies;

 

· successof competitive products or technologies;

 

· changesin our capital structure, such as future issuances of securities or theincurrence of debt;

 

· announcementsby us or our competitors of significant services, contracts, acquisitions orstrategic alliances;

 

· developmentsor announcements related to our application for government stimulus funds;

 

· regulatorydevelopments in the United States, foreign countries or both;

 

· litigationinvolving us, our general industry or both;

 

· additionsor departures of key personnel;

 

· investors’general perception of us; and

 

· changesin general economic, industry and market conditions.

 

In addition, if the market for technology stocks or the stock market ingeneral experiences a loss of investor confidence, the trading price of ourcommon stock could decline for reasons unrelated to our business, financialcondition or results of operations. If any of the foregoing occurs, it couldcause our stock price to fall and may expose us to class action lawsuits that,even if unsuccessful, could be costly to defend and a distraction tomanagement.

 

***A significant portion of our totaloutstanding shares may be sold into the public market at any time, which couldcause the market price of our common stock to drop significantly, even if ourbusiness is doing well.***

 

Sales of a substantial number of shares of our common stock in thepublic market could occur at any time. These sales, or the market perceptionthat the holders of a large number of shares intend to sell shares, couldreduce the market price of our common stock. On March 29, 2010, 71,111,858shares of common stock, subject to a contractual lock-up (which began on theclosing of the IPO on September 29, 2009), became freely tradable, subjectto any applicable volume limitations under federal securities laws.

 

In addition, as of June 30, 2010, there were 10,228,950 sharessubject to outstanding options and 197,829 shares subject to outstandingrestricted stock units that are eligible for sale in the public market to theextent permitted by any applicable vesting requirements and Rule 144 underthe Securities Act of 1933, as amended. Moreover, certain holders of our common stock have rights, subject tosome conditions, to require us to file registration statements covering theirshares and to include their shares in registration statements that we may filefor ourselves or other stockholders. Additional holders of our common stockhave rights, subject to some conditions, to include their shares inregistration statements that we may file for ourselves or other stockholders.We have also registered all shares of common stock that we may issue under ourequity incentive plans, including 6,480,971 shares reserved for future issuanceunder our equity incentive plans, pursuant to a registration statement that wasfiled and

 

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becameimmediately effective on March 31, 2010. Once we issue these shares, theycan be freely sold in the public market upon issuance.

 

Uponthe closing of a private placement in connection with a strategic transactionon January 14, 2010, we issued 479,282 shares of common stock to Fisker AutomotiveInc., or Fisker. The issuance of these shares resulted in dilution tostockholders who held our common stock prior to the private placement. As of June 30,2010 all of the shares of common stock are freely tradable pursuant to aregistration statement filed with the SEC that was declared effective by theSEC on March 29, 2010.

 

***If securities or industry analystsdo not publish or cease publishing research or reports about us, our businessor our market, or if they change their recommendations regarding our stockadversely, our stock price and trading volume could decline.***

 

The trading market for our common stock will be influenced by theresearch and reports that industry or securities analysts may publish about us,our business, our market or our competitors. If any of the analysts who maycover us change their recommendation regarding our stock adversely, or providemore favorable relative recommendations about our competitors, our stock pricewould likely decline. If any analyst who may cover us were to cease coverage ofour company or fail to regularly publish reports on us, we could losevisibility in the financial markets, which in turn could cause our stock priceor trading volume to decline.

 

***Our management has broad discretionover the use of our cash reserves, if any, and might not apply this cash inways that increase the value of your investment.***

 

Our management has broad discretion to use our cash reserves, if any,and you will be relying on the judgment of our management regarding the applicationof this cash. Our management might not apply our cash in ways that increase thevalue of your investment. We expect to use our cash reserves for capitalexpenditures, including capital expenditures related to the expansion of ourmanufacturing capacity in Michigan, working capital, and other generalcorporate purposes, which may in the future include investments in, oracquisitions of, complementary businesses, joint ventures, partnerships,services or technologies. Our management might not be able to yield asignificant return, if any, on any investment of this cash. You will not havethe opportunity to influence our decisions on how to use our cash reserves.

 

***We do not expect to declare anydividends in the foreseeable future.***

 

We do not anticipate declaring any cash dividends to holders of ourcommon stock in the foreseeable future. Consequently, investors may need torely on sales of their common stock after price appreciation, which may neveroccur, as the only way to realize any future gains on their investment.Investors seeking cash dividends should not purchase our common stock.

 

***Anti-takeover provisions containedin our certificate of incorporation and bylaws, as well as provisions ofDelaware law, could impair a takeover attempt.***

 

Our certificate of incorporation, bylaws and Delaware law containprovisions that could have the effect of rendering more difficult ordiscouraging an acquisition deemed undesirable by our board of directors. Ourcorporate governance documents include provisions:

 

· authorizingblank check preferred stock, which could be issued with voting, liquidation,dividend and other rights superior to our common stock;

 

· limitingthe liability of, and providing indemnification to, our directors and officers;

 

· limitingthe ability of our stockholders to call and bring business before specialmeetings and to take action by written consent in lieu of a meeting;

 

· requiringadvance notice of stockholder proposals for business to be conducted atmeetings of our stockholders and for nominations of candidates for election toour board of directors;

 

· controllingthe procedures for the conduct and scheduling of board of directors andstockholder meetings;

 

· providingthe board of directors with the express power to postpone previously scheduledannual meetings and to cancel previously scheduled special meetings;

 

· establishinga classified board of directors so that not all members of our board areelected at one time;

 

· limitingthe determination of the number of directors on our board of directors and thefilling of vacancies or newly created seats on the board to our board ofdirectors then in office; and

 

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· providingthat directors may be removed by stockholders only for cause.

 

These provisions, alone or together, could delay hostile takeovers andchanges in control of our company or changes in our management.

 

As a Delaware corporation, we are also subject to provisions ofDelaware law, including Section 203 of the Delaware General CorporationLaw, which prevents some stockholders holding more than 15% of our outstandingcommon stock from engaging in certain business combinations without approval ofthe holders of substantially all of our outstanding common stock. Any provisionof our amended and restated certificate of incorporation or bylaws or Delawarelaw that has the effect of delaying or deterring a change in control couldlimit the opportunity for our stockholders to receive a premium for theirshares of our common stock, and could also affect the price that some investorsare willing to pay for our common stock.

 

**Item 2. Unregistered Sales of Equity Securities and Useof Proceeds**

 

(a) Sales of UnregisteredSecurities

 

None

 

(b) Use of Proceedsfrom Public Offering of Common Stock

 

On September 29, 2009,we closed our IPO, in which 32,407,576 shares of common stock were sold at aprice to the public of $13.50 per share. We sold 31,727,075 shares of ourcommon stock in the offering and selling stockholders sold 680,501 of theshares of common stock in the offering. The aggregate offering price for allshares sold in the offering, including shares sold by us and the sellingstockholders, was $437.5 million. The offer and sale of all of the shares inthe IPO were registered under the Securities Act pursuant to a registrationstatement on Form S-1 (File No. 333-152871), which was declaredeffective by the SEC on September 23, 2009, and a registration statementon Form S-1 (File No. 333-162090) filed pursuant toRule 424(b) of the Securities Act.. The offering commenced as ofSeptember 23, 2009 and did not terminate before all of the securitiesregistered in the registration statement were sold. Morgan Stanley &Co. Incorporated and Goldman, Sachs, & Co. acted as co-representativesof the underwriters. We raised approximately $391.8 million in net proceedsafter deducting underwriting discounts and commissions of $30.0 millionand other estimated offering costs of $6.7 million. No payments were made by usto directors, officers or persons owning ten percent or more of our commonstock or to their associates, or to our affiliates, other than payments in theordinary course of business to officers for salaries and to non-employeedirectors as compensation for board or board committee service, or as a resultof sales of shares of common stock by selling stockholders in theoffering.  There has been no materialchange in the planned use of proceeds from our IPO as described in our finalprospectus filed with the SEC pursuant to Rule 424(b).  From the effective date of the registrationstatement through June 30, 2010, we used approximately $140.8 million ofthe net proceeds primarily to fund our operations and the expansion of ourfacilities to support the anticipated growth of our business. We have investedthe remainder of the funds in a registered money market fund.

 

(c) Restrictions ondividends

 

We have not paid any cashdividends since inceptions and do not anticipate paying cash dividends in theforeseeable future.  Our term loanrestricts our ability to pay cash dividends.

 

**Item 6. Exhibits**

 

The exhibits listed in theExhibit Index immediately preceding the exhibits are filed (other thanexhibits 32.1 and 32.2) as part of this Quarterly Report on Form 10-Q andsuch Exhibit Index is incorporated herein by reference.

 

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**SIGNATURES**

 

Pursuant to the requirementsof the Securities Exchange Act of 1934, the Registrant has duly caused thisreport to be signed on its behalf by the undersigned, thereunto duly authorized.

 
| ** **                 | **A123  SYSTEMS, INC.** |
|----------------------------|------------------------------|
|                       |                         |
| Date: August 11, 2010 | By:                          | /s/ David P. Vieau |
|                       |                         | David P. Vieau |
|                       |                         | Chief Executive Officer |
|                       |                         | (Principal Executive  Officer) |
|                       |                         |   |
|                       |                         |   |
| Date: August 11, 2010 | By:                          | /s/ Michael Rubino |
|                       |                         | Michael Rubino |
|                       |                         | Chief Financial Officer |
|                       |                         | (Principal Financial and  Accounting Officer) |

 

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*EXHIBIT INDEX*

 

Listed and indexed below areall Exhibits filed as part of this report.

 
| **Exhibit  No.** | ** ** | **Description**                                                                                                                                                 |
|------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------|
|             |       |                                                                                                                                                            |
| 10.1 †      |       | Lease Agreement, dated  May 19, 2010, by and between Boston Properties Limited Partnership and  the Registrant.                                            |
|             |       |                                                                                                                                                            |
| 10.2             |       | Form of Restricted  Stock Unit Agreement under 2009 Stock Incentive Plan.                                                                                  |
|             |       |                                                                                                                                                            |
| 10.3 †      |       | Supply Agreement, dated  June 23, 2010, by and between ConocoPhillips Specialty  Products, Inc. and the Registrant.                                   |
|             |       |                                                                                                                                                            |
| 31.1             |       | Certification of Chief  Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of  2002 by Chief Executive Officer.                           |
|             |       |                                                                                                                                                            |
| 31.2             |       | Certification of Chief  Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of  2002 by Chief Financial Officer.                           |
|             |       |                                                                                                                                                            |
| 32.1 *           |       | Certification pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002, by Chief Executive Officer. |
|             |       |                                                                                                                                                            |
| 32.2  *          |       | Certification pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002, by Chief Financial Officer. |

 

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*                                                                                                                       Thiscertification shall not be deemed “filed” for purposes of Section 18 ofthe Securities Exchange Act of 1934, or otherwise subject to the liability ofthat Section, nor shall it be deemed to be incorporated by reference into anyfiling under the Securities Act of 1933 or the Securities Exchange Act of 1934.

 

†                                                                                                                        Confidentialtreatment requested as to certain portions, which portions have been omittedand filed separately with the Securities and Exchange Commission.

 

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