UNITED
      STATES
                                      SECURITIES
      AND EXCHANGE COMMISSIONWashington,
      D.C. 20549FORM
      10-K


x ANNUAL REPORT
PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE
FISCAL YEAR ENDED   DECEMBER 31,
2009.




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: 0-23336


AROTECH
CORPORATION


(Exact
name of registrant as specified in its charter)
  Delaware
              95-4302784(State
      or other jurisdiction of incorporation or organization)
              (I.R.S.
      Employer Identification No.)1229
      Oak Valley Drive, Ann Arbor, Michigan
              48108(Address
      of principal executive offices)
              (Zip
      Code)


(800)
281-0356
 (Registrant’s
telephone number, including area code)


Securities
registered pursuant to Section 12(b) of the Act:




Title
      of each class
              Name
      of each exchange on which registeredCommon
      Stock, $0.01 par value
              The
      Nasdaq Stock Market LLC




Securities
      registered pursuant to Section 12(g) of the Act:
                Common
      Stock, $0.01 par value




Indicate by check markif the registrant is a well-known seasoned issuer, as defined in Rule 405
of the Securities Act. YesoNo
x




Indicate by check markif the registrant is not required to file reports pursuant to Section 13
or Section 15(d) of the Act. YesoNo
x




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




Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this
chapter) during the preceding 12 months (or for such shorter period that the
registrant was required to submit and post such files). Yes o

No o




Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not
be contained, to the best of registrant’s knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form 10-K
or any amendment to this Form 10-K. o




Indicate
by check mark whether the registrant is large accelerated filer, an accelerated
filer, or a non-accelerated filer. See definition of “accelerated filer and
large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check
one):




Large
      accelerated filer:  o
              Accelerated
      filer:  o
              Non-accelerated
      filer:  o
              Smaller
      reporting company:  x




Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Act). YesoNo x




The
aggregate market value of the registrant’s voting stock held by non-affiliates
of the registrant as of June 30, 2009 was approximately $20,274,426 (based on
the last sale price of such stock on such date as reported by The Nasdaq Global
Market and assuming, for the purpose of this calculation only, that all of the
registrant’s directors and executive officers are affiliates).




(Applicable only to corporate
registrants)  Indicate the number of shares outstanding of each
of the registrant’s classes of common stock, as of the latest practicable
date: 14,429,159 as of
3/15/2010




Documents
      incorporated by reference:
              None




Table of Contents





PRELIMINARY
NOTE




This
annual report contains historical information and forward-looking statements
within the meaning of the Private Securities Litigation Reform Act of 1995 with
respect to our business, financial condition and results of operations. The
words “estimate,” “project,” “intend,” “expect” and similar expressions are
intended to identify forward-looking statements. These forward-looking
statements are subject to risks and uncertainties that could cause actual
results to differ materially from those contemplated in such forward-looking
statements. Further, we operate in an industry sector where securities values
may be volatile and may be influenced by economic and other factors beyond our
control. In the context of the forward-looking information provided in this
annual report and in other reports, please refer to the discussions of risk
factors detailed in, as well as the other information contained in, our other
filings with the Securities and Exchange Commission.




Electric
Fuel® is a
registered trademark and ArotechTM is a trademark of Arotech Corporation,
formerly known as Electric Fuel Corporation. All company and product names
mentioned may be trademarks or registered trademarks of their respective
holders.Unless
otherwise indicated, “we,” “us,” “our” and similar terms refer to Arotech and
its subsidiaries.






Table of Contents








Table of
Contents
   PART
      I
                              
                              PageITEM
      1.
                              BUSINESS
                              3ITEM
      1A.
                              RISK FACTORS
                              13ITEM
      1B.
                              UNRESOLVED STAFF COMMENTS
                              28ITEM
      2.
                              PROPERTIES
                              28ITEM
      3.
                              LEGAL PROCEEDINGS
                              28ITEM
      4.
                              SUBMISSION OF MATTERS TO A VOTE OF SECURITY
      HOLDERS
                              29PART
      IIITEM
      5.
                              MARKET FOR REGISTRANT’S COMMON EQUITY, RE­LATED STOCKHOLDER
      MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
                              30ITEM
      6.
                              SELECTED FINANCIAL DATA
                              31ITEM
      7.
                              MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDI­TION
      AND RESULTS OF OPERATION
                              31ITEM
      8.
                              FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
                              46ITEM
      9.
                              CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
      FINANCIAL DISCLOSURE
                              47ITEM
      9A(T).
                              CONTROLS AND PROCEDURES
                              47ITEM
      9B.
                              OTHER INFORMATION
                              48PART
      IIIITEM
      10.
                              DIRECTORS AND EXECUTIVE OFFICERS OF THE
      REGISTRANT
                              49ITEM
      11.
                              EXECUTIVE COMPENSATION
                              57ITEM
      12.
                              SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
      AND RELATED STOCKHOLDER MATTERS
                              68ITEM
      13.
                              CERTAIN RELATIONSHIPS AND RELATED
    TRANSACTIONS
                              70ITEM
      14.
                              PRINCIPAL ACCOUNTING FEES AND SERVICES
                              71PART
      IVITEM
      15.
                              EXHIBITS, FINANCIAL STATEMENT SCHEDULES
                              72SIGNATURES
                              75









Table of Contents





PART
I




ITEM
      1.
            BUSINESS




General




We are a
defense and security products and services company, engaged in three business
areas: high-level armoring for military and nonmilitary air and ground vehicles;
interactive simulation for military, law enforcement and commercial markets; and
batteries and charging systems for the military. We operate primarily through
our various subsidiaries, which we have organized into three divisions. Our
divisions and subsidiaries (all 100% owned by us) are as follows:




●
            We
      develop, manufacture and market advanced high-tech multimedia and
      interactive digital solutions for use-of-force training and driving
      training of military, law enforcement, security and other personnel
      through our Training
      and Simulation Division:




·
            We
      provide simulators, systems engineering and software products to the
      United States military, government and private industry through our
      subsidiary FAAC Incorporated, located in Ann Arbor, Michigan (“FAAC”);
      and




·
            We
      provide specialized “use of force” training for police, security personnel
      and the military through our subsidiary IES Interactive Training, located
      in Ann Arbor, Michigan, which we merged into our FAAC subsidiary in
      October of 2007 (“IES”).




●
            We
      utilize sophisticated lightweight materials and advanced engineering
      processes to armor vehicles and to manufacture personal and aviation armor
      through our Armor
      Division:




·
            We
      use state-of-the-art lightweight armoring materials, special ballistic
      glass and advanced engineering processes to fully armor military vehicles
      and civilian SUV’s, buses and vans, through our subsidiaries MDT
      Protective Industries, Ltd., located in Lod, Israel (“MDT”), and MDT Armor
      Corporation, located in Auburn, Alabama (“MDT Armor”);
  and




·
            Through
      MDT Armor, we provide ballistic armor kits for rotary and fixed wing
      aircraft under the trade name Armour of America
  (“AoA”).




●
            We
      manufacture and sell lithium and Zinc-Air batteries for defense and
      security products and other military applications through our Battery and
      Power Systems Division:




·
            We
      develop and sell rechargeable and primary lithium batteries and smart
      chargers to the military and to private defense industry in the Middle
      East, Europe and Asia through our subsidiary Epsilor Electronic
      Industries, Ltd., located in Dimona, Israel (in Israel’s Negev desert
      area) (“Epsilor”);




·
            We
      develop, manufacture and market primary Zinc-Air batteries, rechargeable
      batteries and battery chargers for the military, focusing on applications
      that demand high energy and light weight, through our subsidiary Electric
      Fuel Battery Corporation, located in Auburn, Alabama (“EFB”);
      and




·
            We
      produce water-activated lifejacket lights for commercial aviation and
      marine applications through our subsidiary Electric Fuel (E.F.L.) Ltd.,
      located in Beit Shemesh, Israel
(“EFL”).




3
 Table of Contents




Background




We were
incorporated in Delaware in 1990 under the name “Electric Fuel Corporation,” and
we changed our name to “Arotech Corporation” on September 17, 2003. Unless the
context requires otherwise, all references to us refer collectively to Arotech
Corporation and Arotech’s wholly-owned Israeli subsidiaries, EFL, Epsilor and
MDT; and Arotech’s wholly-owned United States subsidiaries, EFB, FAAC and MDT
Armor. Additionally, we operate under the trade names of IES Interactive (IES),
Realtime Technologies, Inc, (RTI) and Armour of America (AoA).




For
financial information concerning the business segments in which we operate, see
Note 16.b. of the Notes to the Consolidated Financial Statements. For financial
information about geographic areas in which we engage in business, see Note
16.c. of the Notes to the Consolidated Financial Statements.




Facilities




Our
principal executive offices are located at 1229 Oak Valley Drive, Ann Arbor,
Michigan 48108, and our toll-free telephone number at our executive offices is
(800) 281-0356. Our corporate website is www.arotech.com. Our
periodic reports, as well as recent filings relating to transactions in our
securities by our executive officers and directors, that have been filed with
the Securities and Exchange Commission in EDGAR format are made available
through hyperlinks located on the investor relations page of our website, at
http://www.arotech.com/compro/investor.html,
as soon as reasonably practicable after such material is electronically filed
with or furnished to the SEC. Reference to our websites does not constitute
incorporation of any of the information thereon or linked thereto into this
annual report.




The
offices and facilities of three of our principal subsidiaries, EFL, MDT and
Epsilor, are located in Israel (in Beit Shemesh, Lod and Dimona, respectively,
all of which are within Israel’s pre-1967 borders). Most of the members of our
senior management work extensively out of EFL’s facilities; our financial
operations are conducted primarily from our principal executive offices in Ann
Arbor. FAAC’s home offices and facilities are located in Ann Arbor, Michigan and
in Royal Oak, Michigan. The facilities of EFB and MDT Armor are located in
Auburn, Alabama.




Training
and Simulation Division




We
develop, manufacture and market advanced high-tech multimedia and interactive
digital solutions for use-of-force training and driver training of military, law
enforcement, security and other personnel through our Training and Simulation
Division, the largest of our three divisions. During 2009 and 2008, revenues
from our Training and Simulation Division were approximately $39.2 million and
$36.0 million, respectively.




4
 Table of Contents





The
Training and Simulation Division concentrates on three different product
areas:




●
            Our
      Vehicle
      Simulation group provides high fidelity vehicle simulators for use
      in operator training and is marketed under our FAAC and Realtime
      Technologies nameplates;




●
            Our
      Military
      Operations group provides weapon simulations used to train military
      pilots in the effective use of air launched weapons and is also marketed
      under our FAAC nameplate; and




●
            Our
      Use of Force
      group provides training products focused on the proper employment of hand
      carried weapons and is marketed under our IES Interactive Training
      nameplate.




Vehicle
Simulation




We
provide simulators, systems engineering and software products focused on
training vehicle operators for cars and trucks. We provide these products to the
United States military, government, municipalities, and private industry through
our FAAC nameplate. Our fully interactive driver-training systems feature
state-of-the-art vehicle simulator technology enabling training in situation
awareness, risk analysis and decision making, emergency reaction and avoidance
procedures, and proper equipment operation techniques. Our simulators have
successfully trained hundreds of thousands of drivers.




Our
Vehicle Simulation group focuses on the development and delivery of complete
driving simulations for a wide range of vehicle types – such as trucks,
automobiles, subway trains, buses, fire trucks, police cars, ambulances, airport
ground vehicles, and military vehicles. In 2009, our Vehicle Simulations group
accounted for approximately 71% of our Training and Simulation Division’s
revenues.




We
believe that we have held a dominant market share in U.S. military wheeled
vehicle operator driver training simulators since 1999 and that we are currently
one of three significant participants in the U.S. municipal wheeled vehicle
simulators market.




In
January of 2008 we added Realtime Technologies Incorporated to our Vehicle
Simulation group. RTI specializes in multi-body vehicle dynamics modeling and
graphical simulation solutions. RTI offers simulation software applications,
consulting services, and custom software and hardware development services
primarily for use by the automobile industry and universities engaged in the
study of vehicle performance or operator/vehicle interactions. We merged RTI
into FAAC in January 2010.




Military
Operations




In the
area of Military Operations, we believe we are a premier developer of validated,
high fidelity analytical models and simulations of tactical air and land warfare
systems for all branches of the Department of Defense and its related industrial
contractors. Our simulations are found in systems ranging from instrumented air
combat and maneuver training ranges (such as Top Gun), full task training
devices such as the F-18 Weapon Tactics Trainer, and in the on-board computer of
many fighter jet aircraft. We supply on-board software to support weapon launch
decisions for the F-15, F-16, F-18, and Joint Strike Fighter (JSF) fighter
aircraft. In 2009, our Military Operations group accounted for 16% of our
Training and Simulation Division’s revenues.




5
 Table of Contents





Use-of-Force




We are a
leading provider of interactive, multimedia, fully digital training simulators
for law enforcement, security, military and similar applications. With a large
customer base spread over twenty countries around the world, we are a leader in
the supply of simulation training products to law enforcement, governmental, and
commercial clients. We conduct our interactive training activities and market
our interactive training products, such as the MILO (Multiple Interactive
Learning/training Objectives) System, the A2Z Classroom Trainer (a
state-of-the-art Computer Based Training (CBT) system that allows students to
interact with realistic interactive scenarios projected life-size in the
classroom), and the Range FDU (firearm diagnostics unit), using our IES
Interactive Training nameplate. In 2009, our Use of Force group accounted for
13% of our Training and Simulation Division’s revenues.




Marketing
and Customers




We market
our Simulation Division products to all branches of the U.S. military, federal
and local government, municipal transportation departments, and public safety
groups. Municipalities throughout the U.S. are using our vehicle simulators and
use-of-force products, and our penetration in Asia, Europe and the Americas
continues through the use of commissioned sales agents and regional
distributors.




We have
long-term relationships, many of over ten years’ duration, with the U.S. Air
Force, U.S. Navy, U.S. Army, U.S. Marine Corps, Department of Homeland Security,
and most major Department of Defense training and simulation prime contractors
and related subcontractors. The quality of our customer relationships is
illustrated by the multiple program contract awards we have earned from many of
our customers.




Competition




Our
technical excellence, superior product reliability, and high customer
satisfaction have enabled us to develop market leadership and attractive
competitive positions in each of our product areas.




Vehicle
Simulators




Several
potential competitors in this segment are large, diversified defense and
aerospace conglomerates who do not focus on our specific niches. As such, we are
able to provide service on certain large military contracts through strategic
agreements with these organizations or can compete directly with these
organizations based on our strength in developing higher quality software
solutions. In municipal market applications, we compete against smaller, less
sophisti­cated software companies. Many of our competitors have financial,
technical, marketing, sales, manufacturing, distribution and other resources
significantly greater than ours.




6
 Table of Contents





Military
Operations




Currently
no significant competitors participate in the markets we serve around our weapon
simulation niche. Our over 30-year history in this space provides a library of
resources that would require a competitor to invest heavily in to offer a
comparable product. The companies that could logically compete with us if they
chose would be the companies that now subcontract this work to us: Boeing,
Raytheon and Cubic.




Use
of Force




We
compete against a number of established companies that provide similar products
and services, many of which have financial, technical, marketing, sales,
manufacturing, distribution and other resources significantly greater than ours.
There are also companies whose products do not compete directly, but are
sometimes closely related. Firearms Training Systems, Inc., Advanced Interactive
Systems, Inc., and LaserShot Inc. are our main competitors in this
space.




Armor
Division




We armor
vehicles and manufacture aviation and other armor through our Armor Division.
During 2009 and 2008, revenues from our Armor Division were approximately $17.5
million and $17.7 million, respectively.




Introduction




We
specialize in armoring vehicles and manufacturing armor kits for aircraft and
vessels by using state-of-the-art lightweight ballistic materials, special
ballistic glass and advanced engineering processes. We fully armor military
vehicles and civilian SUVs, buses and vans. Through MDT Armor, we also provide
ballistic armor kits for rotary and fixed wing aircraft under the trade name
Armour of America.




We
operate through two business units: MDT Protective Industries Ltd., located in
Lod, Israel and MDT Armor Corporation, located in Auburn, Alabama.




We are a
leading supplier to the Israeli military, Israeli Special Forces and special
services. We provide products to the U.S. Army, and to military and defense and
paramilitary customers worldwide. We are also actively exploring marketing armor
products in India, through Concord Safety Solutions Pvt. Ltd., an Indian company
that we own in equal thirds with an Indian vehicle company and an Indian
armoring company.




Our
products have been proven in intensive battlefield situations and under actual
terrorist attack conditions, and are designed to meet the demanding requirements
of governmental and private sector customers worldwide. We have acquired many
years of battlefield experience in Israel. Our vehicles have provided proven
life-saving protection for their passengers in incidents of rock throwing,
handgun and assault rifle attack at point-blank range, roadside bombings and
suicide bombings.




During
2009, we received over $12.0 million in orders from the Israel Defense Forces
for the U.S.-built David, a patrol, combat command and reconnaissance armored
vehicle that is specifically designed as an urban combat vehicle. We also
introduced the Tiger, a new cost-effective, highly-armored light protected
all-terrain vehicle.




7
 Table of Contents





Our
proprietary designs have been developed to meet a wide variety of customer and
industry needs.




Sales,
Marketing and Customers




Most of
our vehicle armoring business has historically come from Israel, although we
have armored vehicles under contracts for companies operating in Iraq. Our
principal customer at present is the Israeli Ministry of Defense. Other
customers include Israeli and American government ministries and agencies,
private companies, medical services and private clients. In the United States,
we have armored vehicles for U.S. operations in Iraq.




In
Israel, we market our vehicle armoring through vehicle importers, both pursuant
to marketing agreements and otherwise, and directly to private customers in the
public and private sectors. Most sales are through vehicle importers.In the U.S., vehicles are
sold to the Army.




Our
commercial aircraft customers have included Bell Helicopter, MD Helicopter,
Robinson Helicopter, Sikorsky Helicopter, Schweitzer Helicopter, Agusta, and
Lockheed-Martin in the United States, as well as Eurocopter (Germany), Alenia
Aerospazio (Italy), EADS (Spain), and Bell (Canada).




Our U.S.
military aircraft customers have included NAVSEA, NAVAIR, Army, Coast Guard,
Marines, State Department, Border Patrol, and various SEAL and Small Boat
Units.




Our
foreign military customers have included the air forces of New Zealand,
Australia, Thailand, Malaysia, Spain, Belgium, Sweden, Norway, Italy, Sri Lanka,
Indonesia, Brazil, Argentina, and Turkey; the navies of Singapore, Thailand,
Malaysia, Ecuador, Mexico, Colombia, Spain, Australia, and Japan; the armies of
Thailand, Malaysia, Sri Lanka, Colombia, Mexico, Ecuador, Venezuela and
Peru.




Manufacturing




Our
manufacturing facilities are located in Lod, Israel, and in Auburn, Alabama. In
Israel we manufacture armored vehicles only, and in the U.S. we manufacture
vehicle armoring, and hard and soft armor.




Our
facilities have been awarded ISO 9001:2000 quality standards
certification.




Competition




The
global armored car industry is highly fragmented. Major suppliers include both
vehicle manufacturers and aftermarket specialists. As a highly labor-intensive
process, vehicle armoring is numerically dominated by relatively small
businesses. Industry estimates place the number of companies doing vehicle
armoring in the range of around 500 suppliers globally. While certain large
companies may armor several hundred cars annually, most of these companies are
smaller operations that may armor in the range of five to fifty cars per
year.




Among
vehicle manufacturers, we believe Mercedes-Benz to have the largest
vehicle-armoring market share. Among aftermarket specialists, we believe the
largest share of the vehicle-armoring market is held by O’Gara-Hess &
Eisenhardt, a subsidiary of Armor Holdings, Inc. Other aftermarket specialists
include International Armoring Corp., Lasco, Texas Armoring and Chicago Armor
(Moloney). Many of these companies have financial, technical, marketing, sales,
manufacturing, distribution and other resources significantly greater than
ours.




8
 Table of Contents





In
military and police armored vehicles, our competitors include Plasan Sasa, BAE
Systems, Oshkosh, International Navistar, Jankel Armouring Limited, General
Dynamics Land Systems, and Lenco Industries Inc.




We
believe the key factor in our competing successfully in this field will be our
ability to penetrate new military and paramilitary markets outside of Israel,
particularly those operating in Iraq and Afghanistan.




Battery
and Power Systems Division




We
manufacture and sell lithium and Zinc-Air batteries for defense and security
products and other military applications through our Battery and Power Systems
Division. During 2009 and 2008, revenues from our Battery and Power Systems
Division were approximately $17.8 million and $15.2 million,
respectively.




Lithium
Batteries and Charging Systems for the Military




Introduction




We sell
lithium batteries and charging systems to the military through our subsidiary
Epsilor Electronic Industries, Ltd., an Israeli corporation established in
1985.




We
specialize in the design and manufacture of primary and rechargeable batteries,
related electronic circuits and associated chargers for military applications.
We have experience in working with government agencies, the military and large
corporations. Our technical team has significant expertise in the fields of
electrochemistry, electronics, software and battery design, production,
packaging and testing.




We have
added lithium-ion battery production capabilities at EFB’s facility in Auburn.
The goal is to enable U.S.-produced lithium-ion batteries and chargers to be
sold using funding from Foreign Military Funding (FMF) program to countries such
as Israel and Turkey. These products are marketed and designed by Epsilor and
manufactured by EFB.




Competition




The main
competitors for our lithium-ion battery products are Bren-tronics Inc. in the
United States, which controls much of the U.S. rechargeable market, ABSL Power
Solutions Limited (a wholly owned subsidiary of CIP Industries Incorporated LLP)
in the United Kingdom, which has the majority of the English military market,
and Ultralife Batteries, Inc. in the United States. On the primary end of the
market there are a host of players who include the cell manufacturers
themselves, including Saft S.A. and Ultralife Batteries, Inc.




It should
be noted that a number of OEMs, such as Motorola, have internal engineering
groups that can develop competitive products in-house. Additionally, many of our
competitors have financial, technical, marketing, sales, manufacturing,
distribution and other resources significantly greater than ours.




9
 Table of Contents





Marketing




We market
to our existing customers through direct sales. To generate new customers and
applications, we rely on our working relationship with a selection of OEMs, with
the intent of having these OEMs design our products into their equipment,
thereby creating a market with a high entry barrier. Another avenue for market
entry is via strategic relationships with major cell manufacturers.




Manufacturing




Our
battery production lines for military batteries and chargers have been ISO-9001
certified since 1994. We believe that Epsilor’s 19,000 square foot facility in
Dimona, Israel has the necessary capabilities and operations to support our
production cycle.




Zinc-Air
Batteries and Chargers for the Military




Introduction




We base
our strategy in the field of Zinc-Air military batteries on the development and
commercialization of our Zinc-Air battery technology, as applied in the
batteries we produce for the U.S. Army’s Communications and Electronics Command
(CECOM) through our subsidiary EFB. We will continue to seek new applications
for our technology in defense projects, wherever synergistic technology and
business benefits may exist. We intend to continue to develop our battery
products for defense agencies, and plan to sell our products either directly to
such agencies or through prime contractors. We will also look to extend our
reach to military markets outside the United States.




Our
batteries have been used in both Afghanistan (Operation Enduring Freedom) and in
Iraq (Operation Iraqi Freedom). In June of 2004, our BA-8180/U Zinc-Air battery
was recognized by the U.S Army Research, Development and Engineering Command as
one of the top ten inventions of 2003.




Our
Zinc-Air batteries, rechargeable batteries and battery chargers for the military
are manufactured through EFB. In 2003, EFB’s facilities were granted ISO 9001
“Top Quality Standard” certification.




Markets/Applications




As an
external alternative to the popular lithium based BA-5590/U, the BA-8180/U can
be used in many applications operated by the BA-5590/U. The BA-8180/U can be
used for a variety of military applications.




Customers




The
principal customers for our Zinc-Air batteries during 2009 were the U.S. Army’s
Communications-Electronics Command (CECOM) and the Defense Logistics Agency
(DLA). In addition, we continue to further penetrate Special Forces and other
specific U.S. military units with direct sales.




10
 Table of Contents





Competition




The
BA-8180/U is the only Zinc-Air battery to hold a US Army battery designation and
an NSN. It does, however, compete with other primary (disposable) batteries, and
primarily lithium based batteries. In some cases it will also compete with
rechargeable batteries.




Zinc-Air
batteries are inherently safer than primary lithium battery packs in storage,
transportation, use, and disposal, and are more cost-effective. They are
lightweight, with up to twice the energy density of primary lithium battery
packs. Zinc-Air batteries for the military are also under development by Rayovac
Corporation. Rayovac’s military Zinc-Air batteries utilize cylindrical cells,
rather than the prismatic cells that we developed. While cylindrical cells may
provide higher specific power than our prismatic cells, we believe they will
generally have lower energy densities and be more difficult to
manufacture.




The most
popular competing primary battery in use by the US Armed Forces is the
BA-5590/U, which uses lithium-sulfur dioxide (LiSO2) cells.
The largest suppliers of LiSO2 batteries
to the US military are believed to be Saft America Inc. and Eagle Picher
Technologies LLC. The battery compartment of most military communications
equipment, as well as other military equipment, is designed for the XX90 family
of batteries, of which the BA-5590/U battery is the most commonly deployed.
Another primary battery in this family is the BA-5390/U, which uses
lithium-manganese dioxide (LiMnO2) cells.
Suppliers of LiMnO2 batteries
include Ultralife Batteries Inc., Saft and Eagle Picher.




Rechargeable
batteries in the XX90 family include lithium-ion (BB-2590/U) and nickel-metal
hydride (BB-390/U) batteries which may be used in training missions in order to
save the higher costs associated with primary batteries. These rechargeable
batteries are also become more prevalent in combat use as their energy densities
improve, their availability expands and their State-of-Charge Indicator (SOCI)
technologies become more reliable.




Our
BA-8180/U does not fit inside the XX90 battery compartment of any military
equipment, and therefore is connected externally using an interface adapter that
we also sell to the Army. Our battery offers greatly extended mission time,
along with lower total mission cost, and these significant advantages often
greatly outweigh the slight inconvenience of fielding an external
battery.




Manufacturing




EFB
maintains a battery and electronics development and manufacturing facility in
Auburn, Alabama, housed in a 30,000-square-foot light industrial space leased
from the city of Auburn. We also have production capabilities for some battery
components at EFL’s facility in Beit Shemesh, Israel. Both of these facilities
have received ISO 9001 “Top Quality Standard” certification.




Lifejacket
Lights




Products




We have a
product line consisting of seven lifejacket light models, five for use with
marine life jackets and two for use with aviation life vests, all of which work
in both freshwater and seawater. Each of our lifejacket lights is certified for
use by relevant governmental agencies under various U.S. and international
regulations. We manufacture, assemble and package all our lifejacket lights
through EFL in our factory in Beit Shemesh, Israel.




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Marketing




We market
our marine safety products through our own network of distributors in Europe,
the United States, Asia and Oceania. We market our lights to the commercial
aviation industry through an independent company that receives a commission on
sales.




Competition




The
largest manufacturer of aviation and marine safety products, including TSO and
SOLAS-approved lifejacket lights, is ACR Electronics Inc. of Hollywood, Florida.
Other significant competitors in the marine market include Daniamant Aps of
Denmark and England, and SIC of Italy.




Backlog




We
generally sell our products under standard purchase orders. Orders constituting
our backlog are subject to changes in delivery schedules and are typically
cancelable by our customers until a specified time prior to the scheduled
delivery date. Accordingly, our backlog is not necessarily an accurate
indication of future sales. As of December 31, 2009 and 2008, our backlog for
the following year was approximately $55.5 million and $36.6 million,
respectively, divided among our divisions as follows:




Division
                          
                          2009
                          
                          
                          2008Training
      and Simulation Division
                          
                          $
                          31,245,000
                          
                          
                          $
                          16,503,000Armor
      Division
                          
                          
                          10,468,000
                          
                          
                          
                          7,874,000Battery
      and Power Systems Division
                          
                          
                          13,802,000
                          
                          
                          
                          12,226,000TOTAL:
                          
                          $
                          55,515,000
                          
                          
                          $
                          36,603,000




Major
Customers




During
2009 and 2008, including all of our divisions, various branches of the United
States military accounted for approximately 50% and 54% of our revenues. See
“Item 1A. Risk Factors – Risks Related to Government Contracts,”
below.




Patents
and Trade Secrets




We rely
on certain proprietary technology and seek to protect our interests through a
combination of patents, trademarks, copyrights, know-how, trade secrets and
security measures, including confidentiality agreements. Our policy generally is
to secure protection for significant innovations to the fullest extent
practicable. Further, we seek to expand and improve the technological base and
individual features of our products through ongoing research and development
programs.




We rely
on the laws of unfair competition and trade secrets to protect our proprietary
rights. We attempt to protect our trade secrets and other proprietary
information through confidentiality and non-disclosure agreements with
customers, suppliers, employees and consultants, and through other security
measures. However, we may be unable to detect the unauthorized use of, or take
appropriate steps to enforce our intellectual property rights. Effective trade
secret protection may not be available in every country in which we offer or
intend to offer our products and services to the same extent as in the United
States. Failure to adequately protect our intellectual property could harm or
even destroy our brands and impair our ability to compete effectively. Further,
enforcing our intellectual property rights could result in the expenditure of
significant financial and managerial resources and may not prove successful.
Although we intend to protect our rights vigorously, there can be no assurance
that these measures will be successful.




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Research
and Development




During
the years ended December 31, 2009 and 2008, our gross research and product
development expenditures were approximately $1.3 million and $1.7 million,
respectively.




Employees




As of
December 31, 2009, we had approximately 470 full-time employees worldwide. Our
success will depend in large part on our ability to attract and retain skilled
and experienced employees.




With
respect to those of our employees who are Israeli residents, Israeli law
generally requires severance pay upon the retirement or death of an employee or
termination of employment without due cause; additionally, some of our senior
employees have special severance arrangements, certain of which are described
under “Item 11. Executive Compensation – Employment Contracts,” below. We
currently fund our ongoing severance obligations by making monthly payments to
approved severance funds or insurance policies.




ITEM
      1A.
            RISK FACTORS




The
following factors, among others, could cause actual results to differ materially
from those contained in forward-looking statements made in this Report and
presented elsewhere by management from time to time.




Business-Related
Risks




We
have had a history of losses and may incur future losses.




We were
incorporated in 1990 and began our operations in 1991. We have funded our
operations principally from funds raised in each of the initial public offering
of our common stock in February 1994; through subsequent public and private
offerings of our common stock and equity and debt securities convertible or
exercisable into shares of our common stock; research contracts and supply
contracts; funds received under research and development grants from the
Government of Israel; and sales of products that we and our subsidiaries
manufacture. We have incurred significant net losses since our inception.
Additionally, as of December 31, 2009, we had an accumulated deficit of
approximately $169.8 million. In an effort to reduce operating expenses and
maximize available resources, we have consolidated certain of our subsidiaries,
shifted personnel and reassigned responsibilities. We have also taken a variety
of other measures to limit spending and will continue to assess our internal
processes to seek additional cost-structure improvements. Although we believe
that such steps will help to reduce our operating expenses and maximize our
available resources, there can be no assurance that we will ever be able to
achieve or maintain profitability consistently or that our business will
continue to exist.




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We
need significant amounts of capital to operate and grow our business and to pay
our debt.




We
require substantial funds to operate our business, including marketing our
products and developing and marketing new products and to pay our outstanding
debt as it comes due. To the extent that we are unable to fully fund our
operations, including repaying our outstanding debt, through profitable sales of
our products and services, we will need to seek additional funding, including
through the issuance of equity or debt securities. In addition, based on our
internal forecasts, the assumptions described under “Liquidity and Capital
Resources” below, and subject to the other risk factors described herein, we
believe that our present cash position and anticipated cash flows from
operations and existing lines of credit should be sufficient to satisfy our
current estimated cash requirements through the next twelve months. However, in
the event our internal forecasts and other assumptions regarding our liquidity
prove to be incorrect, we may need to seek additional funding. There can be no
assurance that we will obtain any such additional financing in a timely manner,
on acceptable terms, or at all. If additional funds are raised by issuing equity
securities or convertible debt securities, stockholders may incur further
dilution. If we incur additional indebtedness, we may be subject to affirmative
and negative covenants that may restrict our ability to operate or finance our
business. If additional funding is not secured, we will have to modify, reduce,
defer or eliminate parts of our present and anticipated future commitments
and/or programs.




Our
existing indebtedness may adversely affect our ability to obtain additional
funds and may increase our vulnerability to economic or business
downturns.




Our bank
and certificated indebtedness (short and long term) totaled approximately $7.2
million as of December 31, 2009 (not including trade payables, other account
payables, seller-financed mortgages, capital leases, and accrued severance pay),
of which $3.2 million is subordinated convertible notes and $4.1 million is bank
working capital lines of credit. In addition, we may incur additional
indebtedness in the future. Accordingly, we are subject to the risks associated
with significant indebtedness, including:




·
            we
      must dedicate a portion of our cash flows from operations to pay principal
      and interest and, as a result, we may have less funds available for
      operations and other purposes;




·
            it
      may be more difficult and expensive to obtain additional funds through
      financings, if available at all;




·
            we
      are more vulnerable to economic downturns and fluctuations in interest
      rates, less able to withstand competitive pressures and less flexible in
      reacting to changes in our industry and general economic conditions;
      and




·
            if
      we default under any of our existing debt instruments, including paying
      the outstanding principal when due, and if our creditors demand payment of
      a portion or all of our indebtedness, we may not have sufficient funds to
      make such payments.




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The
occurrence of any of these events could materially adversely affect our results
of operations and financial condition and adversely affect our stock
price.




The
agreements governing the terms of our notes that mature between 2010 and 2011
contain numerous affirmative and negative covenants, as well as
cross-acceleration and cross-default provisions that make any default under our
other loan agreements a default under our notes, that limit the discretion of
our management with respect to certain business matters and place restrictions
on us, including obligations on our part to preserve and maintain our assets and
restrictions on our ability to incur or guarantee debt, to merge with or sell
our assets to another company, and to make significant capital expenditures
without the consent of the note holders. Our ability to comply with these and
other provisions of such agreements may be affected by changes in economic or
business conditions or other events beyond our control.




Failure
to comply with the terms of our indebtedness could result in a default that
could have material adverse consequences for us.




A failure
to comply with the obligations contained in the agreements governing our
indebtedness could result in an event of default under such agreements which
could result in an acceleration of the notes and the acceleration of debt under
other instruments evidencing indebtedness that contain cross-acceleration or
cross-default provisions. If the indebtedness under the notes or other
indebtedness were to be accelerated, there can be no assurance that our future
cash flow or assets would be sufficient to repay in full such
indebtedness.




We
may not generate sufficient cash flow to service all of our debt
obligations.




Our
ability to make payments on and to refinance our indebtedness and to fund our
operations depends on our ability to generate cash in the future. Our future
operating performance is subject to market conditions and business factors that
are beyond our control. Consequently, we cannot assure you that we will generate
sufficient cash flow to pay the principal and interest on our debt. If our cash
flows and capital resources are insufficient to allow us to make scheduled
payments on our debt, we may have to reduce or delay capital expenditures, sell
assets, seek additional capital or restructure or refinance our debt. We cannot
assure you that the terms of our debt will allow for these alternative measures
or that such measures would satisfy our scheduled debt service obligations. In
addition, in the event that we are required to dispose of material assets or
restructure or refinance our debt to meet our debt obligations, we cannot assure
you as to the terms of any such transaction or how quickly such transaction
could be completed. Our ability to refinance our indebtedness or obtain
additional financing will depend on, among other things:




·
            our
      financial condition at the time;




·
            restrictions
      in the agreements governing our other indebtedness;
  and




·
            other
      factors, including the condition of the financial markets and our
      industry.




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The
payment by us of our subordinated convertible notes in stock or the conversion
of such notes by the holders could result in substantial numbers of additional
shares being issued, with the number of such shares increasing if and to the
extent our market price declines, diluting the ownership percentage of our
existing stockholders.




In August
2008, we issued $5.0 million in subordinated convertible notes due August 15,
2011. The notes are convertible at the option of the holders at a fixed
conversion price of $2.24. The principal amount of the notes is payable over a
period of three years, with the principal amount being amortized in eleven
payments payable at our option in cash and/or stock, by requiring the holders to
convert a portion of their notes into shares of our common stock, provided
certain conditions were met. The failure to meet such conditions could make us
unable to pay our notes, causing us to default. If the price of our common stock
is above $2.24, the holders of our notes will presumably convert their notes to
stock when payments are due, or before, resulting in the issuance of additional
shares of our common stock.




Principal
payments of $454,545 were made in each of February, May, August and November
2009 (most of the November payment by means of exercise of the conversion option
on the part of one note holder) and February 2010, and are due on May 14, 2010,
August 13, 2010, November 15, 2010, February 15, 2011, May 13, 2011 and August
15, 2011, either in cash or by requiring the holder to convert the principal
payment into shares of our common stock. In the event we elect to make payments
of principal on our convertible notes in stock by requiring the holders to
convert a portion of their Notes, either because our cash position at the time
makes it necessary or we otherwise deem it advisable, the price used to
determine the number of shares to be issued on conversion will be calculated
using an 8% discount to the average trading price of our common stock during 17
of the 20 consecutive trading days ending two days before the payment date.
Accordingly, the lower the market price of our common stock at the time at which
we make payments of principal in stock, the greater the number of shares we will
be obliged to issue and the greater the dilution to our existing
stockholders.




In either
case, the issuance of the additional shares of our common stock could adversely
affect the market price of our common stock.




We can
require the holder of our Notes to convert a portion of their Notes into shares
of our common stock at the time principal payments are due only if such shares
are registered for resale and certain other conditions are met. If our stock
price were to decline, we might not have a sufficient number of shares of our
stock registered for resale in order to continue requiring the holders to
convert a portion of their Notes. As a result, we would need to file an
additional registration statement with the SEC to register for resale more
shares of our common stock in order to continue requiring conversion of our
Notes upon principal payment becoming due. Any delay in the registration
process, including through routine SEC review of our registration statement or
other filings with the SEC, could result in our having to pay scheduled
principal repayments on our Notes in cash, which would negatively impact our
cash position and, if we do not have sufficient cash to make such payments in
cash, could cause us to default on our Notes.




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We have purchased
a $2.5 million note from an unaffiliated company, which may have an impact on
our financial results and cash position if they do not pay the interest and
principal within the terms of the note.




In August
2008, we purchased a $2.5 million 10% Senior Subordinated Convertible Note from
an unaffiliated company due December 31, 2009. In the third quarter of 2009, we
wrote down the value of this note by $500,000, to $2.0 million. The issuer has
been paying interest as required under the terms of the note, but did not pay
the principal amount when due. If the payments are not made in a timely manner,
this may impact our cash position and financial results.




Our earnings may
decline if we write off additional goodwill and other intangible
assets.




As of
December 31, 2009, we had recorded goodwill of $32.3 million and any future
impairment of goodwill or other intangible assets may have a significant impact
on earnings. On January 1, 2002, we adopted Financial Accounting Standards Board
Accounting Standards Codification (FASB ASC) 350-10. FASB ASC 350-10 requires
goodwill to be tested for impairment on adoption of the Statement, at least
annually thereafter, and between annual tests in certain circumstances, and
written down when impaired, rather than being amortized as previous accounting
standards required. Goodwill is tested for impairment by comparing the fair
value of our reportable units with their carrying value. Fair value is
determined using discounted cash flows. Significant estimates used in the
methodologies include estimates of future cash flows, future short-term and
long-term growth rates, weighted average cost of capital and estimates of market
multiples for the reportable units. We performed the required annual impairment
test of goodwill, based on our projections and using expected future discounted
operating cash flows.




We
completed our annual goodwill impairment review using the financial results as
of the quarter ended June 30, 2009. Although the cumulative book value of our
reporting units exceeded our market value as of the impairment review,
management nevertheless determined that the fair value of the respective
reporting units exceeded their respective carrying values, and therefore, there
would be no impairment charges relating to goodwill. Several factors contributed
to this determination:




·
            The
      long term horizon of the valuation process versus a short term valuation
      using current market conditions;




·
            The
      valuation by individual business segments versus the market share value
      based on our company as a whole;
and




·
            The
      fact that our stock is thinly traded and widely dispersed with minimal
      institutional ownership, and thus not followed by major market analysts,
      leading management to conclude that the market in our securities was not
      acting as an informationally efficient reflection of all known information
      regarding us.




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We
may consider acquisitions in the future to grow our business, and such activity
could subject us to various risks.




We may
consider acquiring companies that will complement our existing operations or
provide us with an entry into markets we do not currently serve. Growth through
acquisitions involves substantial risks, including the risk of improper
valuation of the acquired business and the risk of inadequate integration. There
can be no assurance that suitable acquisition candidates will be available, that
we will be able to acquire or manage profitably such additional companies or
that future acquisitions will produce returns that justify our investments in
such companies. In addition, we may compete for acquisition and expansion
opportunities with companies that have significantly greater resources than we
do. Furthermore, acquisitions could disrupt our ongoing business, distract the
attention of our senior officers, increase our expenses, make it difficult to
maintain our operational standards, controls and procedures and subject us to
contingent and latent risks that are different, in nature and magnitude, than
the risks we currently face.




We may
finance future acquisitions with cash from operations or additional debt or
equity financings. There can be no assurance that we will be able to generate
internal cash or obtain financing from external sources or that, if available,
such financing will be on terms acceptable to us. The issuance of additional
common stock to finance acquisitions may result in substantial dilution to our
stockholders. Any debt financing may significantly increase our leverage and may
involve restrictive covenants which limit our operations.




If we are
successful in acquiring additional businesses, we may experience a period of
rapid growth that could place significant additional demands on, and require us
to expand, our management, resources and management information systems. Our
failure to manage any such rapid growth effectively could have a material
adverse effect on our financial condition, results of operations and cash
flows.




Some
of the components of our products pose potential safety risks which could create
potential liability exposure for us.




Some of
the components of our products contain elements that are known to pose potential
safety risks. In addition to these risks, there can be no assurance that
accidents in our facilities will not occur. Any accident, whether occasioned by
the use of all or any part of our products or technology or by our manufacturing
operations, could adversely affect commercial acceptance of our products and
could result in significant production delays or claims for damages resulting
from injuries. Any of these occurrences would materially adversely affect our
operations and financial condition. In the event that our products, including
the products manufactured by MDT and AoA, fail to perform as specified, users of
these products may assert claims for substantial amounts. These claims could
have a materially adverse effect on our financial condition and results of
operations. There is no assurance that the amount of the general product
liability insurance that we maintain will be sufficient to cover potential
claims or that the present amount of insurance can be maintained at the present
level of cost, or at all.




Our
fields of business are highly competitive.




The
competition to develop defense and security products and to obtain funding for
the development of these products, is, and is expected to remain,
intense.




Our
defense and security products compete with other manufacturers of specialized
training systems. In addition, we compete with manufacturers and developers of
armor for cars and vans.




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Various
battery technologies are being considered for use in defense and safety products
by other manufacturers and developers, including the following: lead-acid,
nickel-cadmium, nickel-iron, nickel-zinc, nickel-metal hydride, sodium-sulfur,
sodium-nickel chloride, zinc-bromine, lithium-ion, lithium-polymer, lithium-iron
sulfide, primary lithium, rechargeable alkaline and Zinc-Air.




Many of
our competitors have financial, technical, marketing, sales, manufacturing,
distribution and other resources significantly greater than ours. If we are
unable to compete successfully in each of our operating areas, our business and
results of operations could be materially adversely affected.




Our
business is dependent on proprietary rights that may be difficult to protect and
could affect our ability to compete effectively.




Our
ability to compete effectively will depend on our ability to maintain the
proprietary nature of our technology and manufacturing processes through a
combination of patent and trade secret protection, non-disclosure agreements and
licensing arrangements.




Litigation,
or participation in administrative proceedings, may be necessary to protect our
proprietary rights. This type of litigation can be costly and time consuming and
could divert company resources and management attention to defend our rights,
and this could harm us even if we were to be successful in the litigation. In
the absence of patent protection, and despite our reliance upon our proprietary
confidential information, our competitors may be able to use innovations similar
to those used by us to design and manufacture products directly competitive with
our products. In addition, no assurance can be given that others will not obtain
patents that we will need to license or design around. To the extent any of our
products are covered by third-party patents, we could need to acquire a license
under such patents to develop and market our products.




Despite
our efforts to safeguard and maintain our proprietary rights, we may not be
successful in doing so. In addition, competition is intense, and there can be no
assurance that our competitors will not independently develop or patent
technologies that are substantially equivalent or superior to our technology. In
the event of patent litigation, we cannot assure you that a court would
determine that we were the first creator of inventions covered by our issued
patents or pending patent applications or that we were the first to file patent
applications for those inventions. If existing or future third-party patents
containing broad claims were upheld by the courts or if we were found to
infringe third-party patents, we may not be able to obtain the required licenses
from the holders of such patents on acceptable terms, if at all. Failure to
obtain these licenses could cause delays in the introduction of our products or
necessitate costly attempts to design around such patents, or could foreclose
the development, manufacture or sale of our products. We could also incur
substantial costs in defending ourselves in patent infringement suits brought by
others and in prosecuting patent infringement suits against
infringers.




We also
rely on trade secrets and proprietary know-how that we seek to protect, in part,
through non-disclosure and confidentiality agreements with our customers,
employees, consultants, and entities with which we maintain strategic
relationships. We cannot assure you that these agreements will not be breached,
that we would have adequate remedies for any breach or that our trade secrets
will not otherwise become known or be independently developed by
competitors.




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We
are dependent on key personnel and our business would suffer if we fail to
retain them.




We are
highly dependent on the president of our FAAC subsidiary and the general
managers of our MDT and Epsilor subsidiaries, and the loss of the services of
one or more of these persons could adversely affect us. We are especially
dependent on the services of our Chairman and Chief Executive Officer, Robert S.
Ehrlich, and our President and Chief Operating Officer, Steven Esses. The loss
of either Mr. Ehrlich or Mr. Esses could have a material adverse effect on us.
We are party to an employment agreement with Mr. Ehrlich, which agreement
expires at the end of 2011, and an employment agreement with Mr. Esses, which
agreement expires at the end of 2010. We do not have key-man life insurance on
either Mr. Ehrlich or Mr. Esses.




We
face risks related to general domestic and global economic
conditions.




In
general, our operating results can be significantly affected by negative
economic conditions, high labor, material and commodity costs and unforeseen
changes in demand for our products and services. These risks are heightened as
economic conditions globally have deteriorated significantly and may remain at
recessionary levels for the foreseeable future. The current recessionary
conditions could have a potentially significant negative impact on demand for
our products and services, which may have a direct negative impact on our sales
and profitability, as well as our ability to generate sufficient internal cash
flows or access credit at reasonable rates to meet future operating expenses,
service debt and fund capital expenditures.




We
face risks related to the current credit crisis.




During
2009, we operated at a loss but had positive net cash provided by operating
activities. However, the recent disruption in credit markets, may impact demand
for our products and services, as well as our ability to manage normal
relationships with our customers, suppliers and creditors. Tighter credit
markets could result in supplier or customer disruptions.




The
potential bankruptcy of certain suppliers could leave us exposed to certain
risks of collection of outstanding receivables. For example, a substantial
portion of our armor business is associated with the automotive industry, which
has recently experienced significant financial difficulties. If any of our
suppliers declare bankruptcy, this could have a material adverse effect on our
business, financial condition and results of operations.




There
are risks involved with the international nature of our business.




A
significant portion of our sales are made to customers located outside the U.S.,
primarily in Europe and Asia. In 2009 and 2008, 26% and 28%, respectively, of
our revenues, were derived from sales to customers located outside the U.S. We
expect that our international customers will continue to account for a
substantial portion of our revenues in the near future. Sales to international
customers may be subject to political and economic risks, including political
instability, currency controls, exchange rate fluctuations, foreign taxes,
longer payment cycles and changes in import/export regulations and tariff rates.
In addition, various forms of protectionist trade legislation have been and in
the future may be proposed in the U.S. and certain other countries. Any
resulting changes in current tariff structures or other trade and monetary
policies could adversely affect our sales to international customers.See also “Israel-Related
Risks,” below.




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We do not anticipate paying cash
dividends.




We
currently intend to retain any future earnings for funding growth and, as a
result, do not expect to pay any cash dividends in the foreseeable future.
Additionally, our ability to declare dividends should we decide to do so is
restricted by the terms of our debt agreements.




Risks
Related to Government Contracts




A
significant portion of our business is dependent on government contracts and
reduction or reallocation of defense or law enforcement spending could reduce
our revenues.




Many of
the customers of IES, FAAC and AoA to date have been in the public sector of the
U.S., including the federal, state and local governments, and in the public
sectors of a number of other countries, and most of MDT’s customers have been in
the public sector in Israel, in particular the Ministry of Defense.
Additionally, all of EFB’s sales to date of battery products for the military
and defense sectors have been in the public sector in the United States. A
significant decrease in the overall level or allocation of defense or law
enforcement spending in the U.S. or other countries could reduce our revenues
and have a material adverse effect on our future results of operations and
financial condition.




Sales to
public sector customers are subject to a multiplicity of detailed regulatory
requirements and public policies as well as to changes in training and
purchasing priorities. Contracts with public sector customers may be conditioned
upon the continuing availability of public funds, which in turn depends upon
lengthy and complex budgetary procedures, and may be subject to certain pricing
constraints. Moreover, U.S. government contracts and those of many international
government customers may generally be terminated for a variety of factors when
it is in the best interests of the government and contractors may be suspended
or debarred for misconduct at the discretion of the government. There can be no
assurance that these factors or others unique to government contracts or the
loss or suspension of necessary regulatory licenses will not reduce our revenues
and have a material adverse effect on our future results of operations and
financial condition.




Our
U.S. government contracts may be terminated at any time and may contain other
unfavorable provisions.




The U.S.
government typically can terminate or modify any of its contracts with us either
for its convenience or if we default by failing to perform under the terms of
the applicable contract. A termination arising out of our default could expose
us to liability and have a material adverse effect on our ability to re-compete
for future contracts and orders. Our U.S. government contracts contain
provisions that allow the U.S. government to unilaterally suspend us from
receiving new contracts pending resolution of alleged violations of procurement
laws or regulations, reduce the value of existing contracts, issue modifications
to a contract and control and potentially prohibit the export of our products,
services and associated materials.




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Government
agencies routinely audit government contracts. These agencies review a
contractor's performance on its contract, pricing practices, cost structure and
compliance with applicable laws, regulations and standards. If we are audited,
we will not be reimbursed for any costs found to be improperly allocated to a
specific contract, while we would be required to refund any improper costs for
which we had already been reimbursed. Therefore, an audit could result in a
substantial adjustment to our revenues. If a government audit uncovers improper
or illegal activities, we may be subject to civil and criminal penalties and
administrative sanctions, including termination of contracts, forfeitures of
profits, suspension of payments, fines and suspension or debarment from doing
business with United States government agencies. We could suffer serious
reputational harm if allegations of impropriety were made against us. A
governmental determination of impropriety or illegality, or an allegation of
impropriety, could have a material adverse effect on our business, financial
condition or results of operations.




We
may be liable for penalties under a variety of procurement rules and
regulations, and changes in government regulations could adversely impact our
revenues, operating expenses and profitability.




Our
defense and commercial businesses must comply with and are affected by various
government regulations that impact our operating costs, profit margins and our
internal organization and operation of our businesses. Among the most
significant regulations are the following:




·
            the
      U.S. Federal Acquisition Regulations, which regulate the formation,
      administration and performance of government
  contracts;




·
            the
      U.S. Truth in Negotiations Act, which requires certification and
      disclosure of all cost and pricing data in connection with contract
      negotiations; and




·
            the
      U.S. Cost Accounting Standards, which impose accounting requirements that
      govern our right to reimbursement under certain cost-based government
      contracts.




These
regulations affect how we and our customers do business and, in some instances,
impose added costs on our businesses. Any changes in applicable laws could
adversely affect the financial performance of the business affected by the
changed regulations. With respect to U.S. government contracts, any failure to
comply with applicable laws could result in contract termination, price or fee
reductions or suspension or debarment from contracting with the U.S.
government.




We may not be able to receive or retain
the necessary licenses or authorizations required for us to export or re-export
our products, technical data or services, or to transfer technology from foreign
sources (including our own subsidiaries) and to work collaboratively with
them. Denials of such
licenses and authorizations could have a material adverse effect on our business
and results of operations.




U.S. regulations concerning export
controls require us to screen potential customers, destinations, and technology
to ensure that sensitive equipment, technology and services are not exported in
violation of U.S. policy or diverted to improper uses or
users.




22
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In order
for us to export certain products, technical data or services, we are required
to obtain licenses from the U.S. government, often on a
transaction-by-transaction basis. These licenses are generally required for the
export of the military versions of our products and technical data and for
defense services. We cannot be sure of our ability to obtain the U.S. government
licenses or other approvals required to export our products, technical data and
services for sales to foreign governments, foreign commercial customers or
foreign destinations.




In
addition, in order for us to obtain certain technical know-how from foreign
vendors and to collaborate on improvements on such technology with foreign
vendors, including at times our own foreign subsidiaries, we may need to obtain
U.S. government approval for such collaboration through manufacturing license or
technical assistance agreements approved by U.S. government export control
agencies.




The U.S.
government has the right, without notice, to revoke or suspend export licenses
and authorizations for reasons of foreign policy, issues over which we have no
control.




Failure to receive required licenses or
authorizations would hinder our ability to export our products, data and
services and to use some advanced technology from foreign sources. This could
have a material adverse effect on our business, results of operations and
financial condition.




Our
failure to comply with export control rules could have a material adverse effect
on our business.




Our
failure to comply with these rules could expose us to significant criminal or
civil enforcement action by the U.S. government, and a conviction could result
in denial of export privileges, as well as contractual suspension or debarment
under U.S. government contracts, either of which could have a material adverse
effect on our business, results of operations and financial
condition.




Our
operating margins may decline under our fixed-price contracts if we fail to
estimate accurately the time and resources necessary to satisfy our
obligations.




Some of
our contracts are fixed-price contracts under which we bear the risk of any cost
overruns. Our profits are adversely affected if our costs under these contracts
exceed the assumptions that we used in bidding for the contract. Often, we are
required to fix the price for a contract before we finalize the project
specifications, which increases the risk that we will mis-price these contracts.
The complexity of many of our engagements makes accurately estimating our time
and resources more difficult. In the event we fail to estimate our time and
resources accurately, our expenses will increase and our profitability, if any,
under such contracts will decrease.




If
we are unable to retain our contracts with the U.S. government and subcontracts
under U.S. government prime contracts in the competitive rebidding process, our
revenues may suffer.




Upon
expiration of a U.S. government contract or subcontract under a U.S. government
prime contract, if the government customer requires further services of the type
provided in the contract, there is frequently a competitive rebidding process.
We cannot guarantee that we, or if we are a subcontractor that the prime
contractor, will win any particular bid, or that we will be able to replace
business lost upon expiration or completion of a contract. Further, all U.S.
government contracts are subject to protest by competitors. The termination of
several of our significant contracts or nonrenewal of several of our significant
contracts could result in significant revenue shortfalls.




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The
loss of, or a significant reduction in, U.S. military business would have a
material adverse effect on us.




U.S.
military contracts account for a significant portion of our business. The U.S.
military funds these contracts in annual increments. These contracts require
subsequent authorization and appropriation that may not occur or that may be
greater than or less than the total amount of the contract. Changes in the U.S.
military’s budget, spending allocations and the timing of such spending could
adversely affect our ability to receive future contracts. None of our contracts
with the U.S. military has a minimum purchase commitment, and the U.S. military
generally has the right to cancel its contracts unilaterally without prior
notice. We manufacture for the U.S. aircraft and land vehicle armor systems,
protective equipment for military personnel and other technologies used to
protect soldiers in a variety of life-threatening or catastrophic situations,
and batteries for communications devices. The loss of, or a significant
reduction in, U.S. military business for our aircraft and land vehicle armor
systems, other protective equipment, or batteries could have a material adverse
effect on our business, financial condition, results of operations and
liquidity.




Market-Related
Risks




The
price of our common stock is volatile.




The
market price of our common stock has been volatile in the past and may change
rapidly in the future. The following factors, among others, may cause
significant volatility in our stock price:




·
            announcements
      by us, our competitors or our
customers;




·
            the
      introduction of new or enhanced products and services by us or our
      competitors;




·
            changes
      in the perceived ability to commercialize our technology compared to that
      of our competitors;




·
            rumors
      relating to our competitors or us;




·
            actual
      or anticipated fluctuations in our operating
  results;




·
            the
      issuance of our securities, including warrants, in connection with
      financings and acquisitions; and




·
            general
      market or economic conditions.




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If
our shares were to be delisted, our stock price might decline further and we
might be unable to raise additional capital.




One of
the continued listing standards for our stock on the Nasdaq Stock Market (both
the Nasdaq Global Market, on which our stock is currently listed, and the Nasdaq
Capital Market) is the maintenance of a $1.00 bid price. (This rule was
temporarily suspended in 2009.) If our bid price were to decrease and remain
below $1.00 for 30 consecutive business days, Nasdaq could notify us of our
failure to meet the continued listing standards, after which we would have 180
calendar days to correct such failure or be delisted from the Nasdaq Global
Market. Although we would have the opportunity to appeal any potential
delisting, there can be no assurances that this appeal would be resolved
favorably. As a result, there can be no assurance that our common stock will
remain listed on the Nasdaq Global Market. If our common stock were to be
delisted from the Nasdaq Global Market, we might apply to be listed on the
Nasdaq Capital Market if we then met the initial listing standards of the Nasdaq
Capital Market (other than the $1.00 minimum bid standard). If we were to move
to the Nasdaq Capital Market, current Nasdaq regulations would give us the
opportunity to obtain an additional 180-day grace period if we meet certain net
income, stockholders’ equity or market capitalization criteria; if at the end of
that period we had not yet achieved compliance with the minimum bid price rule,
we would be subject to delisting from the Nasdaq Capital Market. Although we
would have the opportunity to appeal any potential delisting, there can be no
assurances that this appeal would be resolved favorably. In addition, we may be
unable to satisfy the other continued listing requirements. As a result, there
can be no assurance that our common stock will remain listed on the Nasdaq Stock
Market.




While our
stock would continue to trade on the over-the-counter bulletin board following
any delisting from the Nasdaq, any such delisting of our common stock could have
an adverse effect on the market price of, and the efficiency of the trading
market for, our common stock. Trading volume of over-the-counter bulletin board
stocks has been historically lower and more volatile than stocks traded on an
exchange or the Nasdaq Stock Market. As a result, holders of our securities
could find it more difficult to sell their securities. Also, if in the future we
were to determine that we need to seek additional equity capital, it could have
an adverse effect on our ability to raise capital in the public equity
markets.




In
addition, if we fail to maintain Nasdaq listing for our securities, and no other
exclusion from the definition of a “penny stock” under the Securities Exchange
Act of 1934, as amended, is available, then any broker engaging in a transaction
in our securities would be required to provide any customer with a risk
disclosure document, disclosure of market quotations, if any, disclosure of the
compensation of the broker-dealer and its salesperson in the transaction and
monthly account statements showing the market values of our securities held in
the customer’s account. The bid and offer quotation and compensation information
must be provided prior to effecting the transaction and must be contained on the
customer’s confirmation. If brokers become subject to the “penny stock” rules
when engaging in transactions in our securities, they would become less willing
to engage in transactions, thereby making it more difficult for our stockholders
to dispose of their shares.




Our
certificate of incorporation and bylaws and Delaware law contain provisions that
could discourage a takeover.




Provisions
of our amended and restated certificate of incorporation may have the effect of
making it more difficult for a third party to acquire, or of discouraging a
third party from attempting to acquire, control of us. These provisions could
limit the price that certain investors might be willing to pay in the future for
shares of our common stock. These provisions:




·
            divide
      our board of directors into three classes serving staggered three-year
      terms;




25
 Table of Contents




·
            only
      permit removal of directors by stockholders “for cause,” and require the
      affirmative vote of at least 85% of the outstanding common stock to so
      remove; and




·
            allow
      us to issue preferred stock without any vote or further action by the
      stockholders.




The
classification system of electing directors and the removal provision may tend
to discourage a third-party from making a tender offer or otherwise attempting
to obtain control of us and may maintain the incumbency of our board of
directors, as the classification of the board of directors increases the
difficulty of replacing a majority of the directors. These provisions may have
the effect of deferring hostile takeovers, delaying changes in our control or
management, or may make it more difficult for stockholders to take certain
corporate actions. The amendment of any of these provisions would require
approval by holders of at least 85% of the outstanding common
stock.




Israel-Related
Risks




A
significant portion of our operations takes place in Israel, and we could be
adversely affected by the economic, political and military conditions in that
region.




The
offices and facilities of three of our subsidiaries, EFL, MDT and Epsilor, are
located in Israel (in Beit Shemesh, Lod and Dimona, respectively, all of which
are within Israel’s pre-1967 borders). Most of our senior management is located
at EFL’s facilities. Although we expect that most of our sales will be made to
customers outside Israel, we are nonetheless directly affected by economic,
political and military conditions in that country. Accordingly, any major
hostilities involving Israel or the interruption or curtailment of trade between
Israel and its present trading partners could have a material adverse effect on
our operations. Since the establishment of the State of Israel in 1948, a number
of armed conflicts have taken place between Israel and its Arab neighbors and a
state of hostility, varying in degree and intensity, has led to security and
economic problems for Israel.




Historically,
Arab states have boycotted any direct trade with Israel and to varying degrees
have imposed a secondary boycott on any company carrying on trade with or doing
business in Israel. Although in October 1994, the states comprising the Gulf
Cooperation Council (Saudi Arabia, the United Arab Emirates, Kuwait, Dubai,
Bahrain and Oman) announced that they would no longer adhere to the secondary
boycott against Israel, and Israel has entered into certain agreements with
Egypt, Jordan, the Palestine Liberation Organization and the Palestinian
Authority, Israel has not entered into any peace arrangement with Syria or
Lebanon. Moreover, since September 2000, there has been a significant
deterioration in Israel’s relationship with the Palestinian Authority, and a
significant increase in terror and violence. Efforts to resolve the problem have
failed to result in an agreeable solution.




In July
and August of 2006, Israel was involved in a full-scale armed conflict with
Hezbollah, a Lebanese Islamist Shiite militia group and political party, in
southern Lebanon, which involved missile strikes against civilian targets in
northern Israel that resulted in economic losses. On August 14, 2006, a
ceasefire was declared relating to that armed conflict, although it is uncertain
whether or not the ceasefire will continue to hold.




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 Table of Contents





Israel
withdrew unilaterally from the Gaza Strip and certain areas in northern Samaria
in 2005. Thereafter Hamas, an Islamist terrorist group responsible for many
attacks, including missile strikes against Israeli civilian targets, won the
majority of the seats in the Parliament of the Palestinian Authority in January
2006 and took control of the entire Gaza Strip, by force, in June 2007. Since
then, Hamas and other Palestinian movements have launched thousands of missiles
from the Gaza strip into civilian targets in southern Israel. In late 2008, a
sharp increase in rocket fire from Gaza on Israel’s western Negev region,
extending as far as 25 miles into Israeli territory and disrupting most
day-to-day civilian activity in the proximity of the border with the Gaza Strip,
prompted the Israeli government to launch military operations against Hamas that
lasted approximately three weeks. Israel declared a unilateral ceasefire in
January 2009, which substantially diminished the frequency of, but did not
entirely eliminate, Hamas rocket attacks against Israeli cities. There can be no
assurance that this period of relative calm will continue.




Our
Israeli production facilities in the cities of Beit Shemesh, Lod and Dimona, are
located approximately 27 miles, 37 miles, and 38 miles, respectively, from
the nearest point of the border with the Gaza Strip. There can be no assurance
that Hamas will not obtain and use longer-range missiles capable of reaching our
facilities, which could result in a significant disruption of the Israel-based
portion of our business. Additionally, any major hostilities involving Israel,
including as a result of the military conflicts between the Fatah and Hamas in
Gaza Strip, Judea and Samaria, or the interruption or curtailment of trade
between Israel and its present trading partners could have a material adverse
effect on our business, operating results and financial condition.




Service
of process and enforcement of civil liabilities on us and our officers may be
difficult to obtain.




We are
organized under the laws of the State of Delaware and will be subject to service
of process in the United States. However, approximately 32% of our assets are
located outside the United States. In addition, two of our directors and most of
our executive officers are residents of Israel and a portion of the assets of
such directors and executive officers are located outside the United
States.




There is
doubt as to the enforceability of civil liabilities under the Securities Act of
1933, as amended, and the Securities Exchange Act of 1934, as amended, in
original actions instituted in Israel. As a result, it may not be possible for
investors to enforce or effect service of process upon these directors and
executive officers or to judgments of U.S. courts predicated upon the civil
liability provisions of U.S. laws against our assets, as well as the assets of
these directors and executive officers. In addition, awards of punitive damages
in actions brought in the U.S. or elsewhere may be unenforceable in
Israel.




Exchange
rate fluctuations between the U.S. dollar and the Israeli NIS may negatively
affect our earnings.




Although
a substantial majority of our revenues and a substantial portion of our expenses
are denominated in U.S. dollars, a portion of our costs, including personnel and
facilities-related expenses, is incurred in New Israeli Shekels (NIS). Inflation
in Israel will have the effect of increasing the dollar cost of our operations
in Israel, unless it is offset on a timely basis by a devaluation of the NIS
relative to the dollar. In 2009, the inflation adjusted NIS appreciated against
the dollar.




27
 Table of Contents




ITEM 1B.
            UNRESOLVED
      STAFF COMMENTS




None.




ITEM 2.
            PROPERTIES




Our
primary executive offices are located in FAAC’s offices, consisting of
approximately 17,300 square feet of office and warehouse space in Ann Arbor,
Michigan, pursuant to a lease expiring in January 2013. FAAC has also leased
17,200 square feet of office and warehouse space adjacent to our main offices
pursuant to a lease beginning in June 2006 and expiring in April 2018.
Additionally, FAAC is leasing approximately 6,600 square feet in a third
building, pursuant to a lease ending in 2010. FAAC also leases approximately
3,900 square feet in Royal Oak, Michigan pursuant to a lease terminating at the
end of April 2011.




EFB
operates out of our leased Auburn, Alabama facilities, constituting
approximately 30,000 square feet, which is leased from the City of Auburn
through January, 2011. Additionally, we have purchased 16,700 square feet of
space used by MDT Armor in Auburn for approximately $1.1 million pursuant to a
seller-financed secured purchase money mortgage. Half the mortgage is payable
over ten years in equal monthly installments through 2017 based on a 20-year
amortization of the full principal amount, and the remaining half is payable at
the end of the ten years in a balloon payment.




Our
management and administrative facilities and research, development and
production facilities for the manufacture and assembly of our Survivor Locator
Lights, constituting approximately 18,300 square feet, are located in Beit
Shemesh, Israel, located between Jerusalem and Tel-Aviv (within Israel’s
pre-1967 borders). The lease for these facilities in Israel expires on December
31, 2017; we have the ability to terminate the lease upon three months’ written
notice at the end of November 2013. Most of the members of our senior
management, including our Chief Executive Officer and our Chief Operating
Officer, work extensively out of our Beit Shemesh facility. Our Chief Financial
Officer works out of our Ann Arbor, Michigan facility.




Our
Epsilor subsidiary rents approximately 19,000 square feet of factory, office and
warehouse space in Dimona, Israel, in Israel’s Negev desert (within Israel’s
pre-1967 borders), on a month-to-month basis and our MDT subsidiary rents
approximately 20,000 square feet of office space in Lod, Israel, near Ben-Gurion
International airport (within Israel’s pre-1967 borders) pursuant to a lease
renewable on an annual basis.




We
believe that our existing and currently planned facilities are adequate to meet
our current and foreseeable future needs.




ITEM 3.
            LEGAL
      PROCEEDINGS




As of the
date of this filing, there were no material pending legal proceedings against
us, except as follows:




NAVAIR
Litigation




In
December 2004, AoA filed an action in the United States Court of Federal Claims
against the United States Naval Air Systems Command (NAVAIR), seeking
approximately $2.2 million in damages for NAVAIR’s alleged improper termination
of a contract for the design, test and manufacture of a lightweight armor
replacement system for the United States Marine Corps CH-46E rotor helicopter.
NAVAIR, in its answer, counterclaimed for approximately $2.1 million in alleged
reprocurement and administrative costs (subsequently revised to approximately
$1.5 million). Trial in this matter has concluded and closing briefs and certain
supplemental briefs have been filed, but no decision has yet been
rendered.




28
 Table of Contents





Based on
the trial results and subsequent inquiries, we, after consultation with our
litigation counsel handling this case and with an outside firm with particular
expertise in government contract litigation, formed a conclusion that it would
be appropriate and prudent to take a allowance against an adverse decision in
this case, in the amount of one-half of the amount of NAVAIR’s
counterclaim.   Based on the legal advice received by management,
the Company deemed a loss of $750,000 in this case to be a probable outcome as
determined under GAAP and recorded the related change as part of Allowances for
Settlements.




Class
Action Litigation




In May
2007, two purported class action complaints (the “Class Action Complaint”) were
filed in the United States District Court for the Eastern District of New York
against us and certain of our officers and directors. These two cases were
consolidated in June 2007. The Class Action Complaint seeks class status on
behalf of all persons who purchased our securities between November 9, 2004 and
November 14, 2005 (the “Period”) and alleges violations by us and certain of our
officers and directors of Sections 10(b) and 20(a) of the Securities Exchange
Act of 1934 and Rule 10b-5 thereunder, primarily related to our acquisition of
Armour of America in 2005 and certain public statements made by us with respect
to our business and prospects during the Period. The Class Action Complaint also
alleges that we did not have adequate systems of internal operational or
financial controls, and that our financial statements and reports were not
prepared in accordance with GAAP and SEC rules. The Class Action Complaint seeks
an unspecified amount of damages.




In
January 2010, we reached an agreement with lead plaintiffs to settle the Class
Action Complaint. Under the terms of the proposed settlement, the lawsuit will
be dismissed with prejudice, and we and all our current and former officers and
directors named in the complaint will receive a full and complete release of all
claims asserted against them in the litigation, as well as any related claims
that could have been asserted. The claims will be settled for $2.9 million. The
monetary payment for this settlement will be funded entirely from insurance
proceeds. The agreement is subject to court approval.




Additionally,
on May 6, 2009 a purported shareholders derivative complaint (the “Derivative
Complaint”) was filed in the United States District Court for the Eastern
District of New York against us and certain of our officers and directors. The
Derivative Complaint is based on the same facts as the class action litigation
currently pending against us in the same district, and primarily relates to our
acquisition of Armour of America in 2005 and certain public statements made by
us with respect to our business and prospects during the Period. The Derivative
Complaint seeks an unspecified amount of damages.




Although
the ultimate outcome of these matters cannot be determined with certainty, we
believe that the allegations stated in the Class Action Complaint and the
Derivative Complaint are without merit and we and our officers and directors
named in the Complaint intend to defend ourselves vigorously against such
allegations.




ITEM
      4.
            RESERVED




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 Table of Contents





PART
II




ITEM
      5.
            MARKET
      FORREGISTRANT’S COMMON EQUITY, RE­LATED STOCKHOLDER
      MATTERS AND ISSUER PURCHASES OF EQUITY
  SECURITIES




Our
common stock is traded on the Nasdaq Global Market. Our Nasdaq ticker symbol is
“ARTX.” The following table sets forth, for the periods indicated, the range of
high and low closing sales prices of our common stock on the Nasdaq Global
Market System:




Year Ended December 31,
2009
                            
                            High
                            
                            
                            LowFourth Quarter
                            
                            $
                            2.35
                            
                            
                            $
                            1.30Third Quarter
                            
                            $
                            2.00
                            
                            
                            $
                            1.25Second Quarter
                            
                            $
                            2.17
                            
                            
                            $
                            0.67First Quarter
                            
                            $
                            0.83
                            
                            
                            $
                            0.37Year Ended December 31,
2008
                            
                            High
                            
                            
                            LowFourth Quarter
                            
                            $
                            1.13
                            
                            
                            $
                            0.39Third Quarter
                            
                            $
                            2.07
                            
                            
                            $
                            1.02Second Quarter
                            
                            $
                            2.70
                            
                            
                            $
                            2.00First Quarter
                            
                            $
                            2.73
                            
                            
                            $
                            1.66




As of
February 28, 2010 we had approximately 234 holders of record of our common
stock.




Share
Repurchase Program




In
February of 2009, we authorized, for a period of one year, the repurchase in the
open market or in privately negotiated transactions of up to $1.0 million of our
common stock. Through September 30, 2009, we repurchased 421,306 shares for a
total of $511,659. The following table shows information relating to the
repurchase of our common stock during the three months ended December 31, 2009;
through such date, 447,358 shares had been purchased for a total cost of
$563,556:




Period
                                
                                Total
      Number of Shares Purchased
                                
                                
                                Average
      Price Paid Per Share(1)
                                
                                
                                Total
      Number of Shares Purchased
                                
                                
                                Maximum
      Approximate Dollar Value of Shares that May Yet be
    PurchasedOctober
      1, 2009 through October 31, 2009
                                
                                
                                0
                                
                                
                                $
                                –
                                
                                
                                
                                0
                                
                                
                                $
                                488,341November
      1, 2009 through November 30, 2009
                                
                                
                                15,000
                                
                                
                                $
                                1.67
                                
                                
                                
                                15,000
                                
                                
                                $
                                463,262December
      1, 2009 through December 31, 2009
                                
                                
                                11,052
                                
                                
                                $
                                1.57
                                
                                
                                
                                11,052
                                
                                
                                $
                                445,901TOTAL
      THIS QUARTER
                                
                                
                                26,052
                                
                                
                                
                                
                                
                                
                                
                                26,052




(1) Average
price paid per share includes commissions and is rounded to the nearest two
decimal places.


The
repurchase program is subject to management’s discretion.




Dividends




We have
never paid any cash dividends on our common stock. The Board of Directors
presently intends to retain all earnings for use in our business. Any future
determination as to payment of dividends will depend upon our financial
condition and results of operations and such other factors as the Board of
Directors deems relevant. Additionally, our ability to declare dividends should
we decide to do so is restricted by the terms of our debt
agreements.




30
 Table of Contents




ITEM
      6.
            SELECTED FINANCIAL DATA




Not
applicable.




ITEM
      7.
            MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDI­TION
      AND RESULTS OF OPERATION




The
following Management’s Discussion and Analysis of Financial Condition and
Results of Operations contains forward-looking statements that involve inherent
risks and uncertainties. When used in this discussion, the words “believes,”
“anticipated,” “expects,” “estimates” and similar expressions are intended to
identify such forward-looking statements. Such statements are subject to certain
risks and uncertainties that could cause actual results to differ materially
from those projected. Readers are cautioned not to place undue reliance on these
forward-looking statements, which speak only as of the date hereof. We undertake
no obligation to publicly release the result of any revisions to these
forward-looking statements that may be made to reflect events or circumstances
after the date hereof or to reflect the occurrence of unanticipated events. Our
actual results could differ materially from those anticipated in these
forward-looking statements as a result of certain factors including, but not
limited to, those set forth elsewhere in this report. Please see “Risk Factors,”
above, and in our other filings with the Securities and Exchange
Commission.




The
following discussion and analysis should be read in conjunction with the
Consolidated Financial Statements contained in Item 8 of this report, and the
notes thereto. We have rounded amounts reported here to the nearest thousand,
unless such amounts are more than 1.0 million, in which event we have rounded
such amounts to the nearest hundred thousand.




General




We are a
defense and security products and services company, engaged in three business
areas: interactive simulation for military, law enforcement and commercial
markets; batteries and charging systems for the military; and high-level
armoring for military, paramilitary and commercial vehicles. We operate in three
business units:




●
            we
      develop, manufacture and market advanced high-tech multimedia and
      interactive digital solutions for use-of-force and driving training of
      military, law enforcement, security and other personnel (our Training
      and Simulation Division);




●
            we
      provide aviation armor kits and we utilize sophisticated lightweight
      materials and advanced engineering processes to armor vehicles (our Armoring
      Division); and




●
            we
      develop, manufacture and market primary Zinc-Air batteries, rechargeable
      batteries and battery chargers for defense and security products and other
      military applications (our Battery and
      Power Systems Division).




31
 Table of Contents





Critical Accounting
Policies




The
preparation of financial statements requires us to make estimates and
assumptions that affect the reported amounts of assets and liabilities and the
disclosure of contingent liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period. On an
ongoing basis, we evaluate our estimates and judgments, including those related
to revenue recognition, allowance for bad debts, stock compensation, taxes,
inventory, contingencies and warranty reserves, impairment of intangible assets
and goodwill. We base our estimates and judgments on historical experience and
on various other factors that we believe to be reasonable under the
circumstances, the results of which form the basis for making judgments about
the carrying values of assets and liabilities that are not readily apparent from
other sources. Under different assumptions or conditions, actual results may
differ from these estimates.




We
believe the following critical accounting policies affect our more significant
judgments and estimates used in the preparation of our consolidated financial
statements.




Revenue
Recognition




Significant
management judgments and estimates must be made and used in connection with the
recognition of revenue in any accounting period. Material differences in the
amount of revenue in any given period may result if these judgments or estimates
prove to be incorrect or if management’s estimates change on the basis of
development of the business or market conditions. Management judgments and
estimates have been applied consistently and have been reliable
historically.




A portion
of our revenue is derived from license agreements that entail the customization
of FAAC’s simulators to the customer’s specific requirements. Revenues from
initial license fees for such arrangements are recognized in accordance with
FASB ASC 605-35 based on the percentage of completion method over the period
from signing of the license through to customer acceptance, as such simulators
require significant modification or customization that takes time to complete.
The percentage of completion is measured by monitoring progress using records of
actual time incurred to date in the project compared with the total estimated
project requirement, which corresponds to the costs related to earned revenues.
Estimates of total project requirements are based on prior experience of
customization, delivery and acceptance of the same or similar technology and are
reviewed and updated regularly by management.




We
believe that the use of the percentage of completion method is appropriate as we
have the ability to make reasonably dependable estimates of the extent of
progress towards completion, contract revenues and contract costs. In addition,
contracts executed include provisions that clearly specify the enforceable
rights regarding services to be provided and received by the parties to the
contracts, the consideration to be exchanged and the manner and terms of
settlement. In all cases we expect to perform our contractual obligations and
our licensees are expected to satisfy their obligations under the contract. The
complexity of the estimation process and the issues related to the assumptions,
risks and uncertainties inherent with the application of the percentage of
completion method of accounting affect the amounts of revenue and related
expenses reported in our consolidated financial statements. A number of internal
and external factors can affect our estimates, including labor rates,
utilization and specification and testing requirement changes.




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We
account for our other revenues from IES simulators in accordance with the
provisions of FASB ASC 985-605. We exercise judgment and use estimates in
connection with the determination of the amount of software license and services
revenues to be recognized in each accounting period.




We assess
whether collection is probable at the time of the transaction based on a number
of factors, including the customer’s past transaction history and credit
worthiness. If we determine that the collection of the fee is not probable, we
defer the fee and recognize revenue at the time collection becomes probable,
which is generally upon the receipt of cash.




Stock
Based Compensation




We
account for stock options and awards issued to employees in accordance with the
fair value recognition provisions of FASB ASC 505-50 using the modified
prospective transition method. Under FASB ASC 505-50, stock-based awards to
employees are required to be recognized as compensation expense, based on the
calculated fair value on the date of grant. We determine the fair value using
the Black Scholes option pricing model. This model requires subjective
assumptions, including future stock price volatility and expected term, which
affect the calculated values.




Allowance
for Doubtful Accounts




We make
judgments as to our ability to collect outstanding receivables and provide
allowances for the portion of receivables when collection becomes doubtful.
Provisions are made based upon a specific review of all significant outstanding
receivables. In determining the provision, we analyze our historical collection
experience and current economic trends. We reassess these allowances each
accounting period. Historically, our actual losses and credits have been
consistent with these provisions. If actual payment experience with our
customers is different than our estimates, adjustments to these allowances may
be necessary resulting in additional charges to our statement of
operations.




Accounting
for Income Taxes




Significant
judgment is required in determining our worldwide income tax expense provision.
In the ordinary course of a global business, there are many transactions and
calculations where the ultimate tax outcome is uncertain. Some of these
uncertainties arise as a consequence of cost reimbursement arrangements among
related entities, the process of identifying items of revenue and expense that
qualify for preferential tax treatment and segregation of foreign and domestic
income and expense to avoid double taxation. Although we believe that our
estimates are reasonable, the final tax outcome of these matters may be
different than that which is reflected in our historical income tax provisions
and accruals. Such differences could have a material effect on our income tax
provision and net income (loss) in the period in which such determination is
made.




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We have
provided a valuation allowance on the majority of our net deferred tax assets,
which includes federal and foreign net operating loss carryforwards, because of
the uncertainty regarding their realization. Our accounting for deferred taxes
under FASB ASC 740-10, involves the evaluation of a number of factors concerning
the realizability of our deferred tax assets. In concluding that a valuation
allowance was required, we primarily considered such factors as our history of
operating losses and expected future losses in certain jurisdictions and the
nature of our deferred tax assets. We provide valuation allowances in respect of
deferred tax assets resulting principally from the carryforward of tax losses.
Management currently believes that it is more likely than not that the deferred
tax regarding the carryforward of losses and certain accrued expenses will not
be realized in the foreseeable future. We do not provide for U.S. federal income
taxes on the undistributed earnings of our foreign subsidiaries because such
earnings are re-invested and, in the opinion of management, will continue to be
re-invested indefinitely.




We have
indefinitely-lived intangible assets consisting of trademarks, workforce, and
goodwill. These indefinitely-lived intangible assets are not amortized for
financial reporting purposes. However, these assets are tax deductible, and
therefore amortized over 15 years for tax purposes. As such, deferred income tax
expense and a deferred tax liability arise as a result of the tax-deductibility
of these indefinitely-lived intangible assets. The resulting deferred tax
liability, which is expected to continue to increase over time, will have an
indefinite life, resulting in what is referred to as a “naked tax credit.” This
deferred tax liability could remain on our balance sheet indefinitely unless
there is an impairment of the related assets (for financial reporting purposes),
or the business to which those assets relate were to be disposed
of.




Due to
the fact that the aforementioned deferred tax liability could have an indefinite
life, it is not  netted against our deferred tax assets when
determining the required valuation allowance. Doing so would result in the
understatement of the valuation allowance and related deferred income tax
expense.




On
January 1, 2007, we adopted the provisions of the FASB ASC 740-10. FASB ASC
740-10 prescribes a recognition threshold and measurement attribute for the
financial statement recognition and measurement of a tax position taken in a tax
return. We must determine whether it is “more-likely-than-not” that a tax
position will be sustained upon examination, including resolution of any related
appeals or litigation processes, based on the technical merits of the position.
Once it is determined that a position meets the more-likely-than-not recognition
threshold, the position is measured to determine the amount of benefit to
recognize in the financial statements. Uncertain tax positions require
determinations and estimated liabilities to be made based on provisions of the
tax law which may be subject to change or varying interpretation. If our
determinations and estimates prove to be inaccurate, the resulting adjustments
could be material to its future financial results.




In
addition, we operate within multiple taxing jurisdictions and may be subject to
audits in these jurisdictions. These audits can involve complex issues that may
require an extended period of time for resolution. In management’s opinion,
adequate provisions for income taxes have been made.




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Inventories




Our
policy for valuation of inventory and commitments to purchase inventory,
including the determination of obsolete or excess inventory, requires us to
perform a detailed assessment of inventory at each balance sheet date, which
includes a review of, among other factors, an estimate of future demand for
products within specific time horizons, valuation of existing inventory, as well
as product lifecycle and product development plans. The estimates of future
demand that we use in the valuation of inventory are the basis for our revenue
forecast, which is also used for our short-term manufacturing plans. Inventory
reserves are also provided to cover risks arising from slow-moving items. We
write down our inventory for estimated obsolescence or unmarketable inventory
equal to the difference between the cost of inventory and the estimated market
value based on assumptions about future demand and market conditions. We may be
required to record additional inventory write-down if actual market conditions
are less favorable than those projected by our management. For fiscal 2009, no
significant changes were made to the underlying assumptions related to estimates
of inventory valuation or the methodology applied.




Goodwill




As of
December 31, 2009, we had recorded goodwill of $32.3 million. Goodwill and
intangible assets deemed to have indefinite lives are no longer amortized but
are subject to annual impairment tests, and tests between annual tests in
certain circumstances, based on estimated fair value, and written down when
impaired.




We
determine fair value using a discounted cash flow analysis. This type of
analysis requires us to make assumptions and estimates regarding industry
economic factors and the profitability of future business strategies.
Significant estimates used in the methodologies include estimates of future cash
flows, future short-term and long-term growth rates, weighted average cost of
capital and estimates of market multiples for the reportable units. It is our
policy to conduct impairment testing based on our current business strategy in
light of present industry and economic conditions, as well as future
expectations. In assessing the recoverability of our goodwill, we may be
required to make assumptions regarding estimated future cash flows and other
factors to determine the fair value of the respective assets. This process is
subjective and requires judgment at many points throughout the analysis. If our
estimates or their related assumptions change in subsequent periods or if actual
cash flows are below our estimates, we may be required to record impairment
charges for these assets not previously recorded.




We
completed our annual goodwill impairment review using the financial results as
of the quarter ended June 30, 2009. Although the cumulative book value of our
reporting units exceeded our market value as of the impairment review,
management nevertheless determined that the fair value of the respective
reporting units exceeded their respective carrying values, and therefore, there
would be no impairment charges relating to goodwill. Several factors contributed
to this determination:




·
            The
      long term horizon of the valuation process versus a short term valuation
      using current market conditions;




35
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·
            The
      valuation by individual business segments versus the market share value
      based on our company as a whole;
and




·
            The
      fact that our stock is thinly traded and widely dispersed with minimal
      institutional ownership, and thus not followed by major market analysts,
      leading management to conclude that the market in our securities was not
      acting as an informationally efficient reflection of all known information
      regarding us.




In view
of the above factors, management felt that in the current market our stock was
undervalued, especially when compared to the estimated future cash flows of the
underlying entities.




Other
Intangible Assets




Other
intangible assets are amortized to the Statement of Operations over the period
during which benefits are expected to accrue, currently estimated at two to ten
years.




The
determination of the value of such intangible assets requires us to make
assumptions regarding future business conditions and operating results in order
to estimate future cash flows and other factors to determine the fair value of
the respective assets. If these estimates or the related assumptions change in
the future, we could be required to record additional impairment
charges.




Contingencies




We are
from time to time involved in legal proceedings and other claims. We are
required to assess the likelihood of any adverse judgments or outcomes to these
matters, as well as potential ranges of probable losses. We have not made any
material changes in the accounting methodology used to establish our
self-insured liabilities during the past three fiscal years.




A
determination of the amount of reserves required, if any, for any contingencies
are made after careful analysis of each individual issue. The required reserves
may change due to future developments in each matter or changes in approach,
such as a change in the settlement strategy in dealing with any contingencies,
which may result in higher net loss.




If actual
results are not consistent with our assumptions and judgments, we may be exposed
to gains or losses that could be material.




Warranty
Reserves




Upon
shipment of products to our customers, we provide for the estimated cost to
repair or replace products that may be returned under warranty. Our warranty
period is typically twelve months from the date of shipment to the end user
customer. For existing products, the reserve is estimated based on actual
historical experience. For new products, the warranty reserve is based on
historical experience of similar products until such time as sufficient
historical data has been collected on the new product. Factors that may impact
our warranty costs in the future include our reliance on our contract
manufacturer to provide quality products and the fact that our products are
complex and may contain undetected defects, errors or failures in either the
hardware or the software.




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Functional
Currency




We
consider the United States dollar to be the currency of the primary economic
environment in which we and our Israeli subsidiary EFL operate and, therefore,
both we and EFL have adopted and are using the United States dollar as our
functional currency. Transactions and balances originally denominated in U.S.
dollars are presented at the original amounts. Gains and losses arising from
non-dollar transactions and balances are included in net income.




The
majority of financial transactions of our Israeli subsidiaries MDT and Epsilor
is in New Israel Shekels (“NIS”) and a substantial portion of MDT’s and
Epsilor’s costs is incurred in NIS. Management believes that the NIS is the
functional currency of MDT and Epsilor. Accordingly, the financial statements of
MDT and Epsilor have been translated into U.S. dollars. All balance sheet
accounts have been translated using the exchange rates in effect at the balance
sheet date. Statement of operations amounts have been translated using the
average exchange rate for the period. The resulting translation adjustments are
reported as a component of accumulated other comprehensive loss in stockholders’
equity.




Executive
Summary




Overview
of Results of Operations




We
incurred net losses for the years ended December 31, 2009 and 2008. While we
expect to continue to derive revenues from the sale of products that we
manufacture and the services that we provide, there can be no assurance that we
will be able to achieve or maintain profitability on a consistent
basis.




A portion
of our operating loss during 2009 and 2008 arose as a result of non-cash
charges. These charges were primarily related to our acquisitions, financings
and issuances of restricted shares and options to employees. To the extent that
we continue certain of these activities during 2010, we would expect to continue
to incur such non-cash charges in the future.




Acquisitions




In
acquisition of subsidiaries, part of the purchase price is allocated to
intangible assets and goodwill. Amortization of intangible assets related to
acquisition of subsidiaries is recorded based on the estimated expected life of
the assets. Accordingly, for a period of time following an acquisition, we incur
a non-cash charge related to amortization of intangible assets in the amount of
a fraction (based on the useful life of the intangible assets) of the amount
recorded as intangible assets. Such amortization charges continued during 2009.
We are required to review intangible assets for impairment whenever events or
changes in circumstances indicate that carrying amount of the assets may not be
recoverable. If we determine, through the impairment review process, that
intangible asset has been impaired, we must record the impairment charge in our
statement of operations.




In the
case of goodwill, the assets recorded as goodwill are not amortized; instead, we
are required to perform an annual impairment review. If we determine, through
the impairment review process, that goodwill has been impaired, we must record
the impairment charge in our statement of operations.




As a
result of the application of the above accounting rule, we incurred non-cash
charges for amortization of definitive lived intangible assets in 2009 and 2008
in the amount of $1.5 million and $1.7 million, respectively.




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Financings
and Issuances of Restricted Shares, Options and Warrants




The
non-cash charges that relate to our financings occurred in connection with our
issuance of convertible securities with warrants, and in connection with our
repricing of certain warrants and grants of new warrants. When we issue
convertible securities, we record a discount for a beneficial conversion feature
that is amortized ratably over the life of the debenture.




During
the third quarter of 2008 and pursuant to the terms of a Securities Purchase
Agreement dated August 14, 2008, we issued and sold to a group of institutional
investors 10% senior convertible notes (the “Notes”) in the aggregate principal
amount of $5.0 million due August 15, 2011. These Notes are convertible at any
time prior to August 15, 2011 at a conversion price of $2.24 per share. As part
of our analysis of the convertible debt and related warrants, we reviewed and
followed the guidance of FASB ASC 718-10, ASC 815-40-15, ASC 470-20-30 and ASC
105-10-05.




The
original accounting for the Notes included the recording of a debt discount of
$412,300 representing the relative fair value of the warrants issued with the
convertible debt.  The relative fair value of the warrants was $412,300 and
recorded as a component of stockholders’ equity.  The embedded conversion
feature did not require bifurcation from the debt and did not result in any
beneficial conversion value.
 
 On
January 1, 2009, we adopted FASB ASC 815-40-15, “Determining Whether an
Instrument is Indexed to an Entity’s Own Stock.” FASB ASC 815-40-15 required us
to re-evaluate the warrants issued with the convertible notes and to also
re-evaluate the embedded conversion option and embedded put options within the
Notes to determine if the previous accounting for these items would change. Upon
this re-evaluation, we were required to record a cumulative adjustment as of
January 1, 2009 that included reclassifying the warrant value previously
included in stockholders' equity ($412,300) to other liabilities, reflecting the
value of the embedded conversion feature as additional debt discount and as
other liabilities as of the debt issuance date ($59,001), increasing financial
expenses due to the larger debt discount and increasing financial expenses to
reflect the change in the value of the warrants and the conversion features from
the debt issuance date to December 31, 2008.  The aggregate additional 2008
expense of $471,301 was recorded as an adjustment to beginning accumulated
deficit as of January 1, 2009.
 The
embedded put options are now classified as derivative liabilities. We again used
the Black-Scholes and other valuation techniques to determine the value of the
warrants, the embedded conversion feature and the embedded put options
associated with the Notes as of January 1, 2009.  On December 31, 2009, we
again revalued these securities. The year to date financial expense associated
with this revaluation is approximately $342,000. The table below lists the
variables used in the Black-Scholes calculation and the resulting
values.




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Variables
              August
      14, 2008
              
              January
      1, 2009
              
              December
      31, 2009Stock
      price
              
              $
              1.68
              
              
              $
              0.41
              
              
              $
              1.70Risk
      free interest rate
              
              
              2.72
              %
              
              
              1.00
              %
              
              
              1.70
              %Volatility
              
              
              77.32
              %
              
              
              81.40
              %
              
              
              79.85
              %Dividend
      yield
              
              
              0.00
              %
              
              
              0.00
              %
              
              
              0.00
              %Contractual
      life
              3.0
      years
              
              2.6
      years
              
              1.6
      yearsValues
              August
      14, 2008
              
              January
      1, 2009
              
              December
      31, 2009Warrants
              
              $
              417,317
              
              
              $
              29,171
              
              
              $
              298,570Conversion
      option
              
              
              143,714
              
              
              
              8,013
              
              
              
              88,156Puts
              
              
              26,060
              
              
              
              14,997
              
              
              
              7,371Total
      value
              
              $
              587,091
              
              
              $
              52,181
              
              
              $
              394,097Change
      in value – charged to financial
      expense
              
              
              
              
              
              
              
              
              
              $
              (341,916
              )


Concurrent
with the Securities Purchase Agreement dated August 14, 2008, we purchased a
$2.5 million Senior Subordinated Convertible Note from an unaffiliated company,
DEI Services Corporation (“DEI”). This 10% Senior Subordinated Convertible Note
(the “DEI Note”) is due December 31, 2009. The DEI Note is convertible at
maturity at our option into such number of shares of DEI’s common stock, no par
value per share, as shall be equal at the time of conversion to twelve percent
(12%) of DEI’s outstanding common stock. In the third quarter of 2009, we wrote
down the value of the DEI Note by $500,000, to $2.0 million. See also “Recent
Developments,” below.




Interest
on the outstanding principal amount of the DEI Note commenced accruing on the
issuance date and is payable quarterly, in arrears. The issuer has been paying
interest as required under the terms of the DEI Note, but did not pay the
principal amount when due. We have discontinued accruing interest on the DEI
Note due to the provision on the DEI Note recorded this quarter. Interest on the
DEI Note will be recognized as a reduction of financial expenses and will be
shown on a cash basis. Related fees and costs will be recorded as general and
administrative expense.




During
2009 and 2008, we issued restricted shares to certain of our employees and to
our directors. These shares were issued as stock bonuses or were the required
annual grant to directors, and are restricted for a period of up to three years
from the date of issuance. Relevant accounting rules provide that the aggregate
amount of the difference between the purchase price of the restricted shares (in
this case, generally zero) and the market price of the shares on the date of
grant is taken as a general and administrative expense, amortized over the
period of the restriction. As a result of the application of the above
accounting rules, we incurred non-cash charges related to stock-based
compensation in 2009 and 2008 in the amount of $849,000 and $1.0 million,
respectively.




Overview
of Operating Performance and Backlog




Overall,
our net loss before earnings from an affiliated company and tax expenses for
2009 was $2.2 million on revenues of $74.5 million, compared to a net loss of
$2.4 million on revenues of $68.9 million during 2008. As of December 31, 2009,
our overall backlog totaled $55.5 million.




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In our
Training and Simulation Division, revenues increased from approximately $36.0
million in 2008 to $39.2 million in 2009. As of December 31, 2009, our backlog
for our Training and Simulation Division totaled $31.2 million.




In our
Armor Division, revenues decreased from approximately $17.7 million in 2008 to
approximately $17.5 million in 2009. As of December 31, 2009, our backlog for
our Armor Division totaled $10.5 million.




In our
Battery and Power Systems Division, revenues increased from approximately $15.2
million in 2008 to approximately $17.8 million in 2009. As of December 31, 2009,
our backlog for our Battery and Power Systems Division totaled $13.8
million.




Common
Stock Repurchase Program




In
February of 2009, we authorized, for a period of one year, the repurchase in the
open market or in privately negotiated transactions of up to $1 million of our
common stock. Pursuant to this plan, through December 31, 2009 we have
repurchased 447,358 shares of our common stock for $563,556 ($554,099 net of
commissions), all of which was purchased after April 1, 2009. Shares repurchased
are carried on our books as treasury stock. At December 31, 2009, we had
remaining authorization for the repurchase of up to $445,901 in shares of our
common stock. The repurchase program is subject to the discretion of our
management.




Recent
Developments




DEI
Note




In the
third quarter of 2009 DEI repaid a portion of their internal shareholder loans,
which was a violation of the DEI Note covenants with us. Because of this, we
agreed in October of 2009 to amend the DEI Note to provide that the interest
rate on the DEI Note would be increased to 15% and would be payable through the
payment date. In the event that the DEI Note is not paid in full at maturity,
the DEI Note will be convertible into a minimum of 20% of DEI’s then outstanding
common stock, or more under certain circumstances.




In
November of 2009 DEI brought in a new investor that was prepared to provide DEI
with additional working capital, but only if we agreed to step aside and accept
a $500,000 discount on the DEI Note and waive our associated rights of first
refusal and conversion. In view of the possibility that DEI would seek an
extension of the DEI Note, we decided to enable DEI to bring in the new investor
and thereby be able to pay the DEI Note on time, albeit at a discount. We
accordingly wrote down the value of the DEI Note by $500,000, to $2.0 million
and charged the associated expense to other income (expense) on the statement of
operations. Inasmuch as the new investor’s investment did not close, we retain
all our rights under the DEI Note, including our right to be paid the full
amount of the DEI Note and its conversion option and right of first
refusal.




We
declared a default on the DEI Note when it was not paid pursuant to its terms at
the end of December 2009. We are presently prohibited from bringing suit to
collect this note pursuant to the terms of a subordination agreement with DEI’s
senior lender. However, we are maintaining communication with DEI, and we
continue to believe that DEI’s anticipated earnings and cash flow will enable
the DEI Note to be paid, albeit late. Interest on the DEI Note has been paid by
DEI through November 15, 2009 and we expect DEI to continue to make timely
interest payments on the DEI Note.




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Results
of Operations




Preliminary
Note




Summary




Following
is a table summarizing our results of operations for the years ended December
31, 2009 and 2008, after which we present a narrative discussion and
analysis:




Year
      Ended December 31,2009
                                
                                
                                2008Revenues:Training
      and Simulation Division
                                
                                $
                                39,206,173
                                
                                
                                $
                                36,032,703Armor
      Division
                                
                                
                                17,507,298
                                
                                
                                
                                17,762,439Battery
      and Power Systems Division
                                
                                
                                17,820,980
                                
                                
                                
                                15,153,827$
                                74,534,451
                                
                                
                                $
                                68,948,969Cost
      of revenues:Training
      and Simulation Division
                                
                                $
                                24,568,708
                                
                                
                                $
                                22,017,653Armor
      Division
                                
                                
                                14,517,491
                                
                                
                                
                                15,932,478Battery
      and Power Systems Division
                                
                                
                                15,328,722
                                
                                
                                
                                12,227,778$
                                54,414,921
                                
                                
                                $
                                50,177,909Research
      and development expenses:Training
      and Simulation Division
                                
                                $
                                569,984
                                
                                
                                $
                                797,112Armor
      Division
                                
                                
                                506,838
                                
                                
                                
                                247,462Battery
      and Power Systems Division
                                
                                
                                249,933
                                
                                
                                
                                613,094$
                                1,326,755
                                
                                
                                $
                                1,657,668Sales
      and marketing expenses:Training
      and Simulation Division
                                
                                $
                                3,387,993
                                
                                
                                $
                                3,232,367Armor
      Division
                                
                                
                                782,937
                                
                                
                                
                                754,645Battery
      and Power Systems Division
                                
                                
                                697,568
                                
                                
                                
                                712,858$
                                4,868,498
                                
                                
                                $
                                4,699,870General
      and administrative expenses:Training
      and Simulation Division
                                
                                $
                                4,651,130
                                
                                
                                $
                                4,068,614Armor
      Division
                                
                                
                                1,588,973
                                
                                
                                
                                1,590,549Battery
      and Power Systems Division
                                
                                
                                1,079,063
                                
                                
                                
                                1,239,288All
      Other
                                
                                
                                4,979,429
                                
                                
                                
                                7,195,313$
                                12,298,595
                                
                                
                                $
                                14,093,764
  41
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 Year
      Ended December 31,2009
                                      
                                      
                                      2008Amortization
      of intangible assets:Training
      and Simulation Division
                                      
                                      $
                                      936,212
                                      
                                      
                                      $
                                      1,212,958Armor
      Division
                                      
                                      
                                      13,350
                                      
                                      
                                      
                                      13,350Battery
      and Power Systems Division
                                      
                                      
                                      509,240
                                      
                                      
                                      
                                      509,240$
                                      1,458,802
                                      
                                      
                                      $
                                      1,735,548Escrow
      adjustment:All
      Other
                                      
                                      $
                                      –
                                      
                                      
                                      $
                                      (1,448,074
                                      )$
                                      –
                                      
                                      
                                      $
                                      (1,448,074
                                      )Operating
      profit (loss):Training
      and Simulation Division
                                      
                                      $
                                      5,092,146
                                      
                                      
                                      $
                                      4,703,999Armor
      Division
                                      
                                      
                                      97,709
                                      
                                      
                                      
                                      (776,045
                                      )Battery
      and Power Systems Division
                                      
                                      
                                      (43,546
                                      )
                                      
                                      
                                      (148,431
                                      )All
      Other
                                      
                                      
                                      (4,979,429
                                      )
                                      
                                      
                                      (5,747,239
                                      )$
                                      166,880
                                      
                                      
                                      $
                                      (1,967,716
                                      )Other
      income:Training
      and Simulation Division
                                      
                                      $
                                      31,591
                                      
                                      
                                      $
                                      34,714Armor
      Division
                                      
                                      
                                      53,778
                                      
                                      
                                      
                                      63,099Battery
      and Power Systems Division
                                      
                                      
                                      293
                                      
                                      
                                      
                                      27All
      Other
                                      
                                      
                                      –
                                      
                                      
                                      
                                      325,043$
                                      85,662
                                      
                                      
                                      $
                                      422,883Allowance
      for settlements:All
      Other
                                      
                                      $
                                      1,250,000
                                      
                                      
                                      $
                                      –$
                                      1,250,000
                                      
                                      
                                      $
                                      –Financial
      expense:Training
      and Simulation Division
                                      
                                      $
                                      1,342
                                      
                                      
                                      $
                                      195Armor
      Division
                                      
                                      
                                      214,042
                                      
                                      
                                      
                                      357,517Battery
      and Power Systems Division
                                      
                                      
                                      70,819
                                      
                                      
                                      
                                      313,671All
      Other
                                      
                                      
                                      965,182
                                      
                                      
                                      
                                      142,706$
                                      1,251,385
                                      
                                      
                                      $
                                      814,089Tax
      expenses (credits):Training
      and Simulation Division
                                      
                                      $
                                      183,621
                                      
                                      
                                      $
                                      68,608Armor
      Division
                                      
                                      
                                      (25,674
                                      )
                                      
                                      
                                      58,147Battery
      and Power Systems Division
                                      
                                      
                                      28,926
                                      
                                      
                                      
                                      100,113All
      Other
                                      
                                      
                                      618,093
                                      
                                      
                                      
                                      800,000$
                                      804,966
                                      
                                      
                                      $
                                      1,026,868Loss
      from affiliated company:Training
      and Simulation Division
                                      
                                      $
                                      –
                                      
                                      
                                      $
                                      (352,166
                                      )Armor
      Division
                                      
                                      
                                      –
                                      
                                      
                                      
                                      (100,000
                                      )$
                                      –
                                      
                                      
                                      $
                                      (452,166
                                      )Net
      income (loss):Training
      and Simulation Division
                                      
                                      $
                                      4,938,774
                                      
                                      
                                      $
                                      4,317,744Armor
      Division
                                      
                                      
                                      (36,881
                                      )
                                      
                                      
                                      (1,228,610
                                      )Battery
      and Power Systems Division
                                      
                                      
                                      (142,998
                                      )
                                      
                                      
                                      (562,188
                                      )All
      Other
                                      
                                      
                                      (7,812,704
                                      )
                                      
                                      
                                      (6,364,902
                                      )$
                                      (3,053,809
                                      )
                                      
                                      $
                                      (3,837,956
                                      )


Fiscal
Year 2009 compared to Fiscal Year 2008




Revenues. During 2009, we (through our
subsidiaries) recognized revenues as follows:




●
            FAAC,
      IES and RTI recognized revenues from the sale of military operations and
      vehicle simulators, interactive use-of-force training systems and from the
      provision of maintenance services in connection with such
      systems.




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●
            MDT,
      MDT Armor and AoA recognized revenues from payments under vehicle armoring
      contracts, for service and repair of armored vehicles, and on sale of
      armoring products.




●
            EFB
      and Epsilor recognized revenues from the sale of batteries, chargers and
      adapters to the military and commercial customers, and under certain
      development contracts with the U.S.
Army.




●
            EFL
      recognized revenues from the sale of water-activated battery (WAB)
      lifejacket lights.




Revenues
for 2009 totaled $74.5 million, compared to $68.9 million in 2008, an increase
of $5.6 million, or 8.1%. This increase was primarily attributable to the
following factors:




●
            Increased
      revenues from our Training and Simulation Division ($3.2 million more in
      2009 versus 2008), primarily due to an increase in sales of military
      vehicle simulators.




●
            Increased
      revenues from our Battery and Power Systems Division ($2.6 million more in
      2009 versus 2008), primarily due to increased military and commercial
      battery sales at Epsilor and EFL.




In 2009,
revenues were $39.2 million for the Training and Simulation Division (compared
to $36.0 million in 2008, an increase of $3.2 million, or 8.8%, due primarily to
increased sales of military vehicle simulators); $17.5 million for the Armor
Division (compared to $17.7 million in 2008, a decrease of $255,000, or 1.4%);
and $17.8 million for the Battery and Power Systems Division (compared to $15.2
million in 2008, an increase of $2.6 million, or 17.6%, due primarily to
increased sales of our battery products at Epsilor and EFL).




Cost of
revenues. Cost of revenues totaled $54.4 million during 2009, compared to
$50.2 million in 2008, an increase of $4.2 million, or 8.4%, due primarily to
increased sales in our Training and Simulation and our Battery and Power Systems
Divisions. Total cost of revenues and cost of revenues as a percentage of
revenue also increased in each division due to several factors, including price
increases in raw materials, increased labor costs and the production of new
products.




Cost of
revenues for our three divisions during 2009 were $24.6 million for the Training
and Simulation Division (compared to $22.0 million in 2008, an increase of $2.6
million, or 11.6%, due to increased revenues and elevated material and labor
costs); $14.5 million for the Armor Division (compared to $15.9 million in 2008,
a decrease of $1.4 million, or 8.9%, due primarily to increased operating
efficiencies, including reduced labor costs, in the production of the “David”
Armored Vehicle); and $15.3 million for the Battery and Power Systems Division
(compared to $12.2 million in 2008, an increase of $3.1 million, or 25.4%, due
primarily to increased materials and labor associated with improved revenues at
Epsilor and EFL; margins were also impacted by newly developed
products).




Research and
development expenses. Research and development
expenses for 2009 were $1.3 million, compared to $1.7 million during 2008, a
decrease of $331,000, or 20.0%, due primarily to reduced expenses in the amount
of $590,000 in our Battery and Power Systems Division and our Training and
Simulation Division, partially offset by increased expenses of $259,000 in our
Armor Division for new product development, including our new Tiger
platform.




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Selling and
marketing expenses. Selling and marketing
expenses for 2009 were $4.9 million, compared to $4.7 million 2008, an increase
of $169,000, or 3.6%, due primarily to increased revenues in the Training and
Simulation Division and their associated sales and marketing
expenses.




General and
administrative expenses. General and administrative
expenses for 2009 were $12.3 million, compared to $14.1 million in 2008, a
decrease of $1.8 million, or 12.7%. This decrease was primarily attributable to
a reduction of corporate expenses and 2008 acquisition expenses of $736,000. The
decrease in expenses was offset by an increase in legal expenses in the Training
and Simulation Division.




Amortization of
intangible assets. Amortization of intangible
assets totaled $1.5 million in 2009, compared to $1.7 million in 2008, a
decrease of $277,000, or 15.9%, due to intangible assets in our Training and
Simulation Division that are now fully amortized.




Escrow adjustment
– credit. An escrow adjustment credit of $1.4 million in 2008 represents
the first quarter 2008 final adjustment to operating expenses resulting from the
completion of an escrow arbitration. This was a contingent earnout obligation
that was identified by us when AoA was purchased and there will be no further
adjustments to this amount.




Allowance for
settlements. Allowances of $1.3 million were expensed in 2009 for pending
activity in two areas. In the third quarter of 2009 the value of the DEI Note
was written down by $500,000, to $2.0 million, and in the fourth quarter of 2009
we recorded an allowance in the amount of $750,000 relating to a potential
adverse judgment in the litigation between our AoA subsidiary (which has since
been merged into MDT) and NAVAIR. See “Item 3. Legal Proceedings – NAVAIR
Litigation.”




Financial
expenses, net.
Financial expenses totaled approximately $1.3 million in 2009 compared to
$814,000 in 2008, an increase of $437,000, or 53.7%. The difference was
primarily due to increased expenses relating to our debt discount and for the
mark-to-market adjustment related to our convertible debt.




Income
taxes. We and
certain of our subsidiaries incurred net operating losses during 2009 and,
accordingly, no provision for income taxes was recorded for these losses. With
respect to some of our subsidiaries that operated at a net profit during 2009,
we were able to offset federal taxes against our accumulated loss carry forward.
We recorded a total of $805,000 in deferred tax expenses in 2009, compared to
$1.0 million in tax expenses in 2008, mainly due to state and local taxes along
with the required adjustment of taxes due to the deduction of goodwill for U.S.
federal taxes, which totaled $560,000 in 2009, as compared to $565,000 in
2008.


Net loss.
Due to the factors cited above, net loss decreased to $3.1 million in 2009 from
$3.8 million in 2008, a difference of $784,000, or 20.4%.




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Liquidity
and Capital Resources




As of
December 31, 2009, we had $1.9 million in cash and $2.0 million in restricted
cash, as compared to at December 31, 2008, when we had $4.3 million in cash,
$382,000 in restricted cash and $49,000 in available-for-sale marketable
securities. Our balance sheet cash position was impacted at year end 2009 due to
$1.9 million in expenditures for the purchase of inventory and materials
relating to our CaPost contract in our FAAC subsidiary. We also had $5.9 million
available in unused bank lines of credit with our main bank without considering
the limitations of the borrowing base calculations and letters of credit, under
a $10.0 million credit facility under our FAAC subsidiary, which is secured by
our assets and the assets of our other subsidiaries and guaranteed by us. There
was $2.6 million of available credit on the primary line at year end based on
our borrowing base calculations.


We used
available funds in 2009 primarily for sales and marketing, continued research
and development expenditures, and other working capital needs. We purchased
approximately $1.2 million of fixed assets during 2009 and also received fixed
asset grants of approximately $260,000 that was credited to fixed assets at the
then-current exchange rate. Our net fixed assets amounted to $4.6 million as at
year end.




Net cash
provided by operating activities for 2009 was $2.0 million, and net cash used in
operating activities for 2008 was $(677,000), an increase of $2.7 million. This
increase in cash provided was primarily the result of changes in working
capital.




Net cash
used in investing activities for 2009 and 2008 was $3.1 million and $2.3
million, respectively, an increase of $753,000. This change was primarily the
result of the increase in restricted cash and additions to capitalized software
in 2009, versus the acquisition activities, convertible loan purchased and the
escrow settlement that took place in 2008.




Net cash
provided by (used in) financing activities for 2009 and 2008 was $(1.4 million)
and $3.9 million, respectively, a decrease of $5.2 million, primarily due to the
$5.0 million note issued in 2008.




As of
December 31, 2009, we had approximately $4.1 million in bank debt and $4.2
million in long-term debt outstanding.




Subject
to all of the reservations regarding “forward-looking statements” set forth
above, we believe that our present cash position, anticipated cash flows from
operations and lines of credit should be sufficient to satisfy our current
estimated cash requirements through the remainder of the year. In this
connection, we note that from time to time our working capital needs are
partially dependent on our subsidiaries’ lines of credit.




Over the
long term, we will need to be profitable, at least on a cash-flow basis, and
maintain that profitability in order to avoid future capital requirements.
Additionally, we would need to raise additional capital in order to fund any
future acquisitions.




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Effective
Corporate Tax Rate




We and
certain of our subsidiaries incurred net operating losses during the years ended
December 31, 2009 and 2008, and accordingly no provision for income taxes was
required. With respect to some of our U.S. subsidiaries that operated at a net
profit during 2009, we were able to offset federal taxes against our net
operating loss carryforward, which amounted to approximately $25.1 million as of
December 31, 2009. These subsidiaries are, however, subject to state taxes that
cannot be offset against our net operating loss carryforward. With respect to
certain of our Israeli subsidiaries that operated at a net profit during 2009,
we were unable to offset their taxes against our net operating loss
carryforward, and we are therefore exposed to Israeli taxes, at a rate of up to
26% in 2009 (less, in the case of companies that have “approved enterprise”
status as discussed in Note [14.b.] to the Notes to Financial Statements). We
also set up a tax liability for the impact of the deductions taken for
goodwill.




As of
December 31, 2009, we had a U.S. net operating loss carryforward of
approximately $25.1 million that is available to offset future taxable income
under certain circumstances, expiring primarily from 2010 through 2026, and
foreign net operating and capital loss carryforwards of approximately $111.3
million, which are available indefinitely to offset future taxable income
under certain circumstances.




ITEM 8.
            FINANCIAL
      STATEMENTS AND SUPPLEMENTARY DATA


Index
to Financial Statements


PageConsolidated Financial
      StatementsReport
      of Independent Registered Public Accounting Firm
                    
                    
                    F-1Consolidated
      Balance Sheets
                    
                    
                    F-2Consolidated
      Statements of Operations
                    
                    
                    F-4Statements
      of Changes in Stockholders’ Equity
                    
                    
                    F-5Consolidated
      Statements of Cash Flows
                    
                    
                    F-7Notes
      to Consolidated Financial Statements
                    
                    
                    F-9Financial Statement
ScheduleSchedule
      II – Valuation and Qualifying Accounts
                    
                    
                    F-41




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ITEM 9.
            CHANGES
      IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
      DISCLOSURE




Not
applicable.




ITEM 9A(T).
            CONTROLS
      AND PROCEDURES




Evaluation
of Disclosure Controls and Procedures




As of
December 31, 2009, our management, including the principal executive officer and
principal financial officer, evaluated our disclosure controls and procedures
related to the recording, processing, summarization, and reporting of
information in our periodic reports that we file with the SEC. These disclosure
controls and procedures are intended to ensure that material information
relating to us, including our subsidiaries, is made known to our management,
including these officers, by other of our employees, and that this information
is recorded, processed, summarized, evaluated, and reported, as applicable,
within the time periods specified in the SEC’s rules and forms. Due to the
inherent limitations of control systems, not all misstatements may be detected.
These inherent limitations include the realities that judgments in
decision-making can be faulty and that breakdowns can occur because of simple
error or mistake. Any system of controls and procedures, no matter how well
designed and operated, can at best provide only reasonable assurance that the
objectives of the system are met and management necessarily is required to apply
its judgment in evaluating the cost benefit relationship of possible controls
and procedures. Additionally, controls can be circumvented by the individual
acts of some persons, by collusion of two or more people, or by management
override of the control. Our controls and procedures are intended to provide
only reasonable, not absolute, assurance that the above objectives have been
met.




Based on
their evaluation as of December 31, 2009, our principal executive officer and
principal financial officer were able to conclude that our disclosure controls
and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities
Exchange Act of 1934) were effective to ensure that the information required to
be disclosed by us in the reports that we file or submit under the Securities
Exchange Act of 1934 is recorded, processed, summarized and reported within the
time periods specified in SEC rules and forms.




We will
continue to review and evaluate the design and effectiveness of our disclosure
controls and procedures on an ongoing basis and to improve our controls and
procedures over time and correct any deficiencies that we may discover in the
future. Our goal is to ensure that our senior management has timely access to
all material financial and non-financial information concerning our business.
While we believe the present design of our disclosure controls and procedures is
effective to achieve our goal, future events affecting our business may cause us
to modify our disclosure controls and procedures.




Management’s
Report on Internal Control Over Financial Reporting




Our
management, including our principal executive and financial officers, is
responsible for establishing and maintaining adequate internal control over our
financial reporting, as such term is defined in Exchange Act Rule 13a-15(f). Our
management has evaluated the effectiveness of our internal controls as of the
end of the period covered by this Annual Report on Form 10-K for the year ended
December 31, 2009. In making our assessment of internal control over financial
reporting, management used the criteria set forth by the Committee of Sponsoring
Organizations (“COSO”) of the Treadway Commission in Internal Control – Integrated
Framework.




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Based on
management’s assessment and these criteria, our management concluded that our
internal control over financial reporting was effective as of December 31,
2009.




This
annual report does not include an attestation report of our registered public
accounting firm regarding internal control over financial reporting.
Management’s report was not subject to attestation by our registered public
accounting firm pursuant to temporary rules of the Securities and Exchange
Commission that permit us to provide only management’s report in this annual
report.




Changes
in Internal Controls Over Financial Reporting




There
have been no changes in our internal control over financial reporting that
occurred during our last fiscal quarter that have materially affected, or are
reasonably likely to materially affect, our internal control over financial
reporting.




ITEM 9B.
            OTHER
      INFORMATION




None.




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PART
III




ITEM 10.
            DIRECTORS
      AND EXECUTIVE OFFICERS OF THE
REGISTRANT




Executive
Officers, Directors and Significant Employees




Executive
Officers and Directors




Our
executive officers and directors and their ages as of February 28, 2010 were as
follows:




Name
                
                Age
                
                PositionRobert
      S. Ehrlich
                
                
                70
                
                Chairman
      of the Board and Chief Executive OfficerSteven
      Esses
                
                
                46
                
                President,
      Chief Operating Officer and DirectorDr.
      Jay M. Eastman
                
                
                61
                
                DirectorEdward
      J. Borey
                
                
                59
                
                DirectorSeymour
      Jones
                
                
                78
                
                DirectorElliot
      Sloyer
                
                
                45
                
                DirectorMichael
      E.
      Marrus
                
                
                46
                
                DirectorArthur
      S.
      Leibowitz
                
                
                56
                
                DirectorThomas
      J.
      Paup
                
                
                61
                
                Vice
      President – Finance and Chief Financial
Officer




Our
by-laws provide for a board of directors of one or more directors. There are
currently seven directors. Under the terms of our certificate of incorporation,
the board of directors is composed of three classes of similar size, each
elected in a different year, so that only one-third of the board of directors is
elected in any single year. Dr. Eastman and Messrs. Esses and Marrus are
designated Class I directors and have been elected for a term expiring in 2012
and until their successors are elected and qualified; Prof. Jones and Mr.
Ehrlich are designated Class II directors elected for a term expiring in 2011
and until their successors are elected and qualified; and Messrs. Borey, Sloyer
and Leibowitz are designated Class III directors elected for a term that expires
in 2010 and until their successors are elected and qualified. A majority of the
Board is “independent” under relevant SEC and Nasdaq regulations.




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Robert S. Ehrlichhas been our
Chairman of the Board since January 1993 and our Chief Executive Officer since
October 2002. From May 1991 until January 1993, Mr. Ehrlich was our Vice
Chairman of the Board, from May 1991 until October 2002 he was our Chief
Financial Officer, and from October 2002 until December 2005, Mr. Ehrlich also
held the title of President. Mr. Ehrlich was a director of Eldat, Ltd., an
Israeli manufacturer of electronic shelf labels, from June 1999 to August 2003.
From 1987 to June 2003, Mr. Ehrlich served as a director of PSC Inc. (“PSCX”), a
manufacturer and marketer of laser diode bar code scanners, and, between April
1997 and June 2003, Mr. Ehrlich was the chairman of the board of PSCX. PSCX
filed a voluntary petition for relief under Chapter 11 of the Bankruptcy Code in
November 2002. Mr. Ehrlich received a B.S. and J.D. from Columbia University in
New York, New York.




Mr.
Ehrlich has experience as an accountant, an attorney and as an investment
banker. He has been involved with public companies since the late 1960s, both as
an investment banker and as the chief financial officer and a director of
Mattel, where he was instrumental in helping to uncover fraudulent practices in
the preparation of certain of that company’s financial statements, and he
continued to serve as a director of Mattel through the late 1980s. After leaving
Mattel, Mr. Ehrlich founded his own boutique investment banking company and
became a director of certain of the companies involved in his investment banking
business. Mr. Ehrlich ultimately became the Chairman and CEO of Fresenius USA,
Inc. and of PSCX, prior to becoming our Chief Financial Officer in 1991 and our
Chief Executive Officer in 2002. We believe that Mr. Ehrlich’s background and
experience make him appropriate to serve as one of our directors in light of our
business and structure.




Steven Esses has been a
director since July 2002, our Executive Vice President since January 2003, our
Chief Operating Officer since February 2003 and our President since December
2005. From 2000 until 2002, Mr. Esses was a principal with Stillwater Capital
Partners, Inc., a New York-based investment research and advisory company (hedge
fund) specializing in alternative investment strategies. During this time, Mr.
Esses also acted as an independent consultant to new and existing businesses in
the areas of finance and business development. In 1995, Mr. Esses founded the
Dunkin’ Donuts franchise in Israel and was its Managing Director and CEO until
2005. Before founding Dunkin’ Donuts Israel, Mr. Esses was the Director of
Retail Jewelry Franchises with Hamilton Jewelry, and before that he served as
Executive Director of Operations for the Conway Organization, a major off-price
retailer with 17 locations.




Mr. Esses
has been actively involved in the day-to-day management of companies since he
was 22, when he co-founded a company that eventually went public. He has worked
in retail and wholesale, in high-tech and low-tech, in a variety of industries.
Throughout his career, he has been highly numbers-oriented, focusing on
budgetary and fiscal matters and on building business value. We believe that Mr.
Esses’s background and experience make him appropriate to serve as one of our
directors in light of our business and structure.




Dr. Jay M. Eastman has been
one of our directors since October 1993. Since November 1991, Dr. Eastman has
served as President and Chief Executive Officer of Lucid, Inc., which is
developing laser technology applications for medical diagnosis and treatment.
Dr. Eastman served as Senior Vice President of Strategic Planning of PSCX from
December 1995 through October 1997. Dr. Eastman is also a director of Dimension
Technologies, Inc., a developer and manufacturer of 3D displays for computer and
video displays. From 1981 until 1983, Dr. Eastman was the Director of the
University of Rochester’s Laboratory for Laser Energetics, where he was a member
of the staff from 1975 to 1981. Dr. Eastman holds a B.S. and a Ph.D. in Optics
from the University of Rochester in New York.




Dr.
Eastman brings to our Board the unique perspective of a trained scientist who
has also been deeply involved in the business world. Since many of our company’s
products are of a “high-tech” nature, Dr. Eastman’s scientific background is
extremely valuable to the Board. Additionally, Dr. Eastman brings to the Board
his experiences as Chairman and Chief Executive Officer of a high-tech company,
as well as his experience as a director of other public companies. We believe
that Dr. Eastman’s background and experience make him appropriate to serve as
one of our directors in light of our business and structure.




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Edward J. Borey has been one
of our directors since December 2003. From July 2004 until October 2006, Mr.
Borey served as Chairman and Chief Executive Officer of WatchGuard Technologies,
Inc., a leading provider of network security solutions (NasdaqGM: WGRD). From
December 2000 to September 2003, Mr. Borey served as President, Chief Executive
Officer and a director of PSCX. Prior to joining PSCX, Mr. Borey was President
and CEO of TranSenda (May 2000 to December 2000). Previously, Mr. Borey held
senior positions in the automated data collection industry. At Intermec
Technologies Corporation (1995-1999), he was Executive Vice President and Chief
Operating Officer and also Senior Vice President/General Manager of the Intermec
Media subsidiary. Mr. Borey holds a B.S. in Economics from the State University
of New York, College of Oswego, an M.A. in Public Administration from the
University of Oklahoma, and an M.B.A. in Finance from Santa Clara
University.




Mr. Borey
has served as the chief executive officer of two public companies and as chief
operating officer of one public and one private company, some of which were very
active in mergers and acquisitions. He has a wealth of experience in the issues
facing public companies and businesses in general, including in turnaround
situations, and he has strong experience in marketing in North America, Europe
and Asia. His background also includes experience with support and maintenance
of military ground vehicles and auxiliary ground vehicles, fixed and rotary
aircraft, and simulation for the United States and foreign militaries. We
believe that Mr. Borey’s background and experience make him appropriate to serve
as one of our directors in light of our business and structure.




Seymour Joneshas been one of
our directors since August 2005. Mr. Jones has been a clinical professor of
accounting at New York University Stern School of Business since September 1993.
Professor Jones teaches courses in accounting, tax, forensic accounting and
legal aspects of entrepreneurism. He is also the Associate Director of Ross
Institute of Accounting Research at Stern School of Business. His primary
research areas include audit committees, auditing, entrepreneurship, financial
reporting, and fraud. Professor Jones is the principal author of numerous books
including Conflict of
Interest,The Coopers
& Lybrand Guide to Growing Your Business, The Emerging Businessand
The Bankers Guide to Audit
Reports and Financial Statements. From April 1974 to September 1995, Mr.
Jones was a senior partner of the accounting firm of Coopers & Lybrand, a
legacy firm of PricewaterhouseCoopers LLP (“PwC”). Professor Jones is a
certified public accountant in New York State. Professor Jones received a B.A.
in economics from City College, City University of New York, and an M.B.A. from
NYU Stern.




Mr. Jones
brings many years of experience as an audit partner at PwC with extensive
financial accounting knowledge that is critical to our board of directors.
Mr. Jones’s experience with accounting principles, financial reporting rules and
regulations, evaluating financial results and generally overseeing the financial
reporting process of large public companies from an independent auditor’s
perspective and as a professor of accounting makes him an invaluable asset to
our board of directors. We believe that Mr. Jones’s background and
experience make him appropriate to serve as one of our directors in light of our
business and structure.




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Elliot Sloyer has served as a
director since October 2007. Mr. Sloyer is a Managing Member of WestLane Capital
Management, LLC, which he founded in 2005. From 1992 until 2005, Mr. Sloyer was
a founder and Managing Director of Harbor Capital Management, LLC, which managed
convertible arbitrage portfolios. Mr. Sloyer is active in community
organizations and currently serves on the investment committee of a charitable
organization. Mr. Sloyer has a B.A. from New York University.




Mr.
Sloyer’s investment advisor experience brings valuable insight to the Board in
enabling us to anticipate the reactions and concerns of the investment
community. We believe that Mr. Sloyer’s background and experience make him
appropriate to serve as one of our directors in light of our business and
structure.




Michael E. Marrus has been one
of our directors since October 2007. Since 2009, Mr. Marrus has been a Managing
Director of Merriman Curhan Ford, Inc., a financial services firm focused on
growth companies. From 1998 to 2008, he was a Managing Director of C. E.
Unterberg, Towbin & Co., an investment banking firm that was acquired by
Collins Stewart plc. Prior to joining Unterberg, Towbin, Mr. Marrus was a
Principal and founding member of Fieldstone Private Capital Group, an investment
banking firm specializing in corporate, project and structured finance.
Previously, he was employed at Bankers Trust Company, initially in the Private
Equity and Merchant Banking Groups and subsequently in BT Securities, the
securities affiliate of Bankers Trust. Mr. Marrus has an A.B. from Brown
University and an M.B.A. from the Graduate School of Business, University of
Chicago.




Mr.
Marrus has been involved in mergers and acquisitions as an investment banker and
has experience in company valuation in a wide range of industries, a critical
skill set for us. We believe that Mr. Marrus’s background and experience make
him appropriate to serve as one of our directors in light of our business and
structure.




Arthur S. Leibowitz has been
one of our directors since June 2009. Mr. Leibowitz is an adjunct professor at
Adelphi University School of Business where he teaches courses in accounting to
both graduate and undergraduate students. Before joining Adelphi University, Mr.
Leibowitz was an audit and business assurance partner at PwC. During his
twenty-seven years at PwC, Mr. Leibowitz served in a national leadership role
for PwC’s retail industry group and was the portfolio audit partner for one of
PwC’s leading private equity firms. Mr. Leibowitz is a certified public
accountant in New York State and received a B.S. in accounting from Brooklyn
College in New York.




Mr.
Leibowitz brings many years of experience as an audit and business assurance
partner at PwC with extensive financial accounting knowledge that is critical to
our board of directors. His skills are a vital asset to our board
of directors at a time when accurate and transparent accounting, a
sound financial footing and exemplary governance practices are essential. We
believe that Mr. Leibowitz’s background and experience make him appropriate to
serve as one of our directors in light of our business and
structure.




Thomas J. Paup has been our
Vice President – Finance since December 2005 and our Chief Financial Officer
since February 2006. Mr. Paup is currently also a Finance Lecturer at Eastern
Michigan University. Mr. Paup was an Affiliated Partner with McMillan|Doolittle
LLP from March 2002 until accepting this position with us, and prior thereto, he
was an Executive in Residence and Finance Instructor at DePaul University’s
Kellstadt Graduate School of Business. Prior to his teaching experience, Mr.
Paup spent over 25 years in the retail industry. Most recently, between 1997 and
2000, Mr. Paup was the Executive Vice President and Chief Financial Officer and
member of the Board of Directors of Montgomery Ward and Company. Mr. Paup brings
a broad background of strategic and operational management experiences from the
department store industry, where he served as CFO of Lord & Taylor and
Kaufmann’s and Controller of Bloomingdale’s and Robinson-May. Mr. Paup holds an
MBA in Finance and a BBS from Eastern Michigan University.




52
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Board
Leadership Structure




We have
chosen to combine the positions of Chairman of the Board and Chief Executive
Officer. We believe that Mr. Ehrlich’s long experience in business, both as a
director and as chairman of the board of other public companies, as well as his
unique understanding of our business, make it desirable that he serve as
Chairman of our Board of Directors, and that the size of our company and the
nature of our business do not require that the positions of Chairman and of
Chief Executive Officer be bifurcated.




Our
independent directors have not chosen to formally designate one of their number
as lead independent director.




Committees
of the Board of Directors




Our board
of directors has an Audit Committee, a Compensation Committee, a Nominating
Committee and an Executive and Finance Committee.




Created
in December 1993, the purpose of the Audit Committee is to review with
management and our independent auditors the scope and results of the annual
audit, the nature of any other services provided by the independent auditors,
changes in the accounting principles applied to the presentation of our
financial statements, and any comments by the independent auditors on our
policies and procedures with respect to internal accounting, auditing and
financial controls. The Audit Committee was established in accordance with
Section 3(a)(58)(A) of the Securities Exchange Act of 1934, as amended. In
addition, the Audit Committee is charged with the responsibility for making
decisions on the engagement of independent auditors. As required by law, the
Audit Committee operates pursuant to a charter, available through a hyperlink
located on the investor relations page of our website, at http://www.arotech.com/compro/investor.html.
The Audit Committee consists of Prof. Jones (Chair) and Messrs. Borey, Sloyer
and Leibowitz. We have determined that each of Prof. Jones and Mr. Leibowitz
qualifies as an “audit committee financial expert” under applicable SEC and
Nasdaq regulations. Prof. Jones and Mr. Leibowitz, as well as all the other
members of the Audit Committee, are “independent,” as independence is defined in
Rule 4200(a)(15) of the National Association of Securities Dealers’ listing
standards and under Item 7(d)(3)(iv) of Schedule 14A of the proxy rules under
the Exchange Act.




The
Compensation Committee, also created in December 1993, recommends annual
compensation arrangements for the Chief Executive Officer and Chief Financial
Officer and reviews annual compensation arrangements for all officers and
significant employees. The Compensation Committee operates pursuant to a
charter, available through a hyperlink located on the investor relations page of
our website, at http://www.arotech.com/compro/investor.html.
The Compensation Committee consists of Dr. Eastman (Chair) and Messrs. Marrus
and Sloyer, all of whom are independent non-employee directors.




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The
Executive and Finance Committee, created in July 2001, exercises the powers of
the Board during the intervals between meetings of the Board, in the management
of the property, business and affairs of the Company (except with respect to
certain extraordinary transactions). The Executive and Finance Committee
consists of Messrs. Ehrlich (Chair), Esses, Marrus and Sloyer.




The
Nominating Committee, created in March 2003, identifies and proposes
candidates to serve as members of the Board of Directors. Proposed nominees for
membership on the Board of Directors submitted in writing by stockholders to the
Secretary of the Companywill be brought to the attention of the
Nominating Committee. The Nominating Committee consists of Mr. Marrus (Chair),
Dr. Eastman and Prof. Jones, all of whom are “independent,” as independence is
defined in Rule 4200(a)(15) of the National Association of Securities Dealers’
listing standards and under Item 7(d)(3)(iv) of Schedule 14A of the proxy rules
under the Exchange Act. The Nominating Committee operates under a formal charter
that governs its duties. The Nominating Committee’s charter is publicly
available through a hyperlink located on the investor relations page of our
website, at http://www.arotech.com/compro/investor.html.




Code
of Ethics




We have
adopted a Code of Ethics, as required by Nasdaq listing standards and the rules
of the SEC, that applies to our principal executive officer, our principal
financial officer, and our principal accounting officer. The Code of Ethics is
publicly available through a hyperlink located on the investor relations page of
our website, at http://www.arotech.com/compro/investor.html.
If we make substantive amendments to the Code of Ethics or grant any waiver,
including any implicit waiver, that applies to anyone subject to the Code of
Ethics, we will disclose the nature of such amendment or waiver on the website
or in a report on Form 8-K in accordance with applicable Nasdaq and SEC
rules.




Code
of Conduct




We have
adopted a general Code of Conduct, as required by Nasdaq listing
standards




and the
rules of the SEC, that applies to all of our employees. The Code of Conduct is
publicly




available
through a hyperlink located on the investor relations page of our website, at
http://www.arotech.com/compro/investor.html.




Whistleblower
Policy




We have
adopted a Whistleblower Policy, as required by Nasdaq listing standards, in
order to ensure compliance with the provisions of the Sarbanes-Oxley Act of
2002. The Whistleblower Policy is publicly available through a hyperlink located
on the investor relations page of our website, at http://www.arotech.com/compro/investor.html.
Employees with complaints about our compliance with applicable legal and
regulatory requirements relating to accounting, auditing and internal control
matters may submit their complaints in person, by mail or other written
communication or by telephone to our Complaint Administrator. The Complaint
Administrator can be contacted anonymously, by submitting the form located on
our corporate website at http://arotech.com/compro/complaint.html.
Complaints sent in this manner will automatically be stripped of all
computer-encoded information identifying the originating e-mail address, and
will then automatically be forwarded to the Complaint Administrator’s regular
e-mail address at Arotech.




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Director
Compensation




Non-employee
members of our Board of Directors are entitled to a cash retainer of $7,000
(plus expenses) per quarter, plus $500 per quarter for each committee on which
such outside directors serve. The members of our Board of Directors voluntarily
agreed to reduce their basic cash retainer fees during 2009 to $4,000 per
quarter, plus $500 per quarter for each committee on which such outside
directors serve. The Chairman of the Audit Committee receives an additional
retainer of $1,500 per quarter, and the Chairman of the Compensation Committee
receives an additional retainer of $1,000 per quarter. No per-meeting fees are
paid. In addition, we have adopted a Non-Employee Director Equity Compensation
Plan, pursuant to which non-employee directors receive an initial grant of a
number of restricted shares having a fair market value on the date of grant
equal to $25,000 upon their election as a director, and an annual grant on March
31 of each year of a number of restricted shares having a fair market value on
the date of grant equal to $15,000. Each grant of restricted stock shall become
free of restrictions in three equal installments on each of the first, second
and third anniversaries of the grant, unless the director resigns from the Board
prior to such vesting. Restrictions lapse automatically in the event of a
director being removed for service other than for cause, or being nominated as a
director but failing to be elected, or death, disability or mandatory
retirement. Furthermore, all restrictions lapse prior to the consummation of a
merger or consolidation involving us, our liquidation or dissolution, any sale
of substantially all of our assets or any other transaction or series of related
transactions as a result of which a single person or several persons acting in
concert own a majority of our then-outstanding common stock.




The
following table shows the compensation earned or received by each of our
non-officer directors for the year ended December 31, 2009:




DIRECTOR
COMPENSATION




Name
                              
                              Fees
      Earned or
                                Paid
      in Cash
                                ($)
                              
                              
                              Stock
      Awards(1)
                                ($)
                              
                              
                              Total
                                ($)Dr.
      Jay M. Eastman
                              
                              $
                              22,000
                              
                              
                              $
                              15,403
                              (2)
                              
                              $
                              37,403Edward
      J. Borey
                              
                              $
                              20,000
                              
                              
                              $
                              15,403
                              (3)
                              
                              $
                              35,403Seymour
      Jones
                              
                              $
                              24,000
                              
                              
                              $
                              15,403
                              (4)
                              
                              $
                              39,403Elliot
      Sloyer
                              
                              $
                              22,000
                              
                              
                              $
                              17,978
                              (5)
                              
                              $
                              39,978Michael
      E.
      Marrus
                              
                              $
                              22,000
                              
                              
                              $
                              17,978
                              (6)
                              
                              $
                              39,978Arthur
      S. Leibowitz(7)
                              
                              $
                              9,000
                              
                              
                              $
                              6,875
                              (7)
                              
                              $
                              15,875
 
 (1)
              This
      column reflects the compensation cost for the year ended December 31, 2009
      of each director’s restricted stock, calculated in accordance with FASB
      ASC 505-50.(2)
              As
      of December 31, 2009, Dr. Eastman held 29,661 restricted shares of our
      common stock.(3)
              As
      of December 31, 2009, Mr. Borey held 29,661 restricted shares of our
      common stock.(4)
              As
      of December 31, 2009, Prof. Jones held 29,661 restricted shares of our
      common stock.(5)
              As
      of December 31, 2009, Mr. Sloyer held 32,951 restricted shares of our
      common stock.(6)
              As
      of December 31, 2009, Mr. Marrus held 32,951 restricted shares of our
      common stock.(7)
              Mr.
      Leibowitz was appointed as a director on June 29, 2009. As of December 31,
      2009, Mr. Leibowitz held 14,970 restricted shares of our common
      stock.




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Significant
Employees




Our
significant employees as of February 28, 2010, and their ages as of December 31,
2009, are as follows:




Name
                
                Age
                
                PositionDean
      Krutty
                
                
                44
                
                President,
      Training and Simulation DivisionJonathan
      Whartman
                
                
                55
                
                President,
      Armor DivisionRonen
      Badichi
                
                
                44
                
                President,
      Battery and Power Systems DivisionYaakov
      Har-Oz
                
                
                52
                
                Senior
      Vice President, General Counsel and SecretaryWilliam
      Graham
                
                
                50
                
                Vice
      President of Government AffairsNorman
      Johnson
                
                
                57
                
                Controller




Dean Krutty became President
of the Simulation Division in January 2005, after having spent the prior
thirteen years as a member of the FAAC management team. He began his career at
FAAC as an electrical engineer in FAAC’s part task trainer division and most
recently served as FAAC’s Director of Military Operations,. He also has
significant experience managing programs in the training and simulation
industry. Mr. Krutty holds a B.S. in electrical engineering from the Michigan
State University.




Jonathan Whartman has been
Senior Vice President since December 2000 and President of our Armor Division
since January 2008. Mr. Whartman was Vice President of Marketing from 1994 to
December 2000, and from 1991 until 1994, Mr. Whartman was our Director of
Special Projects. Mr. Whartman was also Director of Marketing of Amtec from its
inception in 1989 through the merger of Amtec into Arotech in 1991. Before
joining Amtec, Mr. Whartman was Manager of Program Management at Luz, Program
Manager for desktop publishing at ITT Qume in San Jose, California from 1986 to
1987, and Marketing Director at Kidron Digital Systems, an Israeli computer
developer, from 1982 to 1986. Mr. Whartman holds a B.A. in Economics and an
M.B.A. from the Hebrew University, Jerusalem, Israel.




Ronen Badichi became the
General Manager of Epsilor Electronic Industries in May 2005 and the President
of our Battery Division in December 2007. Prior to joining Epsilor, Mr. Badichi
served since 1999 as the General Manager of Maoz Industries, a high end supplier
of displays to the aviation industry. Prior thereto, Mr. Badichi was a project
manager at BAE Systems and served as the F-16 Avionics Integration manager in
the Israeli Air Force, with the rank of Captain. Mr. Badichi holds a B.Sc. in
Physics and Electro-Optic Engineering from the Lev Institute of Technology in
Jerusalem.




Yaakov Har-Oz has served as
our Vice President and General Counsel since October 2000 and as our corporate
Secretary since December 2000; in December 2005 Mr. Har-Oz was promoted to
Senior Vice President. From 1994 until October 2000, Mr. Har-Oz was a partner in
the Jerusalem law firm of Ben-Ze’ev, Hacohen & Co. Prior to moving to Israel
in 1993, he was an administrative law judge and in private law practice in New
York. Mr. Har-Oz holds a B.A. from Brandeis University in Waltham, Massachusetts
and a J.D. from Vanderbilt Law School (where he was an editor of the law review)
in Nashville, Tennessee. He is a member of the New York bar and the Israel
Chamber of Ad­vocates.




56
 Table of Contents





William Grahamjoined us as
Vice President of Government Affairs in January 2005, after twenty years of
military service highlighted by multiple commands and six years of Pentagon
experience. During this time, Mr. Graham interacted continuously with Senators
and their staffs to develop and execute the strategy for presenting the $300+
billion defense budget. After retiring from the Army as a Colonel in 2001, Mr.
Graham joined Washington Operations for Time Domain Corporation (TDC) as a
Director to help the company secure Pentagon contracts and congressional support
for those programs. Mr. Graham completed a B.S. in General Engineering at the
U.S. Military Academy (West Point) in 1980, earned his masters from Central
Michigan University in 1991 and was graduated from the U.S. Army War College in
1999.




Norman Johnson has served as
our Controller and as our chief accounting officer since August 2006. Prior to
joining Arotech, Mr. Johnson was the Corporate Controller with Catuity Inc., a
Nasdaq-listed provider of loyalty and gift card solutions. Prior to Catuity, he
was with the McCoig Group, a Detroit based holding company, and from March 2000
to August 2004 he was the Corporate Controller of Learning Care Group Inc., a
$250 million Nasdaq-listed provider of child care and educational services. Mr.
Johnson holds a B.S. in Accounting from Central Michigan University in Mt.
Pleasant, Michigan.




Section
16(a) Beneficial Ownership Reporting Compliance




Under the
securities laws of the United States, our directors, certain of our officers and
any persons holding more than ten percent of our common stock are required to
report their ownership of our common stock and any changes in that ownership to
the Securities and Exchange Commission. Specific due dates for these reports
have been established and we are required to report any failure to file by these
dates during 2009. We are not aware of any instances during 2008, not previously
disclosed by us, where such “reporting persons” failed to file the required
reports on or before the specified dates.




ITEM
      11.
            EXECUTIVE COMPENSATION




Cash
and Other Compensation




Summary
Compensation Table




The
following table, which should be read in conjunction with the explanations
provided below, shows the compensation that we paid (or accrued) to our
executive officers during the fiscal years ended December 31, 2009 and
2008:




SUMMARY
COMPENSATION TABLE(1)




Name
      and Principal Position
                                                              
                                                              Year
                                                              
                                                              Salary
                                                                ($)
                                                              
                                                              
                                                              Bonus
                                                                ($)
                                                              
                                                              
                                                              Stock
                                                                Awards(2)
                                                                ($)
                                                              
                                                              
                                                              All
      Other
                                                                Compensation
                                                                ($)
                                                              
                                                              
                                                              
                                                              Total
                                                                ($)Robert
      S. Ehrlich
                                                                Chairman,
      Chief Executive Officer and a director
                                                              
                                                              2009
                                                              
                                                              $
                                                              400,000
                                                              
                                                              
                                                              $
                                                              200,000
                                                              
                                                              
                                                              $
                                                              235,807
                                                              
                                                              
                                                              $
                                                              135,057
                                                              
                                                              (3)
                                                              
                                                              $
                                                              970,8642008
                                                              
                                                              $
                                                              400,000
                                                              
                                                              
                                                              $
                                                              90,000
                                                              
                                                              
                                                              $
                                                              442,095
                                                              
                                                              
                                                              $
                                                              518,017
                                                              
                                                              (4)
                                                              
                                                              $
                                                              1,450,112Thomas
      J. Paup
                                                                Vice
      President – Finance and Chief Financial Officer
                                                              
                                                              2009
                                                              
                                                              $
                                                              169,600
                                                              
                                                              
                                                              $
                                                              84,800
                                                              
                                                              
                                                              $
                                                              81,233
                                                              
                                                              
                                                              $
                                                              (615
                                                              )
                                                              (5)
                                                              
                                                              $
                                                              335,0182008
                                                              
                                                              $
                                                              160,000
                                                              
                                                              
                                                              $
                                                              48,000
                                                              
                                                              
                                                              $
                                                              78,874
                                                              
                                                              
                                                              $
                                                              6,188
                                                              
                                                              (5)
                                                              
                                                              $
                                                              293,062Steven
      Esses
                                                                President,
      Chief Operating Officer and a director
                                                              
                                                              2009
                                                              
                                                              $
                                                              141,396
                                                              (6)
                                                              
                                                              $
                                                              160,000
                                                              
                                                              
                                                              $
                                                              232,532
                                                              
                                                              
                                                              $
                                                              129,190
                                                              
                                                              (7)
                                                              
                                                              $
                                                              663,1182008
                                                              
                                                              $
                                                              141,396
                                                              (8)
                                                              
                                                              $
                                                              75,000
                                                              
                                                              
                                                              $
                                                              164,798
                                                              
                                                              
                                                              $
                                                              136,588
                                                              
                                                              (9)
                                                              
                                                              $
                                                              517,782





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(1)
            We
      paid the amounts reported for each named executive officer in U.S. dollars
      and/or New Israeli Shekels (NIS). We have translated amounts paid in NIS
      into U.S. dollars at the exchange rate of NIS into U.S. dollars at the
      time of payment or accrual, except that certain items are pursuant to
      corporate policy paid at a set exchange rate that may be higher than the
      actual exchange rate on the date of payment. The difference, which was a
      positive number in 2008 and 2009, has been reported under “All Other
      Compensation,” below.(2)
            Reflects
      the value of restricted stock awards granted to our executive officers
      based on the compensation cost of the award computed in accordance with
      Financial Accounting Standards Board Statement of Financial Accounting
      Standards No. 123 (revised 2004), Share-Based Payment, which we refer to
      as FASB ASC 505-50. See Note 2.p. of the Notes to Consolidated Financial
      Statements. The number of shares of restricted stock received by our
      executive officers pursuant to such awards in 2009, vesting one-half after
      six months and one-half after one year (based only on tenure), was as
      follows: Mr. Ehrlich, 80,000; Mr. Paup, 42,917; Mr. Esses, 140,000. The
      first tranche of these shares vested in December 2009. There were no
      restricted stock awards granted in 2008. The number of shares of
      restricted stock received by our executive officers pursuant to such
      awards in 2007, vesting in equal amounts over three years (one-half based
      on tenure and performance criteria and one-half based only on tenure), was
      as follows: Mr. Ehrlich, 240,000; Mr. Paup, 43,125; Mr. Esses, 120,000. Of
      these amounts, the performance-based awards for 2008 and 2009 were not
      earned and were cancelled. The number of shares of restricted stock
      received by our executive officers pursuant to such awards in 2006,
      vesting one-quarter immediately and the remaining three-quarters in equal
      amounts over three years (one-half based on tenure and performance
      criteria and one-half based only on tenure), was as follows: Mr. Ehrlich,
      200,000; Mr. Paup, 53,125; Mr. Esses, 100,000. Of these amounts, the
      performance-based awards for 2008 and 2009 were not earned and were
      cancelled. Additionally, 66,666 restricted shares granted to Mr. Ehrlich
      pursuant to the terms of his employment agreement vested based only on
      tenure. See “Employment Agreements – Robert S. Ehrlich,”
      below.(3)
            Of
      this amount, $65,808 represents payments to Israeli pension and education
      funds; $(117,669) represents the change in our accrual for severance pay
      that will be payable to Mr. Ehrlich upon his leaving our employ other than
      if he is terminated for cause, such as a breach of trust; $59,149
      represents the effect of exchange rate differences on salary payments;
      $54,215 represents sick pay redemption; $41,826 represents tax
      reimbursements and $31,726 represents other normal or mandated Israeli
      benefits.(4)
            Of
      this amount, $82,802 represents payments to Israeli pension and education
      funds; $155,943 represents the change in our accrual for severance pay
      that will be payable to Mr. Ehrlich upon his leaving our employ other than
      if he is terminated for cause, such as a breach of
      trust;  $176,442 represents the effect of exchange rate
      differences on salary and bonus payments; $20,397 represents vacation pay
      redemption; $46,218 represents tax reimbursements; and $36,215 represents
      other normal or mandated Israeli benefits..(5)
            Represents
      the increase (decrease) in our accrual for Mr. Paup for accrued but unused
      vacation days.(6)
            Does
      not include $178,356 that we paid in consulting fees to Sampen
      Corporation, a New York corporation owned by members of Steven Esses’s
      immediate family, from which Mr. Esses receives a salary. See “Item 13.
      Certain Relationships and Related Transactions – Consulting Agreement with
      Sampen Corporation,” below.(7)
            Of
      this amount, $28,314 represents payments to Israeli pension and education
      funds; $4,155 represents the change in our accrual for severance pay that
      will be payable to Mr. Esses upon his leaving our employ other than if he
      is terminated for cause, such as a breach of trust; $20,907 represents the
      effect of exchange rate differences on salary payments; $19,143 represents
      sick pay redemption; $34,254 represents tax reimbursements; and $22,417
      represents other normal or mandated Israeli benefits.(8)
            Does
      not include $178,424 that we paid in consulting fees to Sampen
      Corporation, a New York corporation owned by members of Steven Esses’s
      immediate family, from which Mr. Esses receives a salary. See “Item 13.
      Certain Relationships and Related Transactions – Consulting Agreement with
      Sampen Corporation,” below.(9)
            Of
      this amount, $29,671 represents payments to Israeli pension and education
      funds; $(4,641) represents the change in our accrual for severance pay
      that will be payable to Mr. Esses upon his leaving our employ other than
      if he is terminated for cause, such as a breach of trust; $42,701
      represents the effect of exchange rate differences on salary and bonus
      payments; $7,993 represents vacation pay redemption; $36,186 represents
      tax reimbursements; and $24,678 represents other normal or mandated
      Israeli benefits.




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Executive
Loans




In 1999,
2000 and 2002, we extended certain loans to certain of our Named Executive
Officers. These loans are summarized in the following table, and are further
described under “Item 13. Certain Relationships and Related Transactions –
Officer Loans,” below.




Name
      of Borrower
                    
                    Date
      of Loan
                    
                    Original
                      Principal
                      Amount
      of Loan
                    
                    
                    Amount
                      Outstanding
                      as
      of 12/31/09
                    
                    Terms
      of LoanRobert
      S. Ehrlich
                    
                    12/28/1999
                    
                    $
                    167,975
                    
                    
                    $
                    –
                    
                    Ten-year
      non-recourse loan to purchase our stock, secured by the shares of stock
      purchased.Robert
      S. Ehrlich
                    
                    02/09/2000
                    
                    $
                    329,163
                    
                    
                    $
                    452,995
                    
                    Twenty-five-year
      non-recourse loan to purchase our stock, secured by the shares of stock
      purchased.Robert
      S. Ehrlich
                    
                    06/10/2002
                    
                    $
                    36,500
                    
                    
                    $
                    46,593
                    
                    Twenty-five-year
      non-recourse loan to purchase our stock, secured by the shares of stock
      purchased.




Plan-Based
Awards




Grants
of Stock Options




We did
not grant any stock options to our executive officers during 2009.




Grants
of Restricted Stock




During
2009, the Compensation Committee approved the grant of a total of 262,917 shares
of restricted stock to our executive officers. Pursuant to the terms of the
grant, the stock vests one-half after six months and one-half after one year
(based only on tenure).




The table
below sets forth each equity award granted to our executive officers during the
year ended December 31, 2009.




GRANTS
OF PLAN-BASED AWARDS




Name
                                              Grant
      Date
                                              
                                              All
      Other StockAwards: Number of Shares of Stocks(1)
                                              
                                              
                                              Grant
      Date Fair Value of Stock and Option AwardsRobert
      S. Ehrlich
                                              06/29/2009
                                              
                                              
                                              80,000
                                              
                                              
                                              $
                                              133,600Steven
      Esses
                                              06/29/2009
                                              
                                              
                                              140,000
                                              
                                              
                                              $
                                              233,800Thomas
      J. Paup
                                              06/29/2009
                                              
                                              
                                              42,917
                                              
                                              
                                              $
                                              71,671
  (1)  The
restricted shares vest based solely based on continued employment during the
performance period, 50% six months after grant and 50% one year after
grant.


Stock
Option Exercises and Vesting of Restricted Stock Awards




Our
executive officers did not exercise any stock options during 2009. The following
table presents awards of restricted stock that vested during the year ended
December 31, 2009.




59
 Table of Contents


STOCK
VESTED




Name
                    
                    Number
      of Shares
                      Acquired
      on Vesting
                      (#)
                    
                    
                    Value
      Realized
                      on
      Vesting(1)
                      ($)Robert
      S.
      Ehrlich
                    
                    
                    146,666
                    
                    
                    $
                    249,332Steven
      Esses
                    
                    
                    115,000
                    
                    
                    $
                    195,500Thomas
      J.
      Paup
                    
                    
                    42,917
                    
                    
                    $
                    72,959
  (1) 
Reflects
the aggregate market value of the shares of restricted stock determined based on
a per share price of $1.70, the closing price of our common stock on the Nasdaq
Global Market on December 31, 2009, which was the last trading day of
2009.




Outstanding
Equity Awards at Fiscal Year-End




The table
below sets forth information for our executive officers with respect to option
and restricted stock values at the end of the fiscal year ended December 31,
2009.




OUTSTANDING
EQUITY AWARDS AT FISCAL YEAR-END





Name
                                                        
                                                        Option
      Awards
                                                        
                                                        Stock
      AwardsNumber
      of Securities
                                                          Underlying
                                                          Un­exercised
      Options(1)
                                                          (#)
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        Equity
      Incentive
                                                          Plan
      AwardsExercisable
                                                        
                                                        
                                                        Unexercisable
                                                        
                                                        
                                                        Option
                                                          Exercise
                                                          Price
                                                          ($)
                                                        
                                                        Option
                                                          Expiration
                                                          Date
                                                        
                                                        Number
      of
                                                          Shares
      that
                                                          Have
      Not
                                                          Vested
                                                          (#)
                                                        
                                                        
                                                        Market
      Value
                                                          of
      Shares that
                                                          Have
      Not
                                                          Vested(2)
                                                          ($)
                                                        
                                                        
                                                        Number
      of
                                                          Unearned
                                                          Shares
      that
                                                          Have
      Not
                                                          Vested
                                                          (#)
                                                        
                                                        
                                                        Market
      Value
                                                          of
      Unearned
                                                          Shares
      that
                                                          Have
      Not
                                                          Vested(2)
                                                          ($)Robert
      S. Ehrlich
                                                        
                                                        
                                                        5,178
                                                        
                                                        
                                                        
                                                        0
                                                        
                                                        
                                                        $
                                                        5.46
                                                        
                                                        12/31/11
                                                        
                                                        
                                                        40,000
                                                        
                                                        
                                                        $
                                                        68,000
                                                        
                                                        
                                                        
                                                        –
                                                        
                                                        
                                                        
                                                        –4,687
                                                        
                                                        
                                                        
                                                        0
                                                        
                                                        
                                                        $
                                                        5.46
                                                        
                                                        04/01/121,116
                                                        
                                                        
                                                        
                                                        0
                                                        
                                                        
                                                        $
                                                        5.46
                                                        
                                                        07/01/124,687
                                                        
                                                        
                                                        
                                                        0
                                                        
                                                        
                                                        $
                                                        5.46
                                                        
                                                        10/01/126,294
                                                        
                                                        
                                                        
                                                        0
                                                        
                                                        
                                                        $
                                                        5.46
                                                        
                                                        01/01/13Steven
      Esses
                                                        
                                                        
                                                        714
                                                        
                                                        
                                                        
                                                        0
                                                        
                                                        
                                                        $
                                                        8.54
                                                        
                                                        12/31/12
                                                        
                                                        
                                                        145,000
                                                        
                                                        
                                                        $
                                                        246,500
                                                        
                                                        
                                                        
                                                        25,000
                                                        
                                                        
                                                        $
                                                        42,5001,785
                                                        
                                                        
                                                        
                                                        0
                                                        
                                                        
                                                        $
                                                        11.62
                                                        
                                                        07/22/12Thomas
      J. Paup
                                                        
                                                        
                                                        –
                                                        
                                                        
                                                        
                                                        –
                                                        
                                                        
                                                        
                                                        –
                                                        
                                                        –
                                                        
                                                        
                                                        32,291
                                                        
                                                        
                                                        $
                                                        54,895
                                                        
                                                        
                                                        
                                                        10,833
                                                        
                                                        
                                                        $
                                                        18,416
  
 (1)
                    All
      options in the table are vested.(2)
                    Reflects
      the aggregate market value of the shares of restricted stock determined
      based on a per share price of $1.70, the closing price of our common stock
      on the Nasdaq Global Market on December 31, 2009, which was the last
      trading day of
2009.




Employment
Contracts




Robert
S. Ehrlich




Mr.
Ehrlich is party to an employment agreement with us executed in April 2007. The
term of this employment agreement as extended expires on December 31,
2011.




The
employment agreement provides for a base salary of $33,333 per month, as
adjusted annually for Israeli inflation and devaluation of the Israeli shekel
against the U.S. dollar, if any. Mr. Ehrlich has waived this adjustment for
2008, 2009 and 2010. Additionally, the board may at its discretion raise Mr.
Ehrlich’s base salary. The employment agreement also granted Mr. Ehrlich a
retention bonus in the amount of 200,000 shares of restricted stock, which
vested one-third annually on December 31, 2007, 2008 and 2009.




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The
employment agreement provides that we will pay an annual bonus, on a sliding
scale, in an amount equal to 35% of Mr. Ehrlich’s annual base salary then in
effect if the results we actually attain for the year in question are 90% or
more of the amount we budgeted at the beginning of the year, up to a maximum of
75% of his annual base salary then in effect if the results we actually attain
for the year in question are 120% or more of the amount we budgeted at the
beginning of the year. For 2008 and 2009, the Compensation Committee choose
financial targets for determining eligibility for the above-referenced cash
incentive bonus that are determined 50% on the achievement of set budgetary
forecast targets for revenue growth and 50% on the achievement of set budgetary
forecast targets for adjusted EBITDA, a non-GAAP measurement. We did not achieve
the bonus targets set by the Compensation Committee for 2008, and accordingly
the incentive bonus for 2008 was not paid. We did achieve the bonus targets set
by the Compensation Committee for 2009, and accordingly the incentive bonus for
2009 was paid. New bonus targets will be chosen for 2010 based upon future
budgetary forecasts.




The
employment agreement also contains various benefits customary in Israel for
senior executives (please see “Item 1. Business – Employees,” above), tax and
financial planning expenses and an automobile, and contain confidentiality and
non-competition covenants. Pursuant to the employment agreements, we granted Mr.
Ehrlich demand and “piggyback” registration rights covering shares of our common
stock held by him.




We can
terminate Mr. Ehrlich’s employment agreement in the event of death or disability
or for “Cause” (defined as conviction of certain crimes, willful failure to
carry out directives of our board of directors or gross negligence or willful
misconduct). Mr. Ehrlich has the right to terminate his employment upon a change
in our control or for “Good Reason,” which is defined to include adverse changes
in employment status or compensation, our insolvency, material breaches and
certain other events. Additionally, Mr. Ehrlich may terminate his agreement for
any reason upon 120 days’ notice.




Upon
termination of employment, the employment agreement provides for payment of all
accrued and unpaid compensation and benefits (including under most circumstances
Israeli statutory severance, described above), and (unless we have terminated
the agreement for Cause or Mr. Ehrlich has terminated the agreement without Good
Reason and without giving us 120 days’ notice of termination) bonuses (to the
extent earned) due for the year in which employment is terminated and severance
pay in the amount of up to $1,625,400, except that in the event of termination
by Mr. Ehrlich on 120 days’ prior notice, the severance pay will be only that
amount that has vested (meaning that it had been scheduled to have been
deposited in trust as described in the next paragraph). Furthermore, in respect
of any termination by us other than termination for Cause or termination of the
agreement due to Mr. Ehrlich’s death or disability, or by Mr. Ehrlich other than
for Good Reason, all outstanding options and all restricted shares will be fully
vested. Restricted shares that have vested prior to the date of termination are
not forfeited under any circumstances, including termination for
Cause.




A table
describing the payments that would have been due to Mr. Ehrlich under his
employment agreement had Mr. Ehrlich’s employment with us been terminated at the
end of 2009 under various circumstances (pursuant to the terms of his
then-current employment agreement) appears under “Potential Payments and
Benefits upon Termination of Employment – Robert S. Ehrlich,”
below.




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Pursuant
to the terms of our employment agreement with Mr. Ehrlich, funds to secure
payment of Mr. Ehrlich’s contractual severance are to be deposited into accounts
for his benefit, with payments to be made pursuant to an agreed-upon schedule.
These accounts are in our name and continue to be owned by us, and we benefit
from all gains and bear the risk of all losses resulting from deposits of these
funds. Additionally, in April 2009, we, with the agreement of Mr. Ehrlich,
funded an additional portion of his severance security by means of
issuing to him, in trust, restricted stock having a value (based on the closing
price of our stock on the Nasdaq Stock Market on the date on which Mr. Ehrlich
and our board of directors agreed on this arrangement) of $240,000, a total of
328,767 shares. We agreed with Mr. Ehrlich that the economic risk of gain or
loss on these shares is to be borne by Mr. Ehrlich. Should Mr. Ehrlich leave our
employ under circumstances in which he is not entitled to his severance package
(primarily, termination for Cause as defined in his employment agreement), these
shares would be returned to us for cancellation.




Steven
Esses




Mr. Esses
is party to an employment agreement with EFL and guaranteed by us executed in
April 2008, effective as of January 1, 2008. The term of this employment
agreement as extended expires on December 31, 2011.




The
employment agreement provides for a base salary of NIS 53,023.50 per month
(approximately $13,787 at the rate of exchange in effect on January 1, 2008),
with an automatic annual 6% increase to adjust for inflation. Mr. Esses waived
his inflation adjustment for 2008. Additionally, the board may at its discretion
raise Mr. Esses’s base salary. The agreement also provides for a stock retention
bonus of 200,000 shares of restricted stock, vesting (i) 25,000 shares on
December 31, 2008, 25,000 shares on December 31, 2009, and 75,000 shares on
December 31, 2010, with each such vesting being contingent solely on Mr. Esses
being employed by us on the scheduled vesting date, and (ii) 25,000 shares on
December 31, 2008, 25,000 shares on December 31, 2009, and 25,000 shares on
December 31, 2010, with each such vesting being contingent on Mr. Esses being
employed by us on the scheduled vesting date and on performance criteria to be
established by the Compensation Committee of our Board of Directors. We did not
achieve the share vesting targets set by the Compensation Committee for 2008 or
2009, and accordingly the 25,000 performance shares for each of 2008 and 2009
were not vested. The agreement further provides for a cash retention bonus of
NIS 900,000 (approximately $234,000 at the rate of exchange in effect on January
1, 2008).




The
employment agreement provides that if the results we actually attain in a given
year are at least 90% of the amount we budgeted at the beginning of the year, we
will pay a bonus, on a sliding scale, in an amount equal to a minimum of 20% of
Mr. Esses’s annual base salary then in effect, up to a maximum of 75% of his
annual base salary then in effect if the results we actually attain for the year
in question are 120% or more of the amount we budgeted at the beginning of the
year. For 2008 and 2009, the Compensation Committee choose financial targets for
determining eligibility for the above-referenced cash incentive bonus that are
determined 50% on the achievement of set budgetary forecast targets for revenue
growth and 50% on the achievement of set budgetary forecast targets for adjusted
EBITDA, a non-GAAP measurement. We did not achieve the bonus targets set by the
Compensation Committee for 2008, and accordingly the incentive bonus for 2008
was not paid. We did achieve the bonus targets set by the Compensation Committee
for 2009, and accordingly the incentive bonus for 2009 was paid. New bonus
targets will be chosen for 2010 based upon future budgetary
forecasts.




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The
employment agreement also contains various benefits customary in Israel for
senior executives (please see “Item 1. Business – Employees,” above), tax and
financial planning expenses and an automobile, and contain confidentiality and
non-competition covenants. Pursuant to the employment agreements, we granted Mr.
Esses demand and “piggyback” registration rights covering shares of our common
stock held by him.




We can
terminate Mr. Esses’s employment agreement in the event of death or disability
or for “Cause” (defined as conviction of certain crimes, willful failure to
carry out directives of our board of directors or gross negligence or willful
misconduct). Mr. Esses has the right to terminate his employment upon a change
in our control or for “Good Reason,” which is defined to include adverse changes
in employment status or compensation, our insolvency, material breaches and
certain other events. Additionally, Mr. Esses may retire (after age 65), retire
early (after age 55) or terminate his agreement for any reason upon 150 days’
notice.




Upon
termination of employment, the employment agreement provides for payment of all
accrued and unpaid compensation, and (unless we have terminated the agreement
for Cause or Mr. Esses has terminated the agreement without Good Reason and
without giving us 150 days’ notice of termination) bonuses (to the extent
earned) due for the year in which employment is terminated (in an amount of not
less than 20% of base salary) and severance pay, as follows: (A) before the end
of the first year of the agreement, a total of (i) $30,400 plus (ii) eighteen
(18) times monthly salary; (B) before the end of the second year of the
agreement, a total of (i) $56,000 plus (ii) twenty (20) times monthly salary;
(C) before the end of the third year of the agreement, a total of (i) $81,600
plus (ii) twenty-two (22) times monthly salary; or (D) at or after the end of
the third year of the agreement, a total of (i) $107,200 plus (ii) twenty-four
(24) times monthly salary. In all of the above cases, “base salary” and “monthly
salary” mean what Mr. Esses’s salary would have been had he not waived his
inflation adjustment. Furthermore, Mr. Esses will receive, in respect of all
benefits, an additional sum in the amount of (i) $75,000, in the case of
termination due to disability, Good Reason, death, or non-renewal, or (ii)
$150,000, in the case of termination due to early retirement, retirement, change
of control or change of location. Additionally, in respect of any termination
due to a change of control or a change in the primary location from which Mr.
Esses shall have conducted his business activities during the 60 days prior to
such change, all outstanding options and all restricted shares will be fully
vested. Restricted shares that have vested prior to the date of termination are
not forfeited under any circumstances, including termination for
Cause.




A table
describing the payments that would have been due to Mr. Esses under his
employment agreement had Mr. Esses’s employment with us been terminated at the
end of 2009 under various circumstances appears under “Potential Payments and
Benefits upon Termination of Employment – Steven Esses,” below.




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Pursuant
to the terms of our employment agreement with Mr. Esses, funds to secure payment
of Mr. Esses’s contractual severance are to be deposited into accounts for his
benefit, with payments to be made pursuant to an agreed-upon schedule. These
accounts are in our name and continue to be owned by us, and we benefit from all
gains and bear the risk of all losses resulting from deposits of these
funds. Additionally, in April 2009, we, with the agreement of Mr. Esses,
funded an additional portion of his severance security by means of
issuing to him, in trust, restricted stock having a value (based on the closing
price of our stock on the Nasdaq Stock Market on the date on which Mr. Esses and
our board of directors agreed on this arrangement) of $200,000, a total of
273,973 shares. We agreed with Mr. Esses that the economic risk of gain or loss
on these shares is to be borne by Mr. Esses. Should Mr. Esses leave our employ
under circumstances in which he is not entitled to his severance package
(primarily, termination for Cause as defined in his employment agreement), these
shares would be returned to us for cancellation.




See also
“Item 13. Certain Relationships and Related Transactions – Consulting Agreement
with Sampen Corporation,” below.




Thomas
J. Paup




Mr. Paup
is party to an amended and restated employment agreement with us executed in
April 2008, effective as of January 1, 2008, having a term running until
December 31, 2011. Under the terms of his employment agreement, Mr. Paup is
entitled to receive a base salary of $160,000 per annum, with increases of 6%
per year thereafter to take account of inflation, and will be eligible for a
bonus with a target equal to between 20% and 50% of the base salary. The actual
bonus payout shall be determined based upon the Company’s achievement level
against financial and performance objectives determined by the Compensation
Committee of our Board of Directors. We did not achieve the bonus targets set by
the Compensation Committee for 2008, and accordingly the incentive bonus for
2008 was not paid. We did achieve the bonus targets set by the Compensation
Committee for 2009, and accordingly the incentive bonus for 2009 was paid. New
bonus targets will be chosen for 2010 based upon future budgetary
forecasts.




The
agreement also provides for a stock retention bonus of 65,000 shares of
restricted stock, vesting (i) 10,834 shares on December 31, 2008, 10,833 shares
on December 31, 2009, and 10,833 shares on December 31, 2010, with each such
vesting being contingent solely on Mr. Paup being employed by us on the
scheduled vesting date, and (ii) 10,834 shares on December 31, 2008, 10,833
shares on December 31, 2009, and 10,833 shares on December 31, 2010, with each
such vesting being contingent on Mr. Paup being employed by us on the scheduled
vesting date and on performance criteria to be established by the Compensation
Committee of our Board of Directors. We did not achieve the share vesting
targets set by the Compensation Committee for 2008 or 2009, and accordingly the
10,834 performance shares for each of 2008 and 2009 were not vested. Mr. Paup’s
employment agreement provides that if we terminate his agreement other than for
cause (defined as conviction of certain crimes, willful failure to carry out
directives of our board of directors or gross negligence or willful misconduct),
we must pay Mr. Paup severance in an amount of four times his monthly salary
plus an additional two months’ salary for every year worked during the term of
his agreement, with the maximum severance payable of one year’s salary; these
payments are doubled in the event of termination by reason of a change of
control. Additionally, in respect of any termination due to a change of control,
all outstanding options and all restricted shares will be fully vested.
Restricted shares that have vested prior to the date of termination are not
forfeited under any circumstances, including termination for Cause.




64
 Table of Contents





Others




Other
employees have entered into individual employment agreements with us. These
agreements govern the basic terms of the individual’s employment, such as
salary, vacation, overtime pay, severance arrangements and pension plans.
Subject to Israeli law, which restricts a company’s right to relocate an
employee to a work site farther than sixty kilometers from his or her regular
work site, we have retained the right to transfer certain employees to other
locations and/or positions provided that such transfers do not result in a
decrease in salary or benefits. All of these agreements also contain provisions
governing the confidentiality of information and ownership of intellectual
property learned or created during the course of the employee’s tenure with us.
Under the terms of these provisions, employees must keep confidential all
information regarding our operations (other than information which is already
publicly available) received or learned by the employee during the course of
employment. This provision remains in force for five years after the employee
has left our service. Further, intellectual property created during the course
of the employment relationship belongs to us.




A number
of the individual employment agreements, but not all, contain non-competition
provisions which restrict the employee’s rights to compete against us or work
for an enterprise which competes against us. Such provisions remain in force for
a period of two years after the employee has left our service.




Under the
laws of Israel, an employee of ours who has been dismissed from service, died in
service, retired from service upon attaining retirement age, or left due to poor
health, maternity or certain other reasons, is entitled to severance pay at the
rate of one month’s salary for each year of service, pro rata for partial years of
service. We currently fund this obligation by making monthly payments to
approved private provident funds and by its accrual for severance pay in the
consolidated financial statements. See Note 2.r. of the Notes to the
Consolidated Financial Statements.




Potential
Payments and Benefits upon Termination of Employment




This
section sets forth in tabular form quantitative disclosure regarding estimated
payments and other benefits that would have been received by certain of our
executive officers if their employment had terminated on December 31, 2009 (the
last business day of the fiscal year).




For a
narrative description of the severance and change in control arrangements in the
employment contracts of Messrs. Ehrlich, Esses and Paup, see “– Employment
Contracts,” above. Each of Messrs. Ehrlich and Esses will be eligible to receive
severance payments in excess of accrued but unpaid items only if he signs a
general release of claims.




Robert
S. Ehrlich




The
following table describes the potential payments and benefits upon employment
termination for Robert S. Ehrlich, our Chairman and Chief Executive Officer,
pursuant to applicable law and the terms of his employment agreement with us, as
if his employment had terminated on December 31, 2009 (the last business day of
the fiscal year) under the various scenarios described in the column headings as
explained in the footnotes below.




65
 Table of Contents




ROBERT
      S. EHRLICHPayments
      and Benefits
                    
                    Death
      or
                      Disability(1)
                    
                    
                    Cause(2)
                    
                    
                    Good
                      Reason(3)
                    
                    
                    Change
      of
                      Control(4)
                    
                    
                    Termination
                      at
      Will(5)
                    
                    
                    Other
                      Employee
                      Termination(6)Accrued
      but unpaid:Base
      salary
                    
                    $
                    33,333
                    
                    
                    $
                    33,333
                    
                    
                    $
                    33,333
                    
                    
                    $
                    33,333
                    
                    
                    $
                    33,333
                    
                    
                    $
                    33,333Vacation
                    
                    
                    106,218
                    
                    
                    
                    106,218
                    
                    
                    
                    106,218
                    
                    
                    
                    106,218
                    
                    
                    
                    106,218
                    
                    
                    
                    106,218Recuperation
      pay(7)
                    
                    
                    375
                    
                    
                    
                    375
                    
                    
                    
                    375
                    
                    
                    
                    375
                    
                    
                    
                    375
                    
                    
                    
                    375Benefits:Manager’s
      insurance(8)
                    
                    
                    5,277
                    
                    
                    
                    5,277
                    
                    
                    
                    5,277
                    
                    
                    
                    5,277
                    
                    
                    
                    5,277
                    
                    
                    
                    5,277Continuing
      education fund(9)
                    
                    
                    2,500
                    
                    
                    
                    2,500
                    
                    
                    
                    2,500
                    
                    
                    
                    2,500
                    
                    
                    
                    2,500
                    
                    
                    
                    2,500Tax
      gross-up on automobile
                    
                    
                    1,463
                    
                    
                    
                    –
                    
                    
                    
                    1,463
                    
                    
                    
                    1,463
                    
                    
                    
                    1,463
                    
                    
                    
                    –Contractual
      severance
                    
                    
                    1,625,400
                    
                    
                    
                    –
                    
                    
                    
                    1,625,400
                    
                    
                    
                    1,625,400
                    
                    
                    
                    1,625,400
                    
                    
                    
                    –Statutory
      severance(10)
                    
                    
                    787,937
                    
                    
                    
                    –
                    
                    
                    
                    787,937
                    
                    
                    
                    787,937
                    
                    
                    
                    787,937
                    
                    
                    
                    –Accelerated
      vesting of restricted stock
                    
                    
                    68,000
                    
                    
                    
                    –
                    
                    
                    
                    68,000
                    
                    
                    
                    68,000
                    
                    
                    
                    –
                    
                    
                    
                    –TOTAL:
                    
                    $
                    2,630,503
                    
                    
                    $
                    147,703
                    
                    
                    $
                    2,630,503
                    
                    
                    $
                    2,630,503
                    
                    
                    $
                    2,562,503
                    
                    
                    $
                    147,703


(1)
            “Disability”
      is defined in Mr. Ehrlich’s employment agreement as a physical or mental
      infirmity which impairs the Mr. Ehrlich’s ability to substantially perform
      his duties and which continues for a period of at least 180 consecutive
      days.(2)
            “Cause”
      is defined in Mr. Ehrlich’s employment agreement as (i) conviction for
      fraud, crimes of moral turpitude or other conduct which reflects on us in
      a material and adverse manner; (ii) a willful failure to carry out a
      material directive of our Board of Directors, provided that such
      directive concerned matters within the scope of Mr. Ehrlich’s duties,
      would not give Mr. Ehrlich “Good Reason” to terminate his agreement (see
      footnote 4 below) and was capable of being reasonably and lawfully
      performed; (iii) conviction in a court of competent jurisdiction for
      embezzlement of our funds; and (iv) reckless or willful misconduct that is
      materially harmful to us.(3)
            “Good
      Reason” is defined in Mr. Ehrlich’s employment agreement as (i) a change
      in Mr. Ehrlich’s status, title, position or responsibilities which, in Mr.
      Ehrlich’s reasonable judgment, represents a reduction or demotion in his
      status, title, position or responsibilities as in effect immediately prior
      thereto; (ii) a reduction in Mr. Ehrlich’s base salary; (iii) the failure
      by us to continue in effect any material compensation or benefit plan in
      which Mr. Ehrlich is participating; (iv) our insolvency or the filing (by
      any party, including us) of a petition for our winding-up; (v) any
      material breach by us of any provision of Mr. Ehrlich’s employment
      agreement; (vi) any purported termination of Mr. Ehrlich’s employment for
      cause by us which does not comply with the terms of Mr. Ehrlich’s
      employment agreement; and (vii) any movement of the location where Mr.
      Ehrlich is generally to render his services to us from the Jerusalem/Tel
      Aviv area of Israel.(4)
            “Change
      of Control” is defined in Mr. Ehrlich’s employment agreement as (i) the
      acquisition (other than from us in any public offering or private
      placement of equity securities) by any person or entity of beneficial
      ownership of 20% or more of the combined voting power of our
      then-outstanding voting securities; or (ii) individuals who, as of January
      1, 2000, were members of our Board of Directors (the “Original Board”),
      together with individuals approved by a vote of at least 2/3 of the
      individuals who were members of the Original Board and are then still
      members of our Board, cease for any reason to constitute at least 1/3 of
      our Board; or (iii) approval by our shareholders of a complete winding-up
      or an agreement for the sale or other disposition of all or substantially
      all of our assets.(5)
            “Termination
      at Will” is defined in Mr. Ehrlich’s employment agreement as Mr. Ehrlich
      terminating his employment with us on written notice of at least 120 days
      in advance of the effective date of such termination.(6)
            “Other
      Employee Termination” means a termination by Mr. Ehrlich of his employment
      without giving us the advance notice of 120 days needed to make such a
      termination qualify as a “Termination at Will.”(7)
            Pursuant
      to Israeli law and our customary practice, we pay Mr. Ehrlich in July of
      each year the equivalent of ten days’ “recuperation pay” at the statutory
      rate of NIS 340 (approximately $90) per day.(8)
            Payments
      to managers’ insurance, a benefit customarily given to senior executives
      in Israel, come to a total of 15.83% of base salary, consisting of 8.33%
      for payments to a fund to secure payment of statutory severance
      obligations, 5% for pension and 2.5% for disability. The managers’
      insurance funds reflected in the table do not include the 8.33% payments
      to a fund to secure payment of statutory severance obligations with
      respect to amounts paid prior to December 31, 2009, which funds are
      reflected in the table under the “Statutory severance”
      heading.(9)
            Pursuant
      to Israeli law, we must contribute an amount equal to 7.5% of Mr.
      Ehrlich’s base salary to a continuing education fund, up to the
      permissible tax-exempt salary ceiling according to the income tax
      regulations in effect from time to time. At December 31, 2009, the ceiling
      then in effect was NIS 15,712 (approximately $4,133). In Mr. Ehrlich’s
      case, we have customarily contributed to his continuing education fund in
      excess of the tax-exempt ceiling, and then reimbursed Mr. Ehrlich for the
      tax. The sums in the table reflect this additional contribution and the
      resultant tax reimbursement.(10)
            Under
      Israeli law, employees terminated other than for cause receive severance
      in the amount of one month’s base salary for each year of work, at their
      salary rate at the date of
termination.




Steven
Esses




The
following table describes the potential payments and benefits upon employment
termination for Steven Esses, our President and Chief Operating Officer,
pursuant to applicable law and the terms of his employment agreement with us, as
if his employment had terminated on December 31, 2009 (the last business day of
the fiscal year) under the various scenarios described in the column headings as
explained in the footnotes below.




66
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See also
“Item 13. Certain Relationships and Related Transactions – Consulting Agreement
with Sampen Corporation,” below.




STEVEN
      ESSESPayments
      and Benefits
                
                Non-
                  Renewal(1)
                
                
                Death
      or
                  Disability(2)
                
                
                Cause(3)
                
                
                Good
                  Reason(4)
                
                
                Change
      of
                  Control(5)
                
                
                Change
      of
                  Location(6)
                
                
                Retirement(7)
                
                
                Early
                  Retirement(8)
                
                
                Other
                  Employee
                  Termination(9)Accrued
      but unpaid(10):Base
      salary
                
                $
                11,783
                
                
                $
                11,783
                
                
                $
                11,783
                
                
                $
                11,783
                
                
                $
                11,783
                
                
                $
                11,783
                
                
                $
                11,783
                
                
                $
                11,783
                
                
                $
                11,783Vacation
                
                
                68,455
                
                
                
                68,455
                
                
                
                68,455
                
                
                
                68,455
                
                
                
                68,455
                
                
                
                68,455
                
                
                
                68,455
                
                
                
                68,455
                
                
                
                68,455Sick
      leave(11)
                
                
                17,455
                
                
                
                17,455
                
                
                
                17,455
                
                
                
                17,455
                
                
                
                17,455
                
                
                
                17,455
                
                
                
                17,455
                
                
                
                17,455
                
                
                
                17,455Recuperation
      pay(12)
                
                
                263
                
                
                
                263
                
                
                
                263
                
                
                
                263
                
                
                
                263
                
                
                
                263
                
                
                
                263
                
                
                
                263
                
                
                
                263Benefits:Manager’s
      insurance(13)
                
                
                1,866
                
                
                
                1,866
                
                
                
                1,866
                
                
                
                1,866
                
                
                
                1,866
                
                
                
                1,866
                
                
                
                1,866
                
                
                
                1,866
                
                
                
                1,866Continuing
      education fund(14)
                
                
                844
                
                
                
                844
                
                
                
                844
                
                
                
                844
                
                
                
                844
                
                
                
                844
                
                
                
                844
                
                
                
                844
                
                
                
                844Tax
      gross-up on automobile
                
                
                1,450
                
                
                
                1,450
                
                
                
                –
                
                
                
                1,450
                
                
                
                1,450
                
                
                
                1,450
                
                
                
                1,450
                
                
                
                1,450
                
                
                
                –Contractual
      severance
                
                
                356,432
                
                
                
                356,432
                
                
                
                –
                
                
                
                356,432
                
                
                
                356,432
                
                
                
                356,432
                
                
                
                356,432
                
                
                
                356,432
                
                
                
                –Statutory
      severance(15)
                
                
                85,484
                
                
                
                85,484
                
                
                
                –
                
                
                
                85,484
                
                
                
                85,484
                
                
                
                85,484
                
                
                
                85,484
                
                
                
                85,484
                
                
                
                –Benefits
                
                
                75,000
                
                
                
                75,000
                
                
                
                –
                
                
                
                75,000
                
                
                
                150,000
                
                
                
                150,000
                
                
                
                150,000
                
                
                
                150,000
                
                
                
                –TOTAL:
                
                $
                619,032
                
                
                $
                619,032
                
                
                $
                100,666
                
                
                $
                619,032
                
                
                $
                694,032
                
                
                $
                694,032
                
                
                $
                694,032
                
                
                $
                694,032
                
                
                $
                100,666





(1)
              “Non-renewal”
      is defined in Mr. Esses’s employment agreement as a decision, made with
      written notice of at least 90 days in advance of the effective date of
      such decision, by either us or Mr. Esses not to renew Mr. Esses’s
      employment for an additional two-year term. Pursuant to the terms of Mr.
      Esses’s employment agreement, in the absence of such notice, Mr. Esses’s
      employment agreement automatically renews.(2)
              “Disability”
      is defined in Mr. Esses’s employment agreement as a physical or mental
      infirmity which impairs the Mr. Esses’s ability to substantially perform
      his duties and which continues for a period of at least 180 consecutive
      days.(3)
              “Cause”
      is defined in Mr. Esses’s employment agreement as (i) conviction for
      fraud, crimes of moral turpitude or other conduct which reflects on us in
      a material and adverse manner; (ii) a willful failure to carry out a
      material directive of our Chief Executive Officer, provided that such
      directive concerned matters within the scope of Mr. Esses’s duties, would
      not give Mr. Esses “Good Reason” to terminate his agreement (see footnote
      4 below) and was capable of being reasonably and lawfully performed; (iii)
      conviction in a court of competent jurisdiction for embezzlement of our
      funds; and (iv) reckless or willful misconduct that is materially harmful
      to us.(4)
              “Good
      Reason” is defined in Mr. Esses’s employment agreement as (i) a change in
      (a) Mr. Esses’s status, title, position or responsibilities which, in Mr.
      Esses’s reasonable judgment, represents a reduction or demotion in his
      status, title, position or responsibilities as in effect immediately prior
      thereto, or (b) in the primary location from which Mr. Esses shall have
      conducted his business activities during the 60 days prior to such change;
      or (ii) a reduction in Mr. Esses’s base salary; (iii) the failure by us to
      continue in effect any material compensation or benefit plan in which Mr.
      Esses is participating; (iv) our insolvency or the filing (by any party,
      including us) of a petition for our winding-up; (v) any material breach by
      us of any provision of Mr. Esses’s employment agreement; and (vi) any
      purported termination of Mr. Esses’s employment for cause by us which does
      not comply with the terms of Mr. Esses’s employment
    agreement.(5)
              “Change
      of Control” is defined in Mr. Esses’s employment agreement as (i) the
      acquisition (other than from us in any public offering or private
      placement of equity securities) by any person or entity of beneficial
      ownership of 30% or more of the combined voting power of our
      then-outstanding voting securities; or (ii) individuals who, as of January
      1, 2000, were members of our Board of Directors (the “Original Board”),
      together with individuals approved by a vote of at least 2/3 of the
      individuals who were members of the Original Board and are then still
      members of our Board, cease for any reason to constitute at least 1/3 of
      our Board; or (iii) approval by our shareholders of a complete winding-up
      or an agreement for the sale or other disposition of all or substantially
      all of our assets.(6)
              “Change
      of location” is defined in Mr. Esses’s employment agreement as a change in
      the primary location from which Mr. Esses shall have conducted his
      business activities during the 60 days prior to such
    change.(7)
              “Retirement”
      is defined as Mr. Esses terminating his employment with us at age 65 or
      older on at least 150 days’ prior notice.(8)
              “Early
      Retirement” is defined as Mr. Esses terminating his employment with us at
      age 55 or older (up to age 65) on at least 150 days’ prior
      notice.(9)
              Any
      termination by Mr. Esses of his employment with us that does not fit into
      any of the prior categories, including but not limited to Mr. Esses
      terminating his employment with us, with or without notice, other than at
      the end of an employment term or renewal thereof, in circumstances that do
      not fit into any of the prior categories.(10)
              Does
      not include a total of $24,756 in accrued but unpaid consulting fees due
      at December 31, 2009 to Sampen Corporation, a New York corporation owned
      by members of Steven Esses’s immediate family, from which Mr. Esses
      receives a salary. See “Item 13. Certain Relationships and Related
      Transactions – Consulting Agreement with Sampen Corporation,”
      below.(11)
              Limited
      to an aggregate of 30 days.(12)
              Pursuant
      to Israeli law and our customary practice, we pay Mr. Esses in July of
      each year the equivalent of six days’ “recuperation pay” at the statutory
      rate of NIS 340 (approximately $90) per day.(13)
              Payments
      to managers’ insurance, a benefit customarily given to senior executives
      in Israel, come to a total of 15.83% of base salary, consisting of 8.33%
      for payments to a fund to secure payment of statutory severance
      obligations, 5% for pension and 2.5% for disability. The managers’
      insurance funds reflected in the table do not include the 8.33% payments
      to a fund to secure payment of statutory severance obligations with
      respect to amounts paid prior to December 31, 2009, which funds are
      reflected in the table under the “Statutory severance”
      heading.(14)
              Pursuant
      to Israeli law, we must contribute an amount equal to 7.5% of Mr. Esses’s
      base salary to a continuing education fund, up to the permissible
      tax-exempt salary ceiling according to the income tax regulations in
      effect from time to time. At December 31, 2009, the ceiling then in effect
      was NIS 15,712 (approximately $4,350). In Mr. Esses’s case, we have
      customarily contributed to his continuing education fund in excess of the
      tax-exempt ceiling, and then reimbursed Mr. Esses for the tax. The sums in
      the table reflect this additional contribution and the resultant tax
      reimbursement.(15)
              Under
      Israeli law, employees terminated other than for cause receive severance
      in the amount of one month’s base salary for each year of work, at their
      salary rate at the date of
termination.




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Thomas
J. Paup




The
following table describes the potential payments and benefits upon employment
termination for Thomas J. Paup, our Vice President – Finance and Chief Financial
Officer, pursuant to applicable law and the terms of his employment agreement
with us, as if his employment had terminated on December 31, 2009 (the last
business day of the fiscal year) under the various scenarios described in the
column headings as explained in the footnotes below.




THOMAS
      J. PAUPPayments
      and Benefits
                
                Death
      or
                  Disability(1)
                
                
                Cause(2)
                
                
                Change
      of
                  Control(3)
                
                
                Non-Renewal(4)Accrued
      but unpaid:Base
      salary
                
                $
                7,067
                
                
                $
                7,067
                
                
                $
                7,067
                
                
                $
                7,067Vacation
                
                
                11,077
                
                
                
                11,077
                
                
                
                11,077
                
                
                
                11,077Contractual
      severance
                
                
                –
                
                
                
                –
                
                
                
                169,600
                
                
                
                84,800TOTAL:
                
                $
                18,144
                
                
                $
                18,144
                
                
                $
                187,744
                
                
                $
                102,944





(1)
            “Disability”
      is defined in Mr. Paup’s employment agreement as a physical or mental
      infirmity which impairs the Mr. Paup’s ability to substantially perform
      his duties and which continues for a period of at least 180 consecutive
      days.(2)
            “Cause”
      is defined in Mr. Paup’s employment agreement as (i) a breach of trust by
      Mr. Paup, including, for example, but without limitation, commission of an
      act of moral turpitude, theft, embezzlement, self-dealing or insider
      trading; (ii) the unauthorized disclosure by Mr. Paup of confidential
      information of or relating to us; (iii) a material breach by Mr. Paup of
      his employment agreement; or (iv) any act of, or omission by, Mr. Paup
      which, in our reasonable judgment, amounts to a serious failure by Mr.
      Paup to perform his responsibilities or functions or in the exercise of
      his authority, which failure, in our reasonable judgment, rises to a level
      of gross nonfeasance, misfeasance or malfeasance.(3)
            “Change
      of Control” is defined in Mr. Paup’s employment agreement as (i) the
      acquisition (other than from us in any public offering or private
      placement of equity securities) by any person or entity of beneficial
      ownership of 30% or more of the combined voting power of our
      then-outstanding voting securities; or (ii) individuals who, as of
      December 31, 2007, were members of our Board of Directors (the “Original
      Board”), together with individuals approved by a vote of at least 2/3 of
      the individuals who were members of the Original Board and are then still
      members of our Board, cease for any reason to constitute at least 1/3 of
      our Board; or (iii) approval by our shareholders of a complete winding-up
      or an agreement for the sale or other disposition of all or substantially
      all of our assets.(4)
            “Non-Renewal”
      is defined in Mr. Paup’s employment agreement as Mr. Paup terminating his
      employment with us on written notice of at least 120 days in advance of
      the effective date of such
termination.




ITEM
      12.
            SECURITY
      OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
      STOCKHOLDER MATTERS




Security
Ownership of Certain Beneficial Owners and Management




The
following table sets forth information regarding the security ownership, as of
February 28, 2010, of those persons owning of record or known by us to own
beneficially more than 5% of our common stock and of each of our Named Executive
Officers and directors, and the shares of common stock held by all of our
directors and executive officers as a group.




Name
      and Address of Beneficial Owner(1)
                                    
                                    Shares
      Beneficially Owned(2)(3)
                                    
                                    
                                    Percentage
      of Total Shares Outstanding(3)Robert
      S. Ehrlich
                                    
                                    
                                    935,160
                                    (4)
                                    
                                    
                                    6.5
                                    %Steven
      Esses
                                    
                                    
                                    698,257
                                    (5)
                                    
                                    
                                    4.8
                                    %Thomas
      J. Paup
                                    
                                    
                                    150,000
                                    (6)
                                    
                                    
                                    *Dr.
      Jay M. Eastman
                                    
                                    
                                    29,661
                                    (7)
                                    
                                    
                                    *Edward
      J. Borey
                                    
                                    
                                    30,803
                                    (8)
                                    
                                    
                                    *Prof.
      Seymour Jones
                                    
                                    
                                    29,661
                                    (9)
                                    
                                    
                                    *Elliot
      Sloyer
                                    
                                    
                                    62,951
                                    (10)
                                    
                                    
                                    *Michael
      E. Marrus
                                    
                                    
                                    32,951
                                    (11)
                                    
                                    
                                    *Arthur
      S. Leibowitz
                                    
                                    
                                    14,970
                                    (12)
                                    
                                    
                                    *All
      of our directors and executive officers as a group (9
    persons)
                                    
                                    
                                    1,985,014
                                    (13)
                                    
                                    
                                    13.7
                                    %


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*
              Less
      than one percent.(1)
              The
      address of each named beneficial owner is in care of Arotech Corporation,
      1229 Oak Valley Drive, Ann Arbor, Michigan 48108.(2)
              Unless
      otherwise indicated in these footnotes, each of the persons or entities
      named in the table has sole voting and sole investment power with respect
      to all shares shown as beneficially owned by that person, subject to
      applicable community property laws.(3)
              Based
      on 14,429,159 shares of common stock outstanding as of February 28, 2010.
      For purposes of determining beneficial ownership of our common stock,
      owners of options exercisable within sixty days are considered to be the
      beneficial owners of the shares of common stock for which such securities
      are exercisable. The percentage ownership of the outstanding common stock
      reported herein is based on the assumption (expressly required by the
      applicable rules of the Securities and Exchange Commission) that only the
      person whose ownership is being reported has exercised his options for
      shares of common stock.(4)
              Consists
      of 529,333 shares held directly by Mr. Ehrlich, 40,000 shares of unvested
      restricted stock, 328,767 shares held as part of a trust securing the
      payment of Mr. Ehrlich’s severance package pursuant to the terms of our
      employment agreement with him, 3,571 shares held by Mr. Ehrlich’s wife (in
      which shares Mr. Ehrlich disclaims beneficial ownership), 11,527 shares
      held in Mr. Ehrlich’s pension plan, and 21,962 shares issuable upon
      exercise of options exercisable within 60 days of February 28,
      2010.(5)
              Consists
      of 251,785 shares held directly by Mr. Esses, 170,000 shares of unvested
      restricted stock (the vesting of 25,000 of which is subject to future
      performance criteria), 273,973 shares held as part of a trust securing the
      payment of Mr. Esses’s severance package pursuant to the terms of our
      employment agreement with him, and 2,499 shares issuable upon exercise of
      options exercisable within 60 days of February 28,
2010.(6)
              Consists
      of 74,666 shares held directly by Mr. Paup, 21,666 shares of unvested
      restricted stock (the vesting of 10,833 of which is subject to future
      performance criteria), and 21,458 unvested restricted stock
      units.(7)
              Consists
      of 5,122 shares owned directly by Dr. Eastman and 24,539 shares of
      unvested restricted stock.(8)
              Consists
      of 6,264 shares owned directly by Mr. Borey and 24,539 shares of unvested
      restricted stock.(9)
              Consists
      of 5,122 shares owned directly by Prof. Jones and 24,539 shares of
      unvested restricted stock.(10)
              Consists
      of 37,315 shares owned directly by Mr. Sloyer and 25,636 shares of
      unvested restricted stock.(11)
              Consists
      of 7,315 shares owned directly by Mr. Marrus and 25,636 shares of unvested
      restricted stock.(12)
              Consists
      of 14,970 shares of unvested restricted stock.(13)
              Includes
      24,461 shares issuable upon exercise of options exercisable within 60 days
      of February 28, 2010, 371,525 shares of unvested restricted stock (the
      vesting of 35,833 of which is subject to future performance criteria),
      602,740 shares of restricted stock held as part of trusts securing payment
      of severance, and 21,458 unvested restricted stock
  units.




Securities
Authorized for Issuance Under Equity Compensation Plans




The
following table sets forth certain information, as of December 31, 2009, with
respect to our 2004, 2007 and 2009 equity compensation plans, as well as any
other stock options and warrants previously issued by us (including individual
compensation arrangements) as compensation for goods and services:




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EQUITY
COMPENSATION PLAN INFORMATION




Plan
      Category
                
                Number
      of securities to be issued upon exercise of outstanding options, warrants
      and rights
                  (a)
                
                
                Weighted-average
      exercise price of
                  outstanding
      options, warrants and rights
                  (b)
                
                
                Number
      of securities remaining available for future issuance under equity
      compensation plans (excluding securities reflected in column
      (a))
                  (c)Equity
      compensation plans approved by security holders(1)
                
                
                784,274
                
                
                $
                3.97
                
                
                
                5,195,921
 
 (1)
                For
      a description of the material features of grants of options and warrants
      other than options granted under our employee stock option plans, see Note
      13.c. of the Notes to the Consolidated Financial
    Statements.




ITEM 13.
            CERTAIN
      RELATIONSHIPS AND RELATED
TRANSACTIONS




Officer
Loans




On
December 3, 1999, Robert S. Ehrlich purchased 8,928 shares of our common stock
out of our treasury at the closing price of the common stock on December 2,
1999. Payment was rendered by Mr. Ehrlich in the form of non-recourse promissory
notes due in 2009 in the amount of $167,975, bearing simple annual interest at a
rate of 2%, secured by the shares of common stock purchased and other shares of
common stock previously held by him. As of December 31, 2009, the aggregate
amount outstanding pursuant to these promissory notes from Mr. Ehrlich and a
former employee with the same arrangement were $403,141, which were not repaid
and were therefore written off to paid in capital in the fourth quarter of
2009.  Pursuant to the terms of the note, the shares of stock securing
the note were returned to the Company.




On
February 9, 2000, Mr. Ehrlich exercised 9,404 stock options. Mr. Ehrlich paid
the exercise price of the stock options and certain taxes that we paid on his
behalf by giving us a non-recourse promissory note due in 2025 in the amount of
$329,163, bearing annual interest at 1% over the then-current federal funds rate
announced from time to time by the Wall Street Journal, secured
by the shares of our common stock acquired through the exercise of the options
and certain compensation due to Mr. Ehrlich upon termination. As of December 31,
2009, the aggregate amount outstanding pursuant to this promissory note was
$452,995. Again, there is a former employee with the same
arrangement.




On June
10, 2002, Mr. Ehrlich exercised 3,571 stock options. Mr. Ehrlich paid the
exercise price of the stock options by giving us a non-recourse promissory note
due in 2012 in the amount of $36,500, bearing simple annual interest at a rate
equal to the lesser of (i) 5.75%, and (ii) 1% over the then-current federal
funds rate announced from time to time, secured by the shares of our common
stock acquired through the exercise of the options. As of December 31, 2009, the
aggregate amount outstanding pursuant to this promissory note was
$46,593.




Consulting
Agreement with Sampen Corporation




We have a
consulting agreement with Sampen Corporation that we executed in March 2005,
effective as of January 1, 2005. Sampen is a New York corporation owned by
members of Steven Esses’s immediate family, and Mr. Esses is an employee of both
the Company and of Sampen. The term of this consulting agreement as extended
expires on December 31, 2010, and is extended automatically for additional terms
of two years each unless either Sampen or we terminate the agreement
sooner.




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Pursuant
to the terms of our agreement with Sampen, Sampen provides one of its employees
to us for such employee to serve as our Chief Operating Officer. We pay Sampen
$12,800 per month, plus an annual bonus, on a sliding scale, in an amount equal
to a minimum of 20% of Sampen’s annual base compensation then in effect, up to a
maximum of 75% of its annual base compensation then in effect if the results we
actually attain for the year in question are 120% or more of the amount we
budgeted at the beginning of the year. We also pay Sampen, to cover the cost of
our use of Sampen’s offices as an ancillary New York office and the attendant
expenses and insurance costs, an amount equal to 16% of each monthly payment of
base compensation.




ITEM 14.
            PRINCIPAL
      ACCOUNTING FEES AND SERVICES




In
accordance with the requirements of the Sarbanes-Oxley Act of 2002 and the Audit
Committee’s charter, all audit and audit-related work and all non-audit work
performed by our independent accountants, BDO Seidman, LLP (“BDO”), is approved
in advance by the Audit Committee, including the proposed fees for such work.
The Audit Committee is informed of each service actually rendered.




●
            Audit Fees.Audit fees
      billed or expected to be billed to us by BDO for the audit of the
      financial statements included in our Annual Report on Form 10-K, and
      reviews of the financial statements included in our Quarterly Reports on
      Form 10-Q, for the years ended December 31, 2009 and 2008 totaled
      approximately $315,000 and $514,000,
  respectively.




●
            Audit-Related Fees. BDO
      billed us $10,000 and $23,000 for the fiscal years ended December 31, 2009
      and 2008, respectively, for assurance and related services that are
      reasonably related to the performance of the audit or review of our
      financial statements.




●
            Tax
      Fees. BDO billed or
      expected to bill us an aggregate of $25,000 for each of the fiscal years
      ended December 31, 2009 and 2008, for tax services, principally advice
      regarding the preparation of income tax
  returns.




●
            All Other Fees.BDO
      did not provide additional services other than the services reported
      above.




Applicable
law and regulations provide an exemption that permits certain services to be
provided by our outside auditors even if they are not pre-approved. We have not
relied on this exemption at any time since the Sarbanes-Oxley Act was
enacted.




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PART
IV




ITEM
      15.
            EXHIBITS,
      FINANCIAL STATEMENT SCHEDULES




(a)           The
following documents are filed as part of this report:




(1)
                    Financial
      Statements – See Index to Financial Statements on page 44 above and the
      financial pages following page 73 below.(2)
                    Financial Statements
      Schedules – Schedule II - Valuation and Qualifying Accounts. All
      schedules other than those listed above are omittedbecause
      of the absence of conditions under which they are required or because the
      required information is presented in the financial statements or related
      notes thereto.(3)
                    Exhibits
      – The following Exhibits are either filed herewith or have previously been
      filed with the Securities and Exchange Commission and are referred to and
      incorporated herein by reference to such
  filings:







Exhibit No.
                          Description(1)
                          
                          3.1
                          Amended
      and Restated Certificate of Incorporation(3)
                          
                          3.1.1
                          Amendment
      to our Amended and Restated Certificate of
Incorporation(6)
                          
                          3.1.2
                          Amendment
      to our Amended and Restated Certificate of
Incorporation(7)
                          
                          3.1.3
                          Amendment
      to our Amended and Restated Certificate of
Incorporation(12)
                          
                          3.1.4
                          Amendment
      to our Amended and Restated Certificate of
Incorporation(19)
                          
                          3.1.5
                          Amendment
      to our Amended and Restated Certificate of
Incorporation(2)
                          
                          3.2
                          Amended
      and Restated By-Laws(7)
                          
                          4.1
                          Specimen
      Certificate for shares of common stock, $.01 par value(10)
                          
                          10.1
                          Promissory
      Note dated December 3, 1999, from Robert S. Ehrlich to
  us(10)
                          
                          10.2
                          Promissory
      Note dated February 9, 2000, from Robert S. Ehrlich to
  us(10)
                          
                          10.3
                          Promissory
      Note dated January 12, 2001, from Robert S. Ehrlich to
  us(4)
                          
                          10.4
                          Agreement
      of Lease dated December 6, 2000 between Janet Nissim et al. and M.D.T.
      Protection (2000) Ltd. [English summary of Hebrew
  original](4)
                          
                          10.5
                          Agreement
      of Lease dated August 22, 2001 between Aviod Building and Earthworks
      Company Ltd. et
      al. and M.D.T. Protective Industries Ltd. [English summary of
      Hebrew original](5)
                          
                          10.6
                          Promissory
      Note dated July 1, 2002 from Robert S. Ehrlich to us(5)
                          
                          10.7
                          Lease
      dated April 8, 1997, between AMR Holdings, L.L.C. and FAAC
      Incorporated†
      (7)
                          
                          10.8
                          Consulting
      Agreement, effective as of January 1, 2005, between us and Sampen
      Corporation†
      (13)
                          
                          10.9
                          Fourth
      Amended and Restated Employment Agreement, dated April 16, 2007, between
      us, EFL and Robert S. Ehrlich(17)
                          
                          10.9.1
                          Amendment
      letter dated April 9, 2009 between us, EFL and Robert S.
      Ehrlich(18)
                          
                          10.9.2
                          Amendment
      letter dated April 19, 2009 between us, EFL and Robert S.
      Ehrlich
  72
 Table of Contents
 †
      (15)
                          
                          10.10
                          Amended
      and Restated Employment Agreement, dated April 14, 2008 and effective as
      of January 1, 2008, between EFL and Steven Esses(17)
                          
                          10.10.1
                          Amendment
      letter dated April 9, 2009 between us, EFL and Steven
  Esses(18)
                          
                          10.10.2
                          Amendment
      letter dated April 19, 2009 between us, EFL and Steven
    Esses(11)
                          
                          10.11
                          Conversion
      Agreement dated April 7, 2006 between us and the Investors named
      therein†
      (15)
                          
                          10.12
                          Amended
      and Restated Employment Agreement between the Company and Thomas J. Paup
      dated April 14, 2008 and effective as of January 1,
2008(17)
                          
                          10.12.1
                          Amendment
      letter dated April 9, 2009 between us, EFL and Thomas J.
    Paup(10)
                          
                          10.13
                          Lease
      dated February 10, 2006 between Arbor Development Company LLC and FAAC
      Incorporated(14)
                          
                          10.14
                          Loan
      Agreement between FAAC Incorporated and Keybank National Association dated
      December 27, 2007(14)
                          
                          10.15
                          Security
      Agreement between us and Keybank National Association dated December 27,
      2007(14)
                          
                          10.16
                          Guaranty
      from us to Keybank National Association dated December 27,
      2007*
      (15)
                          
                          10.17
                          Agreement
      with Yossi Bar in respect of our purchase of the noncontrolling interest
      of M.D.T. Protective Industries Ltd. and MDT Armor Corporation dated
      January 15, 2008(15)
                          
                          10.18
                          Stock
      Purchase Agreement among FAAC Incorporated, Realtime Technologies Ltd. and
      Richard Romano dated February 4, 2008(16)
                          
                          10.19
                          Securities
      Purchase Agreement dated August 14, 2008 between us and the Investors
      named therein(16)
                          
                          10.20
                          Form
      of Senior Subordinated Note due August 15, 2011(16)
                          
                          10.21
                          Form
      of Warrant dated August 14, 2008(16)
                          
                          10.22
                          Convertible
      Note of DEI Services Corporation due December 31, 2009(16)
                          
                          10.23
                          Limited
      Guaranty, Pledge and Voting Agreement from the stockholders of DEI
      Services Corporation dated August 14, 2008(9)
                          
                          21.1
                          List
      of Subsidiaries of the Registrant**
                          
                          23.1
                          Consent of BDO Seidman, LLP**
                          
                          31.1
                          Certification of Principal Executive Officer pursuant to
      Section 302 of the Sarbanes-Oxley Act of 2002**
                          
                          31.2
                          Certification of Principal Financial Officer pursuant to
      Section 302 of the Sarbanes-Oxley Act of 2002**
                          
                          32.1
                          Certification of Principal Executive Officer pursuant to
      18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002**
                          
                          32.2
                          Certification of Principal Financial Officer pursuant to
      18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the
      Sarbanes-Oxley Act of
2002


73
 Table of Contents


*
              English
      translation or summary from original Hebrew**
              Filed
      herewith†
              Includes
      management contracts and compensation plans and
    arrangements(1)
              Incorporated
      by reference to our Registration Statement on Form S-1 (Registration No.
      33-73256), which became effective on February 23, 1994(2)
              Incorporated
      by reference to our Registration Statement on Form S-1 (Registration No.
      33-97944), which became effective on February 5, 1996(3)
              Incorporated
      by reference to our Current Report on Form 8-K filed January 6,
      2003(4)
              Incorporated
      by reference to our Annual Report on Form 10-K for the year ended December
      31, 2002(5)
              Incorporated
      by reference to our Annual Report on Form 10-K for the year ended December
      31, 2003(6)
              Incorporated
      by reference to our Current Report on Form 8-K filed July 15,
      2004(7)
              Incorporated
      by reference to our Annual Report on Form 10-K for the year ended December
      31, 2004(8)
              Incorporated
      by reference to our Quarterly Report on Form 10-Q for the quarter ended
      June 30, 2004(9)
              Incorporated
      by reference to our Current Report on Form 8-K filed January 5,
      2006(10)
              Incorporated
      by reference to our Annual Report on Form 10-K for the year ended December
      31, 2005(11)
              Incorporated
      by reference to our Current Report on Form 8-K filed April 7,
      2006(12)
              Incorporated
      by reference to our Quarterly Report on Form 10-Q for the quarter ended
      June 30, 2006(13)
              Incorporated
      by reference to our Annual Report on Form 10-K for the year ended December
      31, 2006(14)
              Incorporated
      by reference to our Current Report on Form 8-K filed January 3,
      2008(15)
              Incorporated
      by reference to our Annual Report on Form 10-K for the year ended December
      31, 2007(16)
              Incorporated
      by reference to our Current Report on Form 8-K filed August 15,
      2008(17)
              Incorporated
      by reference to our Annual Report on Form 10-K for the year ended December
      31, 2008(18)
              Incorporated
      by reference to our Current Report on Form 8-K filed April 20,
      2009(19)
              Incorporated
      by reference to our Current Report on Form 8-K filed June 9,
      2009




74
 Table of Contents





SIGNATURES




Pursuant
to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
1934, the registrant has duly caused this report to be signed on its behalf by
the undersigned, thereunto duly authorized.




AROTECH
      CORPORATIONBy:
                  /s/ Robert
      S.
      EhrlichName:
      Robert S. EhrlichTitle:  
      Chairman
      and Chief Executive OfficerDate:
                  March 31, 2010





Pursuant
to the requirements of the Securities Exchange Act of 1934, this report has been
signed below by the following persons on behalf of the registrant and in the
capacities and on the dates indicated.




Signature
                                            
                                            Title
                                            
                                            Date/s/  Robert
      S.
      Ehrlich
                                            
                                            Chairman,
      Chief Executive Officer and Director
                                              (Principal
      Executive Officer)
                                            
                                            March
      31, 2010Robert
      S. Ehrlich/s/  Thomas
      J.
      Paup
                                            
                                            Vice
      President – Finance
                                              (Principal
      Financial Officer)
                                            
                                            March
      31, 2010Thomas
      J. Paup/s/  Norman
      Johnson
                                            
                                            Controller
                                              (Principal
      Accounting Officer)
                                            
                                            March
      31, 2010Norman
      Johnson/s/  Steven
      Esses
                                            
                                            President,
      Chief Operating Officer
                                              and
      Director
                                            
                                            March
      31, 2010Steven
      Esses/s/  Jay
      M.
      Eastman
                                            
                                            Director
                                            
                                            March
      31, 2010Dr.
      Jay M. EastmanDirector
                                            
                                            March
        , 2010Edward
      J. Borey/s/  Seymour
      Jones
                                            
                                            Director
                                            
                                            March
      31, 2010Seymour
      JonesDirector
                                            
                                            March
        , 2010Elliot
      SloyerDirector
                                            
                                            March
        , 2010Michael
      E. Marrus/s/  Arthur
      S. Leibowitz
                                            
                                            Director
                                            
                                            March
      31, 2010Arthur
      S. Leibowitz






75
 Table of Contents




Report
of Independent Registered Public Accounting Firm
  
  To the
Board of Directors and Shareholders of Arotech Corporation:
  Ann
Arbor, Michigan
  We have
audited the accompanying consolidated balance sheets of Arotech Corporation as
of December 31, 2009 and 2008 and the related consolidated statements of
operations, changes in stockholders’ equity and cash flows for the years then
ended. In connection with our audits of the financial statements, we have also
audited the financial statement schedule listed in the accompanying
index.  These financial statements and schedule are the responsibility
of the Company’s management.  Our responsibility is to express an
opinion on these financial statements and schedule based on our
audits.
  We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States).  Those standards require
that we plan and perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement.  The
Company is not required to have, nor were we engaged to perform, an audit of its
internal control over financial reporting.  Our audits included
consideration of internal control over financial reporting as a basis for
designing audit procedures that are appropriate in the circumstances, but not
for the purpose of expressing an opinion on the effectiveness of the Company’s
internal control over financial reporting. Accordingly, we express no such
opinion.  An audit also includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements, assessing
the accounting principles used and significant estimates made by management, as
well as evaluating the overall presentation of the financial statements and
schedules.  We believe that our audits provide a reasonable basis for
our opinion.
  In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of Arotech Corporation and
subsidiaries at December 31, 2009 and 2008, and the results of its operations
and its cash flows for each of the years then ended, in conformity with
accounting principles generally accepted in the United States of
America.
  As
discussed in Note 13 to the consolidated financial statements, the Company
changed its method of accounting for warrants and the conversion option related
to convertible notes due to the adoption of new accounting guidance regarding
Determining Whether an
Instrument is Indexed to an Entity’s Own Stock.
  Also, in
our opinion, the financial statement schedule, when considered in relation to
the basic consolidated financial statements taken as a whole, presents fairly,
in all material respects, the information set forth
therein.
 /s/ BDO Siedman,
LLP
  Grand
Rapids, Michigan
  March 31,
2010
  Table of Contents
 AROTECH
CORPORATION AND ITS SUBSIDIARIES
 CONSOLIDATED
BALANCE SHEETS
 In
U.S. dollars
  December
      31,2009
              
              
              2008ASSETSCURRENT
      ASSETS:Cash
      and cash equivalents
              
              $
              1,901,525
              
              
              $
              4,301,359Restricted
      cash
              
              
              1,997,165
              
              
              
              381,586Available
      for sale marketable securities
              
              
              –
              
              
              
              49,204Trade
      receivables (net of allowance for doubtful accounts in the amount of
      $47,000 and $19,000 as of December 31, 2009 and 2008,
      respectively)
              
              
              14,010,974
              
              
              
              19,346,084Unbilled
      receivables
              
              
              4,142,107
              
              
              
              4,769,264Other
      accounts receivable and prepaid expenses
              
              
              2,825,202
              
              
              
              3,625,955Inventories
              
              
              12,335,037
              
              
              
              9,678,960Total
      current
      assets
              
              
              37,212,010
              
              
              
              42,152,412LONG
      TERM ASSETS:Deferred
      tax assets
              
              
              41,405
              
              
              
              72,114Severance
      pay fund
              
              
              3,447,884
              
              
              
              2,888,867Other
      long term receivables
              
              
              395,456
              
              
              
              463,780Property
      and equipment, net
              
              
              4,624,833
              
              
              
              5,058,263Investment
      in affiliated company
              
              
              67,018
              
              
              
              40,987Other
      intangible assets, net
              
              
              6,025,600
              
              
              
              6,867,873Goodwill
              
              
              32,303,673
              
              
              
              32,250,503Total
      long term assets
              
              
              46,905,869
              
              
              
              47,642,387Total
      assets
              
              $
              84,117,879
              
              
              $
              89,794,799
  The
accompanying notes are an integral part of the consolidated financial
statements.
  F-2
 Table of Contents
 AROTECH
CORPORATION AND ITS SUBSIDIARIES
 CONSOLIDATED
BALANCE SHEETS
 In
U.S. dollars
 December
      31,2009
                
                
                2008LIABILITIES
      AND STOCKHOLDERS’ EQUITYCURRENT
      LIABILITIES:Trade
      payables
                
                $
                5,149,243
                
                
                $
                9,664,558Other
      accounts payable and accrued expenses
                
                
                6,239,436
                
                
                
                5,858,959Current
      portion of capitalized leases
                
                
                45,911
                
                
                
                62,833Current
      portion of long term debt
                
                
                1,902,097
                
                
                
                1,861,187Short
      term bank credit
                
                
                4,074,890
                
                
                
                3,607,890Deferred
      revenues
                
                
                4,434,093
                
                
                
                3,789,020Total
      current liabilities
                
                
                21,845,670
                
                
                
                24,844,447LONG
      TERM LIABILITIESAccrued
      severance pay
                
                
                4,985,011
                
                
                
                5,161,448Long
      term portion of capitalized leases
                
                
                52,021
                
                
                
                122,090Long
      term debt
                
                
                2,270,152
                
                
                
                3,866,727Deferred
      tax liability
                
                
                2,990,000
                
                
                
                2,430,000Other
      long term liabilities
                
                
                555,220
                
                
                
                146,738Total
      long-term liabilities
                
                
                10,852,404
                
                
                
                11,727,003STOCKHOLDERS’
      EQUITY:Share
      capital –Common
      stock – $0.01 par value each;Authorized:
      50,000,000 shares and 250,000,000 shares as of December 31, 2009 and 2008,
      respectively;
                  Issued
      and outstanding:
      14,405,948 shares and 13,637,639 shares as of December 31, 2009 and 2008,
      respectively
                
                
                144,060
                
                
                
                136,377Preferred
      shares – $0.01 par value each ;Authorized:
      1,000,000 shares as of December 31, 2009 and 2008; No shares issued and
      outstanding as of December 31, 2009 and 2008
                
                
                –
                
                
                
                –Additional
      paid-in capital
                
                
                220,481,911
                
                
                
                220,124,075Accumulated
      deficit
                
                
                (169,788,022
                )
                
                
                (167,205,514
                )Notes
      receivable from stockholders
                
                
                (954,647
                )
                
                
                (1,357,788
                )Accumulated
      other comprehensive income
                
                
                1,536,503
                
                
                
                1,526,199Total
      stockholders’ equity
                
                
                51,419,805
                
                
                
                53,223,349Total
      liabilities and stockholders’ equity
                
                $
                84,117,879
                
                
                $
                89,794,799
  The
accompanying notes are an integral part of the consolidated financial
statements.
  F-3
 Table of Contents
 AROTECH CORPORATION AND ITS
SUBSIDIARIES
 CONSOLIDATED
STATEMENTS OF OPERATIONS
 In
U.S. dollars
 
 December
      31,2009
              
              
              2008Revenues
              
              $
              74,534,451
              
              
              $
              68,948,969Cost
      of revenues, exclusive of amortization of intangibles
              
              
              54,414,921
              
              
              
              50,177,909Research
      and development
              
              
              1,326,755
              
              
              
              1,657,668Selling
      and marketing expenses
              
              
              4,868,498
              
              
              
              4,699,870General
      and administrative expenses
              
              
              12,298,595
              
              
              
              14,093,764Amortization
      of intangible assets and capitalized software
              
              
              1,458,802
              
              
              
              1,735,548Escrow
      adjustment
              
              
              –
              
              
              
              (1,448,074
              )Total
      operating costs and expenses
              
              
              74,367,571
              
              
              
              70,916,685Operating
      profit (loss)
              
              
              166,880
              
              
              
              (1,967,716
              )Other
      income
              
              
              85,662
              
              
              
              422,883Allowance
      for settlements
              
              
              (1,250,000
              )
              
              
              –Financial
      expenses, net
              
              
              (1,251,385
              )
              
              
              (814,089
              )Total
      other expenses
              
              
              (2,415,723
              )
              
              
              (391,206
              )Loss
      before earnings from affiliated company and income tax
      expenses
              
              
              (2,248,843
              )
              
              
              (2,358,922
              )Loss
      from affiliated company
              
              
              –
              
              
              
              (452,166
              )Income
      tax expenses
              
              
              (804,966
              )
              
              
              (1,026,868
              )Net
      loss
              
              $
              (3,053,809
              )
              
              $
              (3,837,956
              )Basic
      and diluted net loss per share
              
              $
              (0.24
              )
              
              $
              (0.30
              )Weighted
      average number of shares used in computing basic and diluted net loss per
      share
              
              
              12,777,867
              
              
              
              12,605,786
 The
accompanying notes are an integral part of the consolidated financial
statements.
 
 F-4
 Table of Contents
 
 AROTECH CORPORATION
AND ITS SUBSIDIARIES
 STATEMENTS
OF CHANGES IN STOCKHOLDERS’ EQUITY
 In
U.S. dollars
   Common
      stockShares
                  
                  
                  Amount
                  
                  
                  Additional
                    paid-in
                    capital
                  
                  
                  Accumulated
                    deficit
                  
                  
                  Notes
                    receivable
                    from
                    stockholders
                  
                  
                  Accumulated
                    other
                    comprehensive
                    income
      (loss)
                  
                  
                  Total
                    comprehensive
                    income
      (loss)
                  
                  
                  Total
                    stockholders’
                    equityBalance
      as of January 1, 2008
                  
                  
                  13,544,819
                  
                  
                  $
                  135,448
                  
                  
                  $
                  218,551,110
                  
                  
                  $
                  (163,367,558
                  )
                  
                  $
                  (1,333,833
                  )
                  
                  $
                  1,501,441
                  
                  
                  $
                  –
                  
                  
                  $
                  55,486,608Issuance
      of warrants
                  
                  
                  –
                  
                  
                  
                  –
                  
                  
                  
                  412,300
                  
                  
                  
                  –
                  
                  
                  
                  –
                  
                  
                  
                  –
                  
                  
                  
                  –
                  
                  
                  
                  412,300Stock
      based compensation
                  
                  
                  –
                  
                  
                  
                  –
                  
                  
                  
                  1,039,270
                  
                  
                  
                  –
                  
                  
                  
                  –
                  
                  
                  
                  –
                  
                  
                  
                  –
                  
                  
                  
                  1,039,270Restricted
      stock issued
                  
                  
                  38,472
                  
                  
                  
                  385
                  
                  
                  
                  (385
                  )
                  
                  
                  –
                  
                  
                  
                  –
                  
                  
                  
                  –
                  
                  
                  
                  –
                  
                  
                  
                  –Issuance
      of stock for acquisition
                  
                  
                  54,348
                  
                  
                  
                  544
                  
                  
                  
                  97,825
                  
                  
                  
                  –
                  
                  
                  
                  –
                  
                  
                  
                  –
                  
                  
                  
                  –
                  
                  
                  
                  98,369Interest
      accrued on notes receivable from shareholders
                  
                  
                  –
                  
                  
                  
                  –
                  
                  
                  
                  23,955
                  
                  
                  
                  –
                  
                  
                  
                  (23,955
                  )
                  
                  
                  –
                  
                  
                  
                  –
                  
                  
                  
                  –Other
      comprehensive income – foreign currency translation
    adjustment
                  
                  
                  –
                  
                  
                  
                  –
                  
                  
                  
                  –
                  
                  
                  
                  –
                  
                  
                  
                  –
                  
                  
                  
                  23,103
                  
                  
                  
                  23,103
                  
                  
                  
                  23,103Other
      comprehensive income – unrealized gain on available for sale marketable
      securities
                  
                  
                  –
                  
                  
                  
                  –
                  
                  
                  
                  –
                  
                  
                  
                  –
                  
                  
                  
                  –
                  
                  
                  
                  1,655
                  
                  
                  
                  1,655
                  
                  
                  
                  1,655Net
      loss
                  
                  
                  –
                  
                  
                  
                  –
                  
                  
                  
                  –
                  
                  
                  
                  (3,837,956
                  )
                  
                  
                  –
                  
                  
                  
                  –
                  
                  
                  
                  (3,837,956
                  )
                  
                  
                  (3,837,956
                  )Total
      comprehensive loss
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  $
                  (3,813,198
                  )Balance
      as of December 31, 2008
                  
                  
                  13,637,639
                  
                  
                  $
                  136,377
                  
                  
                  $
                  220,124,075
                  
                  
                  $
                  (167,205,514
                  )
                  
                  $
                  (1,357,788
                  )
                  
                  $
                  1,526,199
                  
                  
                  
                  
                  
                  
                  $
                  53,223,349
  The
accompanying notes are an integral part of the consolidated financial
statements.
 
 
 F-5
 Table of Contents
  AROTECH CORPORATION AND ITS
SUBSIDIARIES
 STATEMENTS
OF CHANGES IN STOCKHOLDERS’ EQUITY
 In
U.S. dollars
 
  Common
      stockShares
                
                
                Amount
                
                
                Additional
                  paid-in
                  capital
                
                
                Accumulated
                  deficit
                
                
                Notes
                  receivable
                  from
                  stockholders
                
                
                Accumulated
                  other
                  comprehensive
                  income
      (loss)
                
                
                Total
                  comprehensive
                  income
      (loss)
                
                
                Total
                  stockholders’
                  equityBalance
      as of December 31, 2008
                
                
                13,637,639
                
                
                $
                136,377
                
                
                $
                220,124,075
                
                
                $
                (167,205,514
                )
                
                $
                (1,357,788
                )
                
                $
                1,526,199
                
                
                $
                –
                
                
                $
                53,223,349ASC
      815-40 cumulative adjustment
                
                
                –
                
                
                
                –
                
                
                
                (412,300
                )
                
                
                471,301
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                59,001Balance
      as of January 1, 2009
                
                
                13,637,639
                
                
                
                136,377
                
                
                
                219,711,775
                
                
                
                (166,734,213
                )
                
                
                (1,357,788
                )
                
                
                1,526,199
                
                
                
                –
                
                
                
                53,282,350Treasury
      stock purchase and retirement
                
                
                (447,358
                )
                
                
                (4,474
                )
                
                
                (559,082
                )
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                (563,556
                )Conversion
      of convertible notes
                
                
                220,017
                
                
                
                2,200
                
                
                
                453,044
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                455,244Stock
      based compensation
                
                
                –
                
                
                
                –
                
                
                
                849,272
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                849,272Restricted
      stock issued
                
                
                412,622
                
                
                
                4,126
                
                
                
                (4,126
                )
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                –Forfeitures
      of prior stock awards
                
                
                (19,712
                )
                
                
                (197
                )
                
                
                197
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                –Issuance
      of stock in lieu of funding severance
                
                
                602,740
                
                
                
                6,028
                
                
                
                433,972
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                440,000Write-down
      of shareholder loans
                
                
                –
                
                
                
                –
                
                
                
                (403,141
                )
                
                
                –
                
                
                
                403,141
                
                
                
                –
                
                
                
                –
                
                
                
                –Other
      comprehensive income – foreign currency translation
    adjustment
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                10,304
                
                
                
                10,304
                
                
                
                10,304Net
      loss
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                (3,053,809
                )
                
                
                –
                
                
                
                –
                
                
                
                (3,053,809
                )
                
                
                (3,053,809
                )Total
      comprehensive loss
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                $
                (3,043,505
                )Balance
      as of December 31, 2009
                
                
                14,405,948
                
                
                $
                144,060
                
                
                $
                220,481,911
                
                
                $
                (169,788,022
                )
                
                $
                (954,647
                )
                
                $
                1,536,503
                
                
                
                
                
                
                $
                51,419,805
 
 
 
 
 
 The
accompanying notes are an integral part of the consolidated financial
statements.
 
 
 F-6
 Table of Contents
 AROTECH CORPORATION AND ITS
SUBSIDIARIES
 CONSOLIDATED
STATEMENTS OF CASH FLOWS
 In
U.S. dollars
 
 2009
              
              
              2008CASH
      FLOWS FROM OPERATING ACTIVITIES:Net
      loss
              
              $
              (3,053,809
              )
              
              $
              (3,837,956
              )Adjustments
      required to reconcile net loss to net cash (used in) provided by operating
      activities:Loss
      from affiliated companies
              
              
              –
              
              
              
              452,168Depreciation
              
              
              1,260,458
              
              
              
              1,246,238Amortization
      of intangible assets and capitalized software costs
              
              
              1,458,802
              
              
              
              1,735,548Amortization
      of debt discount
              
              
              269,801
              
              
              
              51,537Increase
      in escrow receivable
              
              
              –
              
              
              
              (1,845,977
              )Compensation
      related to shares issued to employees, consultants and
      directors
              
              
              849,272
              
              
              
              1,039,270Adjustment
      to value of warrants and embedded features on the senior convertible
      notes
              
              
              341,916
              
              
              
              –Capital
      loss from sale of property and equipment
              
              
              (14,640
              )
              
              
              (11,379
              )Deferred
      tax expense
              
              
              590,709
              
              
              
              570,595Allowances
      for settlements
              
              
              1,250,000
              
              
              
              –Changes
      in operating assets and liabilities, excluding effect of business
      acquisition:Accrued
      (deferred) severance pay, net
              
              
              (295,454
              )
              
              
              234,390Trade
      receivables
              
              
              5,335,110
              
              
              
              (4,570,057
              )Other
      accounts receivable and prepaid expenses
              
              
              369,077
              
              
              
              234,402Inventories
              
              
              (2,656,077
              )
              
              
              (1,760,946
              )Unbilled
      receivables
              
              
              627,157
              
              
              
              (1,432,369
              )Deferred
      revenues
              
              
              645,073
              
              
              
              885,854Trade
      payables
              
              
              (4,515,315
              )
              
              
              5,420,310Other
      accounts payable and accrued expenses
              
              
              (442,130
              )
              
              
              911,112Net
      cash provided by (used in) operating activities
              
              
              2,019,950
              
              
              
              (677,260
              )CASH
      FLOWS FROM INVESTING ACTIVITIES:Purchase
      of property and equipment, net of investment grants received from the
      State of Israel
              
              
              (896,972
              )
              
              
              (1,191,822
              )Convertible
      note purchased from unaffiliated entity
              
              
              –
              
              
              
              (2,500,000
              )Additions
      to capitalized software development
              
              
              (680,398
              )
              
              
              –Proceeds
      from escrow settlement
              
              
              –
              
              
              
              3,325,803Acquisition
      of subsidiary, net of cash acquired
              
              
              –
              
              
              
              (1,037,884
              )Acquisition
      of noncontrolling interest
              
              
              –
              
              
              
              (660,500
              )Investment
      in affiliated company
              
              
              (26,031
              )
              
              
              (140,987
              )Repayment
      of promissory notes related to acquisition of subsidiaries
              
              
              –
              
              
              
              (151,450
              )Proceeds
      from sale of property and equipment
              
              
              84,584
              
              
              
              87,521Proceeds
      from sales of marketable securities
              
              
              49,947
              
              
              
              –Increase
      in restricted cash
              
              
              (1,616,322
              )
              
              
              (63,331
              )Net
      cash provided by (used in) investing activities s
              
              
              (3,085,192
              )
              
              
              (2,332,650
              )FORWARD
              
              $
              (1,065,242
              )
              
              $
              (3,009,910
              )
 The
accompanying notes are an integral part of the consolidated financial
statements.
 
 F-7
 Table of Contents
 
 AROTECH CORPORATION
AND ITS SUBSIDIARIES
 CONSOLIDATED
STATEMENTS OF CASH FLOWS
 In
U.S. dollars
 
 2009
              
              
              2008FORWARD
              
              $
              (1,065,242
              )
              
              $
              (3,009,910
              )CASH
      FLOWS FROM FINANCING ACTIVITIES:Repayment
      of long term debt
              
              
              (1,259,039
              )
              
              
              (166,165
              )Increase
      (decrease) in short term bank credit
              
              
              467,000
              
              
              
              (950,000
              )Increase
      in long term debt
              
              
              –
              
              
              
              5,000,000Purchase
      of treasury stock
              
              
              (563,556
              )
              
              
              –Net
      cash provided by (used in) financing activities
              
              
              (1,355,595
              )
              
              
              3,883,835INCREASE
      (DECREASE) IN CASH AND CASH EQUIVALENTS
              
              
              (2,420,837
              )
              
              
              873,925CASH
      ACCRETION (EROSION) DUE TO EXCHANGE RATE DIFFERENCES
              
              
              21,003
              
              
              
              (20,237
              )CASH
      AND CASH EQUIVALENTS AT THE BEGINNING OF THE YEAR
              
              
              4,301,359
              
              
              
              3,447,671CASH
      AND CASH EQUIVALENTS AT THE END OF THE YEAR
              
              $
              1,901,525
              
              
              $
              4,301,359SUPPLEMENTARY
      INFORMATION ON NON-CASH AND OTHER TRANSACTIONS:Stock
      issued for acquisition
              
              $
              –
              
              
              $
              100,000Assets
      recorded for capital lease addition
              
              $
              –
              
              
              $
              106,029Interest
      paid during the year
              
              $
              671,356
              
              
              $
              455,051Taxes
      on income paid during the year
              
              $
              162,774
              
              
              $
              333,144Relative
      fair value of warrants issued in connections with convertible
      note
              
              $
              –
              
              
              $
              412,300Note
      conversion to common stock
              
              $
              455,244
              
              
              $
              –Write-off
      of non-recourse shareholder loans
              
              $
              403,141
              
              
              $
              –Issuance
      of stock in lieu of funding severance
              
              $
              440,000
              
              
              $
              –
 The
accompanying notes are an integral part of the consolidated financial
statements.
 
 F-8
 Table of Contents
 
 AROTECH CORPORATION
AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 In
U.S. dollars
 NOTE
1:–                      GENERAL
  a.                 Corporate
structure:
  Arotech
Corporation (“Arotech”) and its wholly-owned subsidiaries (the “Company”)
provide defense and security products for the military, law enforcement and
homeland security markets, including advanced zinc-air and lithium batteries and
chargers, multimedia interactive simulators/trainers and lightweight vehicle
armoring. The Company operates primarily through its wholly-owned subsidiaries
FAAC Incorporated (“FAAC”), based in Ann Arbor, Michigan and Royal Oak,
Michigan; MDT Protective Industries, Ltd. (“MDT”), based in Lod, Israel; MDT
Armor Corporation (“MDT Armor”), based in Auburn, Alabama; Electric Fuel Battery
Corporation (“EFB”), based in Auburn, Alabama; Electric Fuel Ltd. (“EFL”), based
in Beit Shemesh, Israel; and Epsilor Electronic Industries, Ltd. (“Epsilor”),
based in Dimona, Israel. The Company’s former subsidiaries Armour of America
Incorporated (“AoA”) and Realtime Technologies, Inc. (“RTI”) have been merged
into MDT Armor and FAAC, respectively.
  b.                 Acquisition
of FAAC:
  The
Company had a contingent earnout obligation in an amount equal to the net income
realized by the Company from certain specific programs that were identified by
the Company and the former shareholders of FAAC as appropriate targets for
revenue increases in 2005. The $151,450 shown as promissory notes in the 2007
balance sheet is the portion of the 2006 earnout that was paid in equal
installments that started in January 2007 and was fully paid in June 2008. The
promissory note was non-interest bearing.
  c.                 Acquisition
of AoA:
  The total
purchase price consisted of $19,000,000 in cash, with additional possible
earn-outs if AoA was awarded certain material contracts. In 2005 and 2007, the
Company recorded impairments of goodwill and intangibles totaling $12.6 million.
Additionally, in connection with the Company’s acquisition of AoA, the Company
had a contingent earnout obligation in an amount equal to the revenues AoA
realized from certain specific programs that were identified by the Company and
the seller of AoA (“Seller”) as appropriate targets for revenue increases. As of
December 31, 2006, the Company had reduced the $3.0 million escrow held by the
Seller by approximately $1,520,000 for a putative claim against such escrow in
respect of such earnout obligation.
  On March
20, 2007, the Company filed a Demand for Arbitration with the American
Arbitration Association against the Seller. In February 2008, the arbitration
panel issued a decision denying the Seller’s counterclaims in respect of the
Company’s earnout obligation, granting the Seller’s counterclaim for $70,000 in
compensation, and awarding the Company the entire $3.0 million escrow, along
with $135,000 in attorneys’ fees and interest of approximately $325,000. The net
impact of the settlement was a gain to the Company of approximately $1.8
million, which included an escrow adjustment in the first quarter 2008 of $1.4
million and approximately $398,000 in interest and net legal fees. This award
was paid to the Company in April 2008, and the time for the Seller to move to
vacate or modify this award has now expired.
  F-9
 Table of Contents
  AROTECH CORPORATION
AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 In
U.S. dollars
  NOTE
1:–                      GENERAL
(Cont.)
  d.                 Purchase
of the Noncontrolling Interest in MDT and MDT Armor
  In
January 2008, the Company purchased the minority shareholder’s 24.5% interest in
MDT Protective Industries Ltd. (“MDT”) and his 12.0% interest in MDT Armor
Corporation (“MDT Armor”), as well as settling all outstanding disputes
regarding severance payments, in exchange for a total of $1.0 million that was
paid in cash. The purchase was treated as a step acquisition using the purchase
method of accounting. The Company evaluated the purchase price and identified
$607,100 in goodwill and workforce intangibles with an indefinite life. The
Company also identified $53,400 as an intangible asset related to its customer
list with a useful life of four years. The remaining balance of $339,500 was
expensed in the first quarter of 2008.
 
 e.                 Acquisition
of Realtime Technologies, Inc.
  In
February 2008, the Company’s FAAC subsidiary acquired all of the outstanding
stock of Realtime Technologies, Inc. (“RTI”), a privately-owned corporation
headquartered in Royal Oak, Michigan, for a total of approximately $1,387,000,
including $1,250,000 in cash, $100,000 in Company stock (54,348 shares) and
approximately $37,000 in legal fees along with a contingent earnout of $250,000
that was earned in 2008 and recorded as compensation expense. RTI specializes in
multi-body vehicle dynamics modeling and graphical simulation solutions. RTI’s
product portfolio provides FAAC with the opportunity to economically add new
features to the driver training products marketed by FAAC.
  RTI’s
operating results are included in the Company’s Training and Simulation Division
as of January 1, 2008 and the effect on operations was not
material.
  Listed
below is the purchase price allocation:
   Current
      assets acquired, net of liabilities
              
              $
              433,389Technology
      and patents - 7 year life
              
              
              663,000Trademark/trade
      names - 10 year life
              
              
              28,000Customer
      relationships - 10 year life
              
              
              62,000Goodwill
      - indefinite life
              
              
              200,222Equity
      value
              
              $
              1,386,611
  f.                 Impairment
of goodwill and other intangible assets:
  Goodwill is tested for impairment at
least annually and between annual tests in certain circumstances, and written
down when impaired, rather than being amortized as previous accounting standards
required. Goodwill is tested for impairment by comparing the fair value of the
Company’s reporting units with their carrying value. All of the Company’s
reporting units have goodwill subject to annual testing. Fair value is
determined using discounted cash flows. Significant estimates used in the
methodologies include estimates of future cash flows, future short-term and
long-term growth rates and weighted average cost of capital.In both 2009
and 2008, the Company evaluated all goodwill at mid-year and determined that
there was no impairment.
  F-10
 Table of Contents
  AROTECH CORPORATION
AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 In
U.S. dollars
  NOTE
1:–                      GENERAL
(Cont.)
 
 The
Company completed its annual goodwill impairment review using the financial
results as of the quarter ended June 30, 2009. Although the cumulative book
value of the Company’s reporting units exceeded the Company’s market value as of
the impairment review, management nevertheless determined that the fair value of
the respective reporting units exceeded their respective carrying values, and
therefore, there would be no impairment charges relating to goodwill. Several
factors contributed to this determination:
  ·
              The
      long term horizon of the valuation process versus a short term valuation
      using current market conditions;
  ·
              The
      valuation by individual business segments versus the market share value
      based on the Company as a whole;
and
  ·
              The
      fact that the Company’s stock is thinly traded and widely dispersed with
      minimal institutional ownership, and thus not followed by major market
      analysts, leading management to conclude that the market in the Company’s
      securities was not acting as an informationally efficient reflection of
      all known information regarding the
Company.
  In view
of the above factors, management felt that in the current market the Company’s
stock was undervalued, especially when compared to the estimated future cash
flows of the underlying entities.
  The
Company’s long-lived assets and amortizable identifiable intangibles are
reviewed for impairment whenever events or changes in circumstances indicate
that the carrying amount of an asset may not be recoverable. Recoverability of
the carrying amount of assets to be held and used is measured by a comparison of
the carrying amount of the assets to the future undiscounted cash flows expected
to be generated by the assets. If such assets are considered to be impaired, the
impairment to be recognized is measured by the amount by which the carrying
amount of the assets exceeds the fair value of the assets.
  g.                 Related
parties
  The
Company has had a consulting agreement with Sampen Corporation since 2005.
Sampen is a New York corporation owned by members of the immediate family of one
of the Company’s executive officers, and this executive officer is an employee
of both the Company and of Sampen. The term of this consulting agreement was
extended automatically for additional term of two years until December 31, 2010,
unless either Sampen or the Company terminates the agreement
sooner.
  Pursuant
to the terms of the Company’s agreement with Sampen, Sampen provides one of its
employees to the Company for such employee to serve as the Company’s Chief
Operating Officer. The Company pays Sampen $12,800 per month, plus an annual
bonus, on a sliding scale, in an amount equal to a minimum of 20% of Sampen’s
annual base compensation then in effect, up to a maximum of 75% of its annual
base compensation then in effect if the results the Company actually attained
for the year in question are 120% or more of the amount the Company budgeted at
the beginning of the year. The Company also pays Sampen, to cover the cost of
the Company’s use of Sampen’s offices as an ancillary New York office and the
attendant expenses and insurance costs, an amount equal to 16% of each monthly
payment of base compensation.
  F-11
 Table of Contents
  AROTECH CORPORATION
AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 In
U.S. dollars
  NOTE
1:–                      GENERAL
(Cont.)
  During
the years ended December 31, 2009 and 2008, the Company paid Sampen a total of
$178,356 and $178,424, respectively.
  On
December 3, 1999, Robert S. Ehrlich purchased 8,928 shares of the Company’s
common stock out of the Company’s treasury at the closing price of the Company’s
common stock on December 2, 1999. Payment was rendered by Mr. Ehrlich in the
form of non-recourse promissory notes due in 2009 in the amount of $167,975,
bearing simple annual interest at a rate of 2%, secured by the shares of common
stock purchased and other shares of common stock previously held by him. As of
December 31, 2008, the aggregate amount outstanding pursuant to these promissory
notes from Mr. Ehrlich and a former employee with the same arrangement were
$403,141, which were not repaid and were therefore written off to paid in
capital in the fourth quarter of 2009.
 On
February 9, 2000, Mr. Ehrlich exercised 9,404 stock options. Mr. Ehrlich paid
the exercise price of the stock options and certain taxes that the Company paid
on his behalf by giving the Company a non-recourse promissory note due in 2025
in the amount of $329,163, bearing annual interest at 1% over the then-current
federal funds rate announced from time to time by the Wall Street Journal, secured
by the shares of the Company’s common stock acquired through the exercise of the
options and certain compensation due to Mr. Ehrlich upon termination. As of
December 31, 2009, the aggregate amount outstanding pursuant to this promissory
note was $452,995.  Again, there is a former employee with the same
arrangement.
  On June
10, 2002, Mr. Ehrlich exercised 3,571 stock options. Mr. Ehrlich paid the
exercise price of the stock options by giving the Company a non-recourse
promissory note due in 2012 in the amount of $36,500, bearing simple annual
interest at a rate equal to the lesser of (i) 5.75%, and (ii) 1% over the
then-current federal funds rate announced from time to time, secured by the
shares of the Company’s common stock acquired through the exercise of the
options. As of December 31, 2009, the aggregate amount outstanding pursuant to
this promissory note was $46,593.
  NOTE
2:–                      SIGNIFICANT
ACCOUNTING POLICIES
  The
consolidated financial statements have been prepared in accordance with
generally accepted accounting principles in the United States (“U.S.
GAAP”).
  a.                 Use
of estimates:
  The
preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the amounts reported in the financial statements and accompanying notes.
Actual results could differ from those estimates.
  F-12
 Table of Contents
  AROTECH CORPORATION
AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 In
U.S. dollars
  NOTE
2:–                      SIGNIFICANT
ACCOUNTING POLICIES (Cont.)
 
 b.                 Financial
statements in U.S. dollars:
  A
majority of the revenues of the Company is generated in U.S. dollars. In
addition, a substantial portion of the Company’s costs are incurred in U.S.
dollars (“dollar”). Management believes that the dollar is the primary currency
of the economic environment in which the Company operates. Thus, the functional
and reporting currency of the Company including most of its subsidiaries, is the
dollar. Accordingly, monetary accounts maintained in currencies other than the
U.S. dollar are remeasured into U.S. dollars, with resulting gains and losses
reflected in the consolidated statements of operations as financial income or
expenses, as appropriate.
  The
majority of transactions of MDT and Epsilor are in New Israel Shekels (“NIS”)
and a substantial portion of MDT’s and Epsilor’s costs is incurred in NIS.
Management believes that the NIS is the functional currency of MDT and Epsilor.
Accordingly, the financial statements of MDT and Epsilor have been translated
into U.S. dollars. All balance sheet accounts have been translated using the
exchange rates in effect at the balance sheet date. Statement of operations
amounts have been translated using the weighted average exchange rate for the
period. The resulting translation adjustments are reported as a component of
accumulated other comprehensive income in stockholders’ equity.
  c.                 Principles
of consolidation:
  The
consolidated financial statements include the accounts of the Company and its
wholly owned subsidiaries. Intercompany balances and transactions have been
eliminated upon consolidation.
  d.                 Cash
equivalents:
  Cash
equivalents are short-term highly liquid investments that are readily
convertible to cash with maturities of three months or less when
acquired.
  e.                 Restricted
cash:
  Restricted
cash is primarily invested in highly liquid deposits which are used as a
security for the Company’s performance guarantees at FAAC and MDT
Armor.
  f.                 Marketable
securities:
  The
Company determines the appropriate classification of its investments in debt and
equity securities at the time of purchase and reevaluates such determinations at
each balance sheet date. Investment in trust funds are classified as
available-for-sale and stated at fair value, with unrealized gains and losses
reported in accumulated other comprehensive income (loss), a separate component
of stockholders’ equity, net of taxes. Realized gains and losses on sales of
investments, as determined on a specific identification basis, are included in
the consolidated statements of income.
  F-13
 Table of Contents
  AROTECH CORPORATION
AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 In
U.S. dollars
  NOTE
2:–                      SIGNIFICANT
ACCOUNTING POLICIES (Cont.)
 
 The
Company sold all marketable securities and as of December 31, 2009, the balance
was zero.
  g.                 Inventories:
  Inventories
are stated at the lower of cost or market value. Inventory write-offs and
write-down provisions are provided to cover risks arising from slow-moving items
or technological obsolescence and for market prices lower than cost. The Company
periodically evaluates the quantities on hand relative to current and historical
selling prices and historical and projected sales volume. Based on this
evaluation, provisions are made to write inventory down to its market value. In
2009 and 2008, the Company wrote off $12,000 and $155,000, respectively, of
obsolete inventory, which has been included in the cost of
revenues.
  Cost is
determined as follows:
  Raw and
packaging materials – by the average cost method or FIFO.
  Work in
progress – represents the cost of manufacturing with additions of allocable
indirect and direct manufacturing cost.
  Finished
products – on the basis of direct manufacturing costs with additions of
allocable indirect manufacturing costs.
  h.                 Property
and equipment:
  Property
and equipment are stated at cost net of accumulated depreciation and investment
grants received from the State of Israel for investments in fixed assets under
the Investment Law.  Investment grants of approximately $270,000 were
received in 2009 and no investment grants were received during
2008.
  Depreciation
is calculated by the straight-line method over the following estimated useful
lives of the assets:
  Depreciable
      life (in years)Computers
      and related equipment
              
              3
      to 5Motor
      vehicles
              
              5
      to 7Office
      furniture and equipment
              
              
              10Machinery
      and equipment
              
              
              10Buildings
              
              
              30Land
              
              Not
      depreciatedLeasehold
      improvements
              
              Shorter
      of the term of the lease
                or
      the life of the assetDemo
      inventory
              
              
              5
 
 F-14
 Table of Contents
  AROTECH CORPORATION
AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 In
U.S. dollars
  NOTE
2:–                      SIGNIFICANT
ACCOUNTING POLICIES (Cont.)
 
 i.                 Revenue
recognition:
  The
Company is a defense and security products and services company, engaged in
three business areas: interactive simulation for military, law enforcement and
commercial markets; batteries and charging systems for the military; and
high-level armoring for military, paramilitary and commercial vehicles. During
2009 and 2008, the Company recognized revenues as follows: (i) from the sale and
customization of interactive training systems and from the maintenance services
in connection with such systems (Training and Simulation Division); (ii) from
revenues under armor contracts and for service and repair of armored vehicles
(Armor Division); (iii) from the sale of batteries, chargers and adapters to the
military, and under certain development contracts with the U.S. Army (Battery
and Power Systems Division); and (iv) from the sale of lifejacket lights
(Battery and Power Systems Division).
  Revenues
from products sold by the Battery and Power Systems Division and the Armor
Division are recognized when persuasive evidence of an agreement exists,
delivery has occurred, the fee is fixed or determinable, collectability is
probable, and no further obligation remains.
  Revenues
from contracts in the Training and Simulation division that involve
customization of the system to customer specific specifications are recognized
using contract accounting on a percentage of completion method, in accordance
with the “Input Method.” The amount of revenue recognized is based on the
percentage to completion achieved. The percentage to completion is measured by
monitoring progress using records of actual time, materials and other costs
incurred to date in the project compared to the total estimated project
requirement. Estimates of total project requirements are based on prior
experience of customization, delivery and acceptance of the same or similar
technology and are reviewed and updated regularly by management. Provisions for
estimated losses on uncompleted contracts are made in the period in which such
losses are first determined, in the amount of the estimated loss on the entire
contract.
  The
Company believes that the use of the percentage of completion method is
appropriate as the Company has the ability to make reasonably dependable
estimates of the extent of progress towards completion, contract revenues and
contract costs. In addition, contracts executed include provisions that clearly
specify the enforceable rights regarding services to be provided and received by
the parties to the contracts, the consideration to be exchanged and the manner
and the terms of settlement, including in cases of terminations for convenience.
In all cases, the Company expects to perform its contractual obligations and its
customers are expected to satisfy their obligations under the
contract.
  Revenues
from simulators that do not require significant customization are recognized
when persuasive evidence of an agreement exists, delivery has occurred, no
significant obligations with regard to implementation remain, the fee is fixed
or determinable and collectability is probable.
  Maintenance
and support revenue included in multiple element arrangements is deferred and
recognized on a straight-line basis over the term of the maintenance and support
services. Revenues from training are recognized when it is performed. The Vendor
Specific Objective Evidence (“VSOE”) of fair value of the maintenance, training
and support services is determined based on the price charged when sold
separately or when renewed.
  F-15
 Table of Contents
  AROTECH CORPORATION
AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 In
U.S. dollars
  NOTE
2:–                      SIGNIFICANT
ACCOUNTING POLICIES (Cont.)
 
 Unbilled
receivables include cost and gross profit earned in excess of
billing.
  Deferred
revenues include unearned amounts received under maintenance and support
services and billing in excess of costs and estimated earnings on uncompleted
contracts.
  j.                 Right
of return:
  When a
right of return exists, the Company defers its revenues until the expiration of
the period in which returns are permitted.
  k.                 Warranty:
  The
Company offers up to a one year warranty for most of its products. The specific
terms and conditions of those warranties vary depending upon the product sold
and country in which the Company does business. The Company estimates the costs
that may be incurred under its basic limited warranty, including parts and
labor, and records deferred revenue in the amount of such costs at the time
product revenue is recognized. Factors that affect the Company’s warranty
liability include the number of installed units, historical and anticipated
rates of warranty claims, and cost per claim. The Company periodically assesses
the adequacy of its reserves and adjusts the amounts as necessary.
  l.                 Research
and development cost:
  The
Company capitalizes certain software development costs, subsequent to the
establishment of technological feasibility. Based on the Company’s product
development process, technological feasibility is established upon the
completion of a working model or a detailed program design. Research and
development costs incurred in the process of developing product improvements or
new products are generally charged to expenses as incurred. Significant costs
incurred by the Company between completion of the working model or a detailed
program design and the point at which the product is ready for general release
have been capitalized.Capitalized
software costs will be amortized by the greater of the amount computed using:
(i) the ratio that current gross revenues from sales of the software bears to
the total of current and anticipated future gross revenues from sales of that
software, or (ii) the straight-line method over the estimated useful life of the
product (two to five years). The Company assesses the net realizable value of
this intangible asset on a regular basis by determining whether the amortization
of the asset over its remaining life can be recovered through undiscounted
future operating cash flows from the specific software product sold. Based on
its most recent analyses, management believes that no impairment of capitalized
software development costs exists as of December 31, 2009.
  In 2009,
the Training and Simulation division capitalized approximately $680,000 in
software development costs that will be amortized on a straight-line method over
2 years, the useful life of the software.
  F-16
 Table of Contents
 AROTECH CORPORATION
AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 In
U.S. dollars
 NOTE
2:–                      SIGNIFICANT
ACCOUNTING POLICIES (Cont.)
 
 m.                Income
taxes:
  The
Company accounts for income taxes under the liability method, whereby deferred
tax assets and liability account balances are determined based on differences
between financial reporting and the tax basis of assets and liabilities and are
measured using the enacted tax rates and laws that will be in effect when the
differences are expected to reverse. The Company provides a valuation allowance,
if necessary, to reduce deferred tax assets to their estimated realizable
value.
  n.                Concentrations
of credit risk:
  Financial
instruments that potentially subject the Company to concentrations of credit
risk consist principally of cash and cash equivalents, restricted cash, trade
receivables and available-for-sale marketable securities. Cash and cash
equivalents are invested mainly in U.S. dollar deposits with major Israeli and
U.S. banks. Such deposits in the U.S. may be in excess of insured limits and are
not insured in other jurisdictions. Management believes that the financial
institutions that hold the Company’s investments are financially sound and,
accordingly, minimal credit risk exists with respect to these
investments.
  The trade
receivables of the Company are mainly derived from sales to customers located
primarily in the United States and Israel along with the countries listed in
footnote 16 c. Management believes that credit risks are moderated by the
diversity of its end customers and geographical sales areas. The Company
performs ongoing credit evaluations of its customers’ financial condition. An
allowance for doubtful accounts is determined with respect to those accounts
that the Company has determined to be doubtful of collection.
  The
Company’s available-for-sale marketable securities have included investments in
debentures of U.S.and Israeli corporations
and state and local governments. Management believes that those corporations and
governments are institutions that are financially sound and that minimal credit
risk exists with respect to these types of marketable securities. The Company
sold all marketable securities and as of December 31, 2009, the balance was
zero.
  The
Company had no off-balance-sheet concentration of credit risk such as foreign
exchange contracts, option contracts or other foreign hedging
arrangements.
  o.                 Basic
and diluted net loss per share:
  Basic net
loss per share is computed based on the weighted average number of shares of
common stock outstanding during each year. Diluted net loss per share is
computed based on the weighted average number of shares of common stock
outstanding during each year, plus dilutive common stock equivalents related to
outstanding stock options, non vested restricted stock, warrants and convertible
debt. All common stock equivalents have been excluded from the calculation of
the diluted net loss per common share because all such securities are
anti-dilutive for all periods presented. The total weighted average number of
shares related to the outstanding common stock equivalents excluded from the
calculations of diluted net loss per share was 1,387,014 and 958,881 for the
years ended December 31, 2009 and 2008, respectively.
  F-17
 Table of Contents
  AROTECH CORPORATION
AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 In
U.S. dollars
  NOTE
2:–                      SIGNIFICANT
ACCOUNTING POLICIES (Cont.)
 
 p.                 Accounting
for stock-based compensation
  Stock-based
awards to employees are recognized as compensation expense based on the
calculated fair value on the date of grant. The Company determines the fair
value using the Black-Scholes option pricing model. This model requires
subjective assumptions, including future stock price volatility and expected
term.
  The
Company did not grant any options in 2008 or 2009. The Company assumed a 20%
forfeiture rate on existing options for both years. The Company uses a 10%
forfeiture rate for restricted stock and adjusts both forfeiture rates based on
historical forfeitures.
  q.                 Fair
value of financial instruments:
  The
following methods and assumptions were used by the Company in estimating their
fair value disclosures for financial instruments:
  The
carrying amounts of cash and cash equivalents, restricted cash, trade and other
receivables, short-term bank credit, and trade payables approximate their fair
value due to the short-term maturity of such instruments.
  The fair
value of available for sale marketable securities, if any, is based on the
quoted market price.
  Long-term
promissory notes are estimated by discounting the future cash flows using
current interest rates for loans of similar terms and maturities. The carrying
amount of the long-term liabilities approximates their fair value.
  r.                 Severance
pay:
  The
Company’s liability for severance pay for its Israeli employees is calculated
pursuant to Israeli severance pay law based on the most recent salary of the
employees multiplied by the number of years of employment as of the balance
sheet date. Israeli employees are entitled to one month’s salary for each year
of employment, or a portion thereof. The Company’s liability for all of its
Israeli employees is fully provided by monthly deposits with severance pay
funds, insurance policies and by accrual. The value of these policies is
recorded as an asset in the Company’s balance sheet.
  In
addition, according to certain employment agreements, the Company is obligated
to provide for a special severance pay in addition to amounts due to certain
employees pursuant to Israeli severance pay law. The Company has made a
provision of $2,160,428 for this special severance pay. As of December 31, 2009
and 2008, the unfunded severance pay in that regard amounted to $857,624 and
$1,472,523, respectively.
  Pursuant
to the terms of the respective employment agreements between the Company and its
Chief Executive Officer and its Chief Operating Officer, funds to secure payment
of their respective contractual severance amounts are to be deposited for their
benefit, with payments to be made pursuant to an agreed-upon schedule. These
funds continue to be owned by the Company, which benefits from all gains and
bears the risk of all losses resulting from investments of these
funds.
  F-18
 Table of Contents
  AROTECH CORPORATION
AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 In
U.S. dollars
  NOTE
2:–                      SIGNIFICANT
ACCOUNTING POLICIES (Cont.)
 
 The
deposited funds include profits accumulated up to the balance sheet date. The
deposited funds may be withdrawn only upon the fulfillment of the obligation
pursuant to Israeli severance pay law or labor agreements. The value of the
deposited funds is based on the cash surrender value of these policies and
includes immaterial profits.
  In April
2009, the Company, with the agreement of its Chief Executive Officer and its
Chief Operating Officer, funded an additional portion of their
severance security by means of issuing to them, in trust, restricted stock
having a value (based on the closing price of the Company’s stock on the Nasdaq
Stock Market on the date on which the executives and the Company’s board of
directors agreed on this arrangement) of $440,000, a total of 602,740 shares.
The Company agreed with the executives that the economic risk of gain or loss on
these shares is to be borne by them. Should they leave the Company’s employ
under circumstances in which they are not entitled to their severance package
(primarily, termination for Cause as defined in his employment agreement), these
shares would be returned to the Company for cancellation and because of this,
these shares are not included in the basic EPS calculation.
  Severance
expenses for the years ended December 31, 2009 and 2008 amounted to $61,107 and
$202,627, respectively.
  s.                 Advertising
costs:
  The
Company records advertising costs as incurred. Advertising expense for the years
ended December 31, 2009 and 2008 was approximately $87,955 and $100,347,
respectively.
  t.                 New
accounting pronouncements:
  In June
2009, the FASB issued ASU 2009-01, “The FASB Accounting Standards Codification
and the Hierarchy of Generally Accepted Accounting Principles.” The FASB
Accounting Standards Codification is intended to be the source of authoritative
GAAP and reporting standards as issued by the FASB. Its primary purpose is to
improve clarity and use of existing standards by grouping authoritative
literature under common topics. This Statement is effective for financial
statements issued for interim and annual periods ending after September 15,
2009. The Company adopted ASU 2009-01 in the third quarter of 2009 and has
included references to the ASC within its consolidated financial
statements.
  In
October 2009, the FASB issued ASU 2009-13, “Revenue Recognition (ASC
605) – Multiple-Deliverable Revenue Arrangements” and ASU 2009-14, “Software (ASC
985) – Certain Revenue Arrangements That Include Software Elements.” ASU
2009-13 modifies the requirements that must be met for an entity to recognize
revenue from the sale of a delivered item that is part of a multiple-element
arrangement when other items have not yet been delivered. ASU 2009-13 eliminates
the requirement that all undelivered elements must have either: i)
vendor-specific objective evidence (“VSOE”) or ii) third-party evidence (“TPE”),
before an entity can recognize the portion of an overall arrangement
consideration that is attributable to items that already have been delivered. In
the absence of VSOE or TPE of the standalone selling price for one or more
delivered or undelivered elements in a multiple-element arrangement, entities
will be required to estimate the selling prices of those elements. Overall
arrangement consideration will be allocated to each element (both delivered and
undelivered items) based on their relative selling prices, regardless of whether
those selling prices are evidenced by VSOE or TPE or are based on the entity’s
estimated selling price. The residual method of allocating arrangement
consideration has been eliminated. ASU 2009-14 modifies the
software revenue recognition guidance to exclude from its scope tangible
products that contain both software and non-software components that function
together to deliver a product’s essential functionality. These new updates are
effective for revenue arrangements entered into or materially modified in fiscal
years beginning on or after June 15, 2010. Early adoption is permitted. The
Company is currently evaluating both the timing and the impact of the pending
adoption of these ASU’s on its consolidated financial statements.
  F-19
 Table of Contents
  AROTECH CORPORATION
AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 In
U.S. dollars
  NOTE
2:–                      SIGNIFICANT
ACCOUNTING POLICIES (Cont.)
 
 In
October 2009, the FASB issued ASU 2009-15, “Accounting for Own-Share Lending
Arrangements in Contemplation of Convertible Debt Issuance or Other Financing,”
which amends ASC Topic 470 and provides guidance for accounting and reporting
for own-share lending arrangements issued in contemplation of a convertible debt
issuance. At the date of issuance, a share-lending arrangement entered into on
an entity’s own shares should be measured at fair value in accordance with Topic
820 and recognized as an issuance cost, with an offset to additional paid-in
capital. Loaned shares are excluded from basic and diluted earnings per share
unless default of the share-lending arrangement occurs. The amendments also
require several disclosures including a description and the terms of the
arrangement and the reason for entering into the arrangement. The effective
dates of the amendments are dependent upon the date the share-lending
arrangement was entered into and include retrospective application for
arrangements outstanding as of the beginning of fiscal years beginning on or
after December 15, 2009. The Company does not believe that the adoption of this
standard will have any material impact on the its financial position or results
of operations.
  u.                 Share
repurchase:
  In
February 2009, the Company authorized, for a period of one year, the repurchase
in the open market or in privately negotiated transactions of up to $1.0 million
of the Company’s common stock. Through December, 2009, the Company repurchased
447,358 shares for a total of $563,556. The repurchase program is subject to
management’s discretion.
  The
repurchase program is subject to management’s discretion.
  v.                 Reclassification:
  Prior
period amounts are reclassified to conform to the current period
presentation.
  NOTE
      3:–
              RESTRICTED
      CASH
  December
      31,2009
              
              
              2008Short-term:Deposits
      in connection with MDT Projects
              
              $
              380,165
              
              
              $
              381,586Deposits
      in connection with FAAC Projects
              
              
              1,617,000
              
              
              
              –Total
      Cash
              
              $
              1,997,165
              
              
              $
              381,586
  F-20
 Table of Contents
 AROTECH CORPORATION
AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 In
U.S. dollars
  NOTE
4:
–                      AVAILABLE
FOR SALE MARKETABLE SECURITIES
  The
following is a summary of investments in marketable securities as of December
31, 2009 and 2008:
  Cost
              
              
              Unrealized
      gains
              
              
              Estimated
      fair value2009
              
              
              2008
              
              
              2009
              
              
              2008
              
              
              2009
              
              
              2008Available
      for sale marketable securities
              
              $
              –
              
              
              $
              47,005
              
              
              $
              –
              
              
              $
              2,199
              
              
              $
              –
              
              
              $
              49,204
  The
marketable securities were sold in the fourth quarter of 2009.
   NOTE
5:–                      OTHER
ACCOUNTS RECEIVABLE AND PREPAID EXPENSES
 December
      31,2009
                
                
                2008Government
      authorities
                
                $
                321,630
                
                
                $
                114,090Employees
                
                
                62,643
                
                
                
                45,458Prepaid
      expenses
                
                
                440,693
                
                
                
                623,561Loan
      to non-affiliated entity
                
                
                2,000,000
                
                
                
                2,531,250Other
                
                
                236
                
                
                
                311,596Total
                
                $
                2,825,202
                
                
                $
                3,625,955
 
 In August
2008, the Company purchased a $2,500,000 10% Senior Subordinated Convertible
Note from DEI Services Corporation (“DEI”), an unaffiliated company. This 10%
Senior Subordinated Convertible Note (the “DEI Note”) was due December 31, 2009.
Interest was payable on a quarterly basis. The DEI Note is convertible at the
Company’s option into such number of shares of DEI’s common stock, no par value
per share, equal at the time of conversion to twelve percent (12%) of DEI’s
outstanding common stock.
 
 In the
third quarter of 2009 DEI repaid a portion of their internal shareholder loans,
which was a violation of the DEI Note covenants with the Company. Because of
this, the Company agreed in October of 2009 to amend the DEI Note to provide
that the interest rate on the DEI Note would be increased to 15% and would be
payable through the payment date. In the event that the DEI Note is not paid in
full at maturity, the DEI Note will be convertible into a minimum of 20% of
DEI’s then outstanding common stock, or more under certain
circumstances.
 
 In
November 2009, DEI brought in a new investor that was prepared to provide DEI
with additional working capital, but only if the Company agreed to step aside
and accept a $500,000 discount on the DEI Note and waive its associated rights
of first refusal and conversion. In view of the possibility that DEI would seek
an extension of the DEI Note, the Company decided to enable DEI to bring in the
new investor and thereby be able to pay the DEI Note on time, albeit at a
discount. The Company accordingly wrote down the value of the DEI Note in the
third quarter of 2009 by $500,000, to $2.0 million and charged the associated
expense to allowance for settlements on the statement of operations. When the
new investor’s investment did not close, the Company retained all its rights
under the DEI Note, including its right to be paid the full amount of the DEI
Note and its conversion option and right of first refusal.
  F-21
 Table of Contents
  AROTECH CORPORATION
AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 In
U.S. dollars
  NOTE
5:–                      OTHER
ACCOUNTS RECEIVABLE AND PREPAID EXPENSES (Cont.)
 
 The
Company declared a default on the DEI Note when it was not paid pursuant to its
terms at the end of December 2009. The Company is presently prohibited from
bringing suit to collect this note pursuant to the terms of a subordination
agreement with DEI’s senior lender. However, the Company is maintaining
communication with DEI, and the Company continues to believe that DEI’s
anticipated earnings and cash flow will enable the DEI Note to be paid, albeit
late. Interest on the DEI Note has been paid by DEI through November 15, 2009
and the Company expects DEI to continue to make timely interest payments on the
DEI Note.
 
 Management
has determined that the DEI Note, in the event of an impairment, would be valued
using Level 2 inputs under FASB ASC 820-10, using inputs related to interest
rates, term of the note and relative risk on similar notes available in the
marketplace.
 
 NOTE
6:–                      INVENTORIES
  December
      31,2009
              
              
              2008Raw
      and packaging materials
              
              $
              7,479,672
              
              
              $
              6,798,662Work
      in progress
              
              
              3,943,073
              
              
              
              2,251,734Finished
      products
              
              
              912,292
              
              
              
              628,564Total
              
              $
              12,335,037
              
              
              $
              9,678,960
  NOTE
7:–                      PROPERTY
AND EQUIPMENT, NET
  a.                 Composition
of property and equipment is as follows:
  December
      31,2009
                
                
                2008Cost:Computers and related
      equipment
                
                $
                2,293,941
                
                
                $
                2,408,734Motor vehicles
                
                
                508,199
                
                
                
                529,685Office furniture and
      equipment
                
                
                1,228,694
                
                
                
                1,030,199Machinery, equipment and
      installations
                
                
                4,618,750
                
                
                
                5,499,776Buildings
                
                
                1,172,072
                
                
                
                1,172,072Land
                
                
                115,538
                
                
                
                115,538Leasehold
      improvements
                
                
                1,047,208
                
                
                
                973,360Demo inventory
                
                
                1,607,948
                
                
                
                1,424,83112,592,350
                
                
                
                13,154,195
  F-22
 Table of Contents
  AROTECH CORPORATION
AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 In
U.S. dollars
  NOTE
7:–                      PROPERTY
AND EQUIPMENT, NET (Cont.)
  December
      31,2009
                
                
                
                2008Accumulated
      depreciation:Computers and related
      equipment
                
                
                2,010,768
                
                
                
                2,163,444Motor vehicles
                
                
                163,632
                
                
                
                290,839Office furniture and
      equipment
                
                
                873,151
                
                
                
                648,278Machinery, equipment and
      installations
                
                
                3,232,669
                
                
                
                3,671,997Buildings
                
                
                85,150
                
                
                
                55,097Leasehold
      improvements
                
                
                724,992
                
                
                
                611,139Demo
      inventory
                
                
                877,155
                
                
                
                655,1387,967,517
                
                
                
                8,095,932Property
      and equipment, net
                
                $
                4,624,833
                
                
                $
                5,058,263
  b.                 Depreciation
expense amounted to $1,260,458 and $1,246,238 for the years ended December 31,
2009 and 2008, respectively.
  c.                 In
March 2007, the Company purchased 16,700 square feet of space in Auburn, Alabama
for approximately $1.1 million pursuant to a seller-financed secured purchase
money mortgage. Half the mortgage is payable over ten years in equal monthly
installments based on a 20-year amortization of the full principal amount, and
the remaining half is payable at the end of ten years in a balloon
payment.
  As for
liens, see Note 11.d.
  NOTE
8:–                      GOODWILL
AND OTHER INTANGIBLE ASSETS, NET
  a.               
Goodwill
  A summary
of the goodwill by business segment is as follows:
  December
      31,
                2008
              
              
              Additions
              
              
              Adjustments
      (currency)
              
              
              December
      31,
                2009Simulation
              
              $
              24,435,641
              
              
              $
              –
              
              
              $
              –
              
              
              $
              24,435,641Armor
              
              
              1,799,393
              
              
              
              –
              
              
              
              10,146
              
              
              
              1,809,539Battery
              
              
              6,015,469
              
              
              
              –
              
              
              
              43,024
              
              
              
              6,058,493Total
              
              $
              32,250,503
              
              
              $
              –
              
              
              $
              53,170
              
              
              $
              32,303,673
  F-23
 Table of Contents
  AROTECH CORPORATION
AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 In
U.S. dollars
  NOTE
8:–                      GOODWILL
AND OTHER INTANGIBLE ASSETS, NET (Cont.)
 
 b.              
 Other intangible assets:
  December
      31,2009
              
              
              2008Useful
      life
              
              Cost
              
              
              Net
      Book Value
              
              
              Cost
              
              
              Net
      Book ValueTechnology
              4-8
      years
              
              $
              7,068,000
              
              
              $
              1,626,071
              
              
              $
              7,068,000
              
              
              $
              2,297,036Capitalized
      software costs
              1-3
      years
              
              
              2,401,387
              
              
              
              674,699
              
              
              
              1,720,991
              
              
              
              100,408Trademarks
              10
      years
              
              
              28,000
              
              
              
              22,400
              
              
              
              28,000
              
              
              
              25,200Backlog/customer
      relationship
              1-10
      years
              
              
              744,000
              
              
              
              49,600
              
              
              
              744,000
              
              
              
              55,800Covenants
      not to compete
              5
      years
              
              
              99,000
              
              
              
              –
              
              
              
              99,000
              
              
              
              –Customer
      list
              2-10
      years
              
              
              7,602,045
              
              
              
              2,513,609
              
              
              
              7,602,045
              
              
              
              3,186,342Certification
              3
      years
              
              
              246,969
              
              
              
              –
              
              
              
              246,969
              
              
              
              –18,189,401
              
              
              $
              4,886,379
              
              
              
              17,509,005
              
              
              $
              5,664,786Exchange
      differences
              
              
              
              340,221
              
              
              
              
              
              
              
              404,088Less
      - accumulated amortization
              
              
              
              (13,303,022
              )
              
              
              
              
              
              
              (11,844,220
              )Amortized
      cost
              
              
              
              5,226,600
              
              
              
              
              
              
              
              6,068,873Trademarks
      (indefinite lives)
              
              
              
              799,000
              
              
              
              
              
              
              
              799,000Net
      book value
              
              
              $
              6,025,600
              
              
              
              
              
              
              $
              6,867,873Subsequent
      to the 2004 purchase of AoA, the Company recorded an impairment charge in
      2005 to fully impair related goodwill ($10.5 million) and intangible
      assets ($2.6 million). Additionally, due to an earnout on the same
      transaction, the Company recorded an additional $316,000 in goodwill in
      2007 and immediately recorded an impairment of $316,000. The Company
      has not recorded any other goodwill impairment charges.
  Amortization
expense amounted to $1,458,802 and $1,735,548 for the years ended December 31,
2009 and 2008, respectively, including amortization of capitalized software
costs of $106,105 and $342,408, respectively.
 c.               
Estimated
amortization expenses for the years ended:
  Year
      ended December 31,2010
              
              $
              1,586,3312011
              
              
              1,642,7532012
              
              
              801,1252013
              
              
              725,4552014
      and forward
              
              
              130,715Total
              
              $
              4,886,379
  Goodwill
and other intangible assets are adjusted on a quarterly basis for any change due
to currency fluctuations and any variation is included in the accumulated other
comprehensive loss on the Balance Sheet.
  F-24
 Table of Contents
  AROTECH CORPORATION
AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 In
U.S. dollars
  NOTE
9:–                      SHORT-TERM
BANK CREDIT AND LOANS
  The
Company has $10.7 million authorized in credit lines from certain banks, of
which $675,000 is denominated in NIS and carries various approximate interest
rates of prime rate + 4.3% and $10.0 million is denominated in U.S. dollars (the
Company’s primary line which expires in December 2010) and carries an interest
rate of lender’s prime rate + 1.5% which was 4.75% as of December 31, 2009. As
of December 31, 2009, $4.1 million was borrowed under the Company’s primary
line, and an additional $1.3 million is committed to six letters of credit
issued to customers and vendors of the Company. The Company has an additional
$1.6 million letter of credit that does not impact the borrowing base as it is
collateralized by $1.6 million in restricted cash. Approximately $2.6 million of
credit on the primary line, based on the Company’s borrowing base calculations,
was available at year end.
 These
lines of credit are collateralized by the accounts receivable and inventory of
the relevant subsidiary of the Company.
  NOTE
10:–                     OTHER
ACCOUNTS PAYABLE AND ACCRUED EXPENSES
  December
      31,2009
              
              
              2008Employees
      and payroll accruals
              
              $
              2,696,018
              
              
              $
              1,557,628Accrued
      vacation pay
              
              
              711,373
              
              
              
              675,142Accrued
      expenses
              
              
              1,744,469
              
              
              
              1,759,873Government
      authorities
              
              
              107,832
              
              
              
              333,390Advances
      from customers
              
              
              979,744
              
              
              
              1,532,926Total
              
              $
              6,239,436
              
              
              $
              5,858,959
  NOTE
11:–                     COMMITMENTS
AND CONTINGENT LIABILITIES
  a.                 Royalty
commitments:
  Under
EFL’s research and development agreements with the Office of the Chief Scientist
(“OCS”), and pursuant to applicable laws, EFL is required to pay royalties at
the rate of 3%-3.5% of net sales of products developed with funds provided by
the OCS, up to an amount equal to 100% of research and development grants
received from the OCS. (Amounts due in respect of projects approved after year
1999 also bear interest at the Libor rate). EFL is obligated to pay royalties
only on sales of products in respect of which OCS participated in their
development. Should the project fail, EFL will not be obligated to pay any
royalties or refund the grants.
  Royalties
paid or accrued for the years ended December 31, 2009 and 2008 to the OCS
amounted to $19,832 and $11,821, respectively.
  b.                 Lease
commitments:
  The
Company rents its facilities under various operating lease agreements, which
expire on various dates through 2018. The minimum rental payments under
non-cancelable operating leases are as follows:
  December
      312010
              
              $
              806,4832011
              
              
              532,7972012
              
              
              524,1352013
              
              
              347,0852014
              
              
              322,615Thereafter
              
              
              869,389Total
              
              $
              3,402,504
  F-25
 Table of Contents
  AROTECH CORPORATION
AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 In
U.S. dollars
  NOTE
11:–                     COMMITMENTS
AND CONTINGENT LIABILITIES (Cont.)
 
 Total
rent expenses for the years ended December 31, 2009 and 2008 were $835,370 and
$805,518, respectively.
  The
existing capital leases have terms from 3 to 5 years and are for equipment
purchases. The equipment is classified under machinery and equipment in fixed
assets.
  The table
below details the original value, depreciation and net book value of the assets
included.
  Leased
      Assets
              
              December
      31,2009
              
              
              2008Equipment
              
              $
              206,564
              
              
              $
              355,561Less:
      Accumulated depreciation
              
              
              (85,058
              )
              
              
              (179,429
              )Net
      book value
              
              $
              121,506
              
              
              $
              176,132
  The table
below details the remaining liability of the capital lease
obligations.
  Liabilities
              
              December
      31, 2009Obligations
      under capital leases:Current
              
              $
              64,961Non-current
              
              
              59,357Total
      minimum payments
              
              
              124,318Less:
      Interest
              
              
              (26,386
              )Present
      value of payments
              
              $
              97,932
  The table
below details the future lease payments due as of December 31,
2009.
  Future
      Minimum Lease Payments
              
              December
      31,2010
              
              $
              64,9612011
              
              
              46,9502012
              
              
              11,9062013
              
              
              501Total
      minimum lease payments
              
              $
              124,318
  c.                 Guarantees:
  The
Company obtained bank guarantees in the amount of $436,000 in connection (i)
obligations of two of the Company’s subsidiaries to the Israeli customs
authorities, and (ii) the obligation of one of the Company’s subsidiaries to
secure the return of products loaned to the Company from one of its customers.
In addition, the Company has outstanding letters of credit totaling $2.9 million
for the benefit of its subsidiaries’ vendors and customers.
  F-26
 Table of Contents
  AROTECH CORPORATION
AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 In
U.S. dollars
  NOTE
11:–                     COMMITMENTS
AND CONTINGENT LIABILITIES (Cont.)
 
 d.                 Liens:
  As
security for compliance with the terms related to the investment grants from the
State of Israel, EFL and Epsilor have registered floating liens (that is, liens
that apply not only to assets owned at the time but also to after-acquired
assets) on all of their assets, in favor of the State of Israel.
  The
Company has $8.4 million in credit liens collateralized by the assets of the
Company and guaranteed by the Company.
  Epsilor
has recorded a lien on all of its assets in favor of its banks to secure lines
of credit. In addition Epsilor has a specific pledge on assets in respect of
which government guaranteed loans were given.
  e.                 Litigation
and other claims:
  As of the
date of this filing, there were no material pending legal proceedings against
the Company, except as follows:
  1.  NAVAIR
Litigation
  In
December 2004, AoA filed an action in the United States Court of Federal Claims
against the United States Naval Air Systems Command (“NAVAIR”), seeking
approximately $2.2 million in damages for NAVAIR’s alleged improper termination
of a contract for the design, test and manufacture of a lightweight armor
replacement system for the United States Marine Corps CH-46E rotor helicopter.
NAVAIR, in its answer, counterclaimed for approximately $2.1 million in alleged
reprocurement and administrative costs (subsequently revised to approximately
$1.5 million). Trial in this matter has concluded and closing briefs and certain
supplemental briefs have been filed, but no decision has yet been
rendered.
  Based on
the trial results and subsequent inquiries, the Company, after consultation with
its litigation counsel handling this case and with an outside firm with
particular expertise in government contract litigation, formed a conclusion that
it would be appropriate and prudent to take a allowance against an adverse
decision in this case, in the amount of one-half of the amount of NAVAIR’s
counterclaim.  Based on the legal advice received by management, the
Company deemed a loss of $750,000 in this case to be a probable outcome as
determined under GAAP and recorded the related change as part of Allowances for
Settlements.
 
 2.  Class
Action Litigation
  In May
2007, two purported class action complaints (the “Class Action Complaint”) were
filed in the United States District Court for the Eastern District of New York
against the Company and certain of the Company’s officers and directors. These
two cases were consolidated in June 2007. The Class Action Complaint seeks class
status on behalf of all persons who purchased our securities between November 9,
2004 and November 14, 2005 (the “Period”) and alleges violations by us and
certain of the Company’s officers and directors of Sections 10(b) and 20(a) of
the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, primarily related
to the Company’s acquisition of Armour of America in 2005 and certain public
statements made by the Company with respect to the Company’s business and
prospects during the Period. The Class Action Complaint also alleges that the
Company did not have adequate systems of internal operational or financial
controls, and that the Company’s financial statements and reports were not
prepared in accordance with GAAP and SEC rules. The Class Action Complaint seeks
an unspecified amount of damages.
  F-27
 Table of Contents
  AROTECH CORPORATION
AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 In
U.S. dollars
  NOTE
11:–                     COMMITMENTS
AND CONTINGENT LIABILITIES (Cont.)
 
 In
January 2010, the Company reached an agreement with lead plaintiffs to settle
the Class Action Complaint. Under the terms of the proposed settlement, the
lawsuit will be dismissed with prejudice, and the Company and all of the
Company’s current and former officers and directors named in the complaint will
receive a full and complete release of all claims asserted against them in the
litigation, as well as any related claims that could have been asserted. The
claims will be settled for $2.9 million. The monetary payment for this
settlement will be funded entirely from insurance proceeds. The agreement is
subject to final court approval, having received preliminary approval in early
2010.
  Additionally,
on May 6, 2009 a purported shareholders derivative complaint (the “Derivative
Complaint”) was filed in the United States District Court for the Eastern
District of New York against the Company and certain of the Company’s officers
and directors. The Derivative Complaint is based on the same facts as the class
action litigation currently pending against the Company in the same district,
and primarily relates to the Company’s acquisition of Armour of America in 2005
and certain public statements made by the Company with respect to the Company’s
business and prospects during the Period. The Derivative Complaint seeks an
unspecified amount of damages. The Company has moved for dismissal of the
Derivative Complaint.
  Although
the ultimate outcome of these matters cannot be determined with certainty, the
Company believes that the allegations stated in the Class Action Complaint and
the Derivative Complaint are without merit and the Company and the Company’s
officers and directors named in the Complaint intend to defend vigorously
against such allegations.
  NOTE
      12:–
              CONVERTIBLE
      DEBT, DETACHABLE WARRANTS AND OTHER LONG TERM
      DEBT
  a.                 Subordinated
convertible notes due August 15, 2011
  In August
2008, the Company issued $5.0 million in 10% subordinated convertible notes due
August 15, 2011, the “Notes.” The Notes are convertible at the option of the
holders at a fixed conversion price of $2.24. The principal amount of the Notes
is payable over a period of three years, with the principal amount being
amortized in eleven payments payable at the Company’s option in cash and/or
stock, by requiring the holders to convert a portion of their Notes into shares
of the Company’s common stock, provided certain conditions are met. The failure
to meet such conditions could make the Company unable to pay its Notes, causing
it to default. If the price of the Company’s common stock is above $2.24, the
holders of its Notes will presumably convert their Notes to stock when payments
are due, or before, resulting in the issuance of additional shares of the
Company’s common stock.
  F-28
 Table of Contents
  AROTECH CORPORATION
AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 In
U.S. dollars
  NOTE
12:–                    CONVERTIBLE
DEBT, DETACHABLE WARRANTS AND OTHER LONG TERM
DEBT (Cont.)
 
 The
Company primarily made the principal payments in cash, due February, May, August
and November 2009 and February 2010 (a portion of the November 2009 and February
2010 principal payment was paid in stock, at the request of one of the Note
holders, by the Note holder’s conversion of a portion of the quarterly principal
payment due for that quarter) and further payments are due in May, August and
November 2010, and February, May and August 2011. In the event the Company
elects to make payments of principal on its Notes in stock by requiring the
holders to convert a portion of their Notes, either because its cash position at
the time makes it necessary or it otherwise deems it advisable, the price used
to determine the number of shares to be issued on conversion will be calculated
using an 8% discount to the average trading price of the Company’s common stock
during 17 of the 20 consecutive trading days ending two days before the payment
date. Accordingly, the lower the market price of the Company’s common stock at
the time at which it makes payments of principal in stock, the greater the
number of shares the Company will be obliged to issue and the greater the
dilution to its existing stockholders. This pricing method is also used by the
Note holders when all or a portion of the Notes are converted
voluntarily.
  Convertible
      notes
                
                As
      of December 31,2009
                
                
                2008Principal
      balance
                
                $
                3,181,820
                
                
                $
                5,000,000Debt
      discount balance
                
                $
                202,144
                
                
                $
                471,945
 Debt
      discount is amortized over the term of the note using the effective
      interest method. $1,818,180 of the  Notes are due in 2010 and
      $1,363,640 are due in 2011.
 
 The
Company can require the holder of its Notes to convert a portion of their Notes
into shares of the Company’s common stock at the time principal payments are due
only if such shares are registered for resale and certain other conditions are
met.  Embedded in the Notes are put options associated with potential
defaults, change in control and not meeting certain equity conditions along with
a call option available to the Company.
  The Notes
include certain customary restrictive covenants and rights upon an event of
default. The events of default includes suspension of trading, failure to cure a
conversion failure, failure to timely make principal and interest payments,
defaults on other credit arrangements, bankruptcy, judgments in excess of $1.0
million and generally any uncured breach of the Notes.
  Contemporaneously
with the signing of a securities purchase agreement for the above Notes, the
Company also executed a Registration Rights Agreement. This agreement required
the registration of additional shares of the Company and that the registration
statement, which was declared effective in 2008, remains effective throughout
the term of the Notes. If it were to cease to be effective for any reason, the
Company would owe the Note holders 1.5% of the remaining principal amount of the
Notes for each month that the registration statement was not effective. The
maximum amount due per month as of December 31, 2009 would be $48,000 and
decreases as the principal is repaid. Additional requirements of this agreement
require the Company to, among other things, abide by all rules and regulations
of the SEC and timely file all required reports. As of December 31, 2009, the
Company was in compliance with all requirements of this agreement.
  F-29
 Table of Contents
  AROTECH CORPORATION
AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 In
U.S. dollars
  NOTE
12:–                    CONVERTIBLE
DEBT, DETACHABLE WARRANTS AND OTHER LONG TERM
DEBT (Cont.)
 
 The
original accounting for the Notes included the recording of a debt discount of
$412,300 representing the relative fair value of the warrants issued with the
convertible debt.  The relative fair value of the warrants was $412,300 and
recorded as a component of stockholders’ equity.  The embedded conversion
feature did not require bifurcation from the debt and did not result in any
beneficial conversion value.
  On
January 1, 2009, the Company adopted FASB ASC 815-40-15, “Determining Whether an
Instrument is Indexed to an Entity’s Own Stock.” FASB ASC 815-40-15 required the
Company to re-evaluate the warrants issued with the convertible notes and to
also re-evaluate the embedded conversion option and embedded put options within
the Notes to determine if the previous accounting for these items would change.
Upon this re-evaluation, the Company was required to record a cumulative
adjustment as of January 1, 2009 that included reclassifying the warrant value
previously included in stockholders' equity ($412,300) to other liabilities,
reflecting the value of the embedded conversion feature as additional debt
discount and as other liabilities as of the debt issuance date ($59,001),
increasing financial expenses due to the larger debt discount and increasing
financial expenses to reflect the change in the value of the warrants and the
conversion features from the debt issuance date to December 31, 2008.  The
aggregate additional 2008 expense of $471,301 was recorded as an adjustment to
beginning accumulated deficit as of January 1, 2009.
 The
embedded put options are now classified as derivative liabilities. The Company
again used the Black-Scholes and other valuation techniques to determine the
value of the warrants, the embedded conversion feature and the embedded put
options associated with the Notes as of January 1, 2009.  On December 31,
2009, the Company again revalued these securities. The year to date financial
expense associated with this revaluation is approximately $342,000. The table
below lists the variables used in the Black-Scholes calculation and the
resulting values.
 Variables
                
                August
      14, 2008
                
                
                January
      1, 2009
                
                
                December
      31, 2009Stock
      price
                
                $
                1.68
                
                
                $
                0.41
                
                
                $
                1.70Risk
      free interest rate
                
                
                2.72
                %
                
                
                1.00
                %
                
                
                1.70
                %Volatility
                
                
                77.32
                %
                
                
                81.40
                %
                
                
                79.85
                %Dividend
      yield
                
                
                0.00
                %
                
                
                0.00
                %
                
                
                0.00
                %Contractual
      life
                
                3.0
      years
                
                
                2.6
      years
                
                
                1.6
      yearsValues
                
                August
      14, 2008
                
                
                January
      1, 2009
                
                
                December
      31, 2009Warrants
                
                $
                417,317
                
                
                $
                29,171
                
                
                $
                298,570Conversion
      option
                
                
                143,714
                
                
                
                8,013
                
                
                
                88,156Puts
                
                
                26,060
                
                
                
                14,997
                
                
                
                7,371Total
      value
                
                $
                587,091
                
                
                $
                52,181
                
                
                $
                394,097Change
      in value – charged to financial expense
                
                
                
                
                
                $
                (341,916
                )
  b.                 Mortgage
Note, Auburn, Alabama:
  In March
2007, the Company purchased space in Auburn, Alabama for approximately $1.1
million pursuant to a seller-financed secured purchase money mortgage. Half the
mortgage is payable over ten years in equal monthly installments based on a
20-year amortization of the full principal amount, and the remaining half is
payable at the end of ten years in a balloon payment. The note requires a
payment (principal and interest) of approximately $9,300 per month at an
interest rate of 8% per annum. The balance of this note is shown in the short
and long term sections of the balance sheet.
  Mortgage
      - Future Principal Payments
              
              December
      31,2010
              
              $
              29,3552011
              
              
              31,7922012
              
              
              34,4232013
              
              
              37,2872014
              
              
              40,382Thereafter
              
              
              872,430$
              1,045,669
  The
Company has additional long term debt outstanding of approximately $147,000,
primarily vehicle loans. This amount is payable through 2012.
   F-30
 Table of Contents
  AROTECH CORPORATION
AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 In
U.S. dollars
  NOTE
13:–                    STOCKHOLDERS’
EQUITY
 a.                 Stockholders’
rights:
  The
Company’s shares confer upon the holders the right to receive notice to
participate and vote in the general meetings of the Company and right to receive
dividends, if and when declared.
 b.                  Warrants:
  As part
of a securities purchase agreement entered into in August 2008, the Company
issued to the purchasers of the Notes, warrants to purchase an aggregate of
558,036 shares of common stock at any time prior to August 15, 2011 at a price
of $2.24 per share. The warrants were originally classified as equity based on
their relative fair value of $412,300, which was also recorded as a debt
discount and none of the warrants have been exercised as of December 31,
2009.
  c.                 The
Company has adopted the following stock plans, whereby options may be granted
for purchase of shares of the Company’s common stock and where restricted shares
and restricted stock units may be granted and approved by the Board of
Directors. Under the terms of the employee plans, the Board of Directors or the
designated committee grants options, restricted stock and restricted stock
units.  The Board of Directors or the designated committee also
determines the vesting period and the exercise terms:
  1.                 2004
Employee Option Plan – 535,714 shares reserved for issuance, of which zero were
available for future grants to employees and consultants as of December 31,
2009.
  2.                 2007
Non-Employee Director Equity Compensation Plan – 750,000 shares reserved for
issuance, of which 574,255 were available for future grants to outside directors
as of December 31, 2009.
  3.                 2009
Equity Incentive Plan – 5,000,000 shares reserved for issuance, of which
4,621,666 were available for future grants to employees and consultants as of
December 31, 2009.
  4.                 Under
these plans, options generally expire no later than 5-10 years from the date of
grant. Each option can be exercised to purchase one share, conferring the same
rights as the other common shares. Options that are cancelled or forfeited
before expiration become available for future grants. The options generally vest
over a three-year period (33.3% per annum) and restricted shares also generally
vest after three years or pursuant to defined performance criteria; in the event
that employment is terminated within that period, unvested restricted shares
generally revert back to the Company.
  F-31
 Table of Contents
  AROTECH CORPORATION
AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 In
U.S. dollars
  NOTE
13:–                    STOCKHOLDERS’
EQUITY (Cont.)
 
 5.                 A
summary of the status of the Company’s plans and other share options and
restricted shares granted as of December 31, 2009 and 2008, and changes during
the years ended on those dates, is presented below:
  Stock
Options:
 2009
              
              
              2008Amount
              
              
              Weighted
      average
                exercise
      price
              
              
              Amount
              
              
              Weighted
      average
                exercise
      priceOptions
      outstanding at be­ginning of year
              
              
              236,906
              
              
              $
              6.14
              
              
              
              291,390
              
              
              $
              6.03Changes
      during year:Granted
              
              
              –
              
              
              $
              –
              
              
              
              –
              
              
              $
              –Exercised
              
              
              –
              
              
              $
              –
              
              
              
              –
              
              
              $
              –Forfeited
              
              
              (17,985
              )
              
              $
              5.10
              
              
              
              (54,484
              )
              
              $
              5.52Options
      outstanding at end of year
              
              
              218,921
              
              
              $
              6.23
              
              
              
              236,906
              
              
              $
              6.14Options
      vested at end of year (1)
              
              
              218,921
              
              
              $
              6.23
              
              
              
              203,908
              
              
              $
              6.69Options
      expected to vest
              
              
              –
              
              
              $
              –
              
              
              
              32,998
              
              
              $
              2.77
  (1)
Deferred stock compensation is amortized and recorded as compensation expenses
ratably over the vesting period of the option or the restriction period of the
restricted shares. The stock compensation expense that has been charged in the
consolidated statements of operations in respect of options and restricted
shares to employees and directors in 2009 and 2008 was $849,272 and $1,039,270,
respectively.
  The
calculated intrinsic value of vested and unvested options for 2009 and 2008 was
zero.
   Restricted
Shares:
 2009
              
              
              2008Shares
              
              
              Weighted
                average
      fair value at grant date
              
              
              Shares
              
              
              Weighted
                average
      fair value at grant dateNon-vested
      at the beginning of the year
              
              
              713,313
              
              
              $
              2.41
              
              
              
              994,452
              
              
              $
              2.42Changes
      during year:Restricted
      stock granted
              
              
              412,622
              
              
              $
              1.46
              
              
              
              38,472
              
              
              $
              2.73Restricted
      units granted
              
              
              77,917
              
              
              $
              1.67
              
              
              
              –
              
              
              
              –Vested
              
              
              (439,578
              )
              
              $
              2.18
              
              
              
              (244,538
              )
              
              $
              2.39Forfeited
              
              
              (16,735
              )
              
              $
              2.89
              
              
              
              (75,073
              )
              
              $
              2.22Non-vested
      at the end of the year(1)
              
              
              747,539
              
              
              $
              1.68
              
              
              
              713,313
              
              
              $
              2.41Restricted
      shares vested at end of year
              
              
              1,232,925
              
              
              $
              2.40
              
              
              
              793,347
              
              
              $
              2.53
 
 (1) Deferred
stock compensation is amortized and recorded as compensation expenses ratably
over the vesting period of the option or the restriction period of the
restricted shares. The stock compensation expense that has been charged in the
consolidated statements of operations in respect of options and restricted
shares to employees and directors in 2009 and 2008 was $849,272 and $1,039,270,
respectively.
  F-32
 Table of Contents
  AROTECH CORPORATION
AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 In
U.S. dollars
  NOTE
13:–                    STOCKHOLDERS’
EQUITY (Cont.)
 
 6.                 
The options outstanding as of December 31, 2009 have been separated into ranges
of exercise price, as follows:
  Total
      options outstanding
              
              
              Vested
      options outstandingRange
      of
                exercise
                prices
              
              
              Amount
                outstanding
      at
                December
      31,
                2009
              
              
              Weighted
                average
                remaining
      years
                contractual
      life
              
              
              Weighted
                average
                exercise
      price
              
              
              Amount
                exercisable
      at
                December
      31, 2009
              
              
              Weighted
                average
                exercise
      price0.00-4.99
              
              
              
              94,000
              
              
              
              1.97
              
              
              $
              2.77
              
              
              
              94,000
              
              
              $
              2.775.00-9.99
              
              
              
              89,921
              
              
              
              2.35
              
              
              $
              5.91
              
              
              
              89,921
              
              
              $
              5.9110.00-34.99
              
              
              
              35,000
              
              
              
              2.30
              
              
              $
              16.36
              
              
              
              35,000
              
              
              $
              16.36Total
              
              
              
              218,921
              
              
              
              2.18
              
              
              $
              6.23
              
              
              
              218,921
              
              
              $
              6.23
  7.                 Options
issued to consultants:
  The
Company’s outstanding options to consultants are as follows:
  2009
              
              
              2008Amount
              
              
              Weighted
      average exercise price
              
              
              Amount
              
              
              Weighted
      average exercise priceOptions
      outstanding at beginning of year
              
              
              7,317
              
              
              $
              68.24
              
              
              
              11,870
              
              
              $
              54.39Changes
      during year:Granted
              
              
              –
              
              
              
              –
              
              
              
              –
              
              
              
              –Exercised
              
              
              –
              
              
              
              –
              
              
              
              –
              
              
              
              –Forfeited
      or cancelled
              
              
              –
              
              
              
              –
              
              
              
              (4,553
              )
              
              $
              32.12Options
      outstanding at end of year
              
              
              7,317
              
              
              $
              68.24
              
              
              
              7,317
              
              
              $
              68.24Options
      vested at end of year
              
              
              7,317
              
              
              $
              68.24
              
              
              
              7,317
              
              
              $
              68.24
  In
connection with the grant of stock options to consultants, the Company did not
recognize any expenses for the years ended December 31, 2009 and
2008.
  8.                 The
remaining total compensation cost related to non-vested stock options and
restricted share awards not yet recognized (before applying a forfeiture rate)
in the income statement as of December 31, 2009 was $277,840, of which zero was
for stock options and $277,840 was for restricted shares. The weighted average
period over which this compensation cost is expected to be recognized is
approximately 1.5 years.
  9.                 On
January 1, 2009 the Company adopted FASB ASC 260-45-28, Share-Based Payment
Arrangements, which classifies unvested share-based payment awards that contain
nonforfeitable rights to dividends or dividend equivalents (whether paid or
unpaid) as participating securities and requires them to be included in the
computation of diluted earnings per share using the two class method. The
Company has determined that the unvested restricted stock issued to our
employees and directors are “participating securities” and as such, are
included, net of estimated forfeitures, in the total shares used to calculate
the Company’s diluted loss per share but not the basic loss per share as they
are anti-dilutive.
  F-33
 Table of Contents
 
 AROTECH CORPORATION
AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 In
U.S. dollars
 
 NOTE
13:–                    STOCKHOLDERS’
EQUITY (Cont.)
 
 d.                 Dividends:
  In the
event that cash dividends are declared in the future, such dividends will be
paid in U.S. dollars. The Company does not intend to pay cash dividends in the
foreseeable future.
  NOTE
14:–                     INCOME
TAXES
  a.                 Taxation
of U.S. parent company (Arotech) and other U.S. subsidiaries:
  As of
December 31, 2009, Arotech has operating loss carryforwards for U.S. federal
income tax purposes of approximately $25.1 million, which are available to
offset future taxable income, if any, expiring in 2010 through 2026. Utilization
of U.S. net operating losses may be subject to substantial annual limitations
due to the “change in ownership” provisions of the Internal Revenue Code of 1986
and similar state provisions. The annual limitation may result in the expiration
of net operating loses before utilization.
  The
Company adopted the provisions of FASB ASC 740-10 on January 1, 2007. As a
result of the implementation of this standard, the Company did not record a
liability for unrecognized tax positions. The adoption of this standard did not
impact the Company’s financial condition, results of operations or cash
flows.
  At
December 31, 2009, the Company had net deferred tax assets of $40.9 million. The
deferred tax assets are primarily composed of federal, state and foreign tax net
operating loss (“NOL”) carryforwards. Due to uncertainties surrounding the
Company’s ability to generate future taxable income to realize these assets, a
full valuation has been established to offset its net deferred tax asset.
Additionally, the future utilization of the Company’s NOL carryforwards to
offset future taxable income is subject to a substantial annual limitation as a
result of ownership changes that have occurred. The Company completed an IRS
Section 382 analysis in 2007 regarding the limitation of the net operating
losses and determined that the maximum amount of U.S. federal NOL available as
of January 1, 2007 was $18,851,605, compared to the amount shown on the tax
return of $31,161,945. The related Deferred Tax Asset and corresponding
valuation allowance were reduced by $4,185,516 for the U.S. federal NOLs and by
$3,555,231 for the state NOLs. The Company has also reevaluated the unrecognized
tax benefits under this standard as of December 31, 2009 after the completion of
the Section 382 review. The Company does not believe that the unrecognized tax
benefits will change within 12 months of this reporting date. Any carryforwards
that will expire prior to utilization as a result of such limitations will be
removed from deferred tax assets with a corresponding reduction of the valuation
allowance. Due to the existence of the valuation allowance, future changes in
the Company’s unrecognized tax benefits will not impact the Company’s effective
tax rate.
  The
Company has indefinitely-lived intangible assets consisting of trademarks,
workforce, and goodwill. These indefinitely-lived intangible assets are not
amortized for financial reporting purposes. However, these assets are tax
deductible, and therefore amortized over 15 years for tax purposes. As such,
deferred income tax expense and a deferred tax liability arise as a result of
the tax-deductibility of these indefinitely-lived intangible assets. The
resulting deferred tax liability, which is expected to continue to increase over
time, will have an indefinite life, resulting in what is referred to as a “naked
tax credit.” This deferred tax liability could remain on the Company’s balance
sheet indefinitely unless there is an impairment of the related assets (for
financial reporting purposes), or the business to which those assets relate were
to be disposed of.
  F-34
 Table of Contents
  AROTECH CORPORATION
AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 In
U.S. dollars
  NOTE
14:–                     INCOME
TAXES (Cont.)
 
 Due to
the fact that the aforementioned deferred tax liability could have an indefinite
life, it is not netted against the Company’s deferred tax assets when
determining the required valuation allowance. Doing so would result in the
understatement of the valuation allowance and related deferred income tax
expense.
  The
Company files income tax returns, including returns for its subsidiaries, with
federal, state, local and foreign jurisdictions. The Company is no longer
subject to IRS examination for periods prior to 2007, although carryforward
losses that were generated prior to 2007 may still be adjusted by the IRS if
they are used in a future period. Additionally, the Company is no longer subject
to examination in Israel for periods prior to 2004.
  The
Company files consolidated tax returns with its U.S. subsidiaries.
  b.                 Israeli
subsidiary (Epsilor):
  Tax
benefits under the Law for the Encouragement of Capital Investments, 1959 (the
“Investments Law”):
  Currently,
Epsilor is operating under two programs, as follows:
  1.                 Program
one:
  Epsilor’s
first expansion program of its existing enterprise in Dimona was granted the
status of an “approved enterprise” under the Investments Law and was entitled to
investment grants from the State of Israel in the amount of 24% on property and
equipment located at its Dimona plant.
  The
approved expansion program is in the amount of approximately $600,000. Epsilor
effectively operated the program during 2002, and is entitled to the tax
benefits available under the Investments Law (commencing from
2003).
  Taxable
income derived from the approved enterprise is subject to a reduced tax rate
during seven years beginning from the year in which taxable income is first
earned (tax exemption for the first two-year period and 25% tax rate for the
five remaining years).
  Those
benefits are limited to 12 years from the year that the enterprise began
operations, or 14 years from the year in which the approval was granted,
whichever is earlier. This program expired in 2009.
  2.                 Program
two:
  Epsilor’s
second expansion program of its existing enterprise in Dimona was granted the
status of an “approved enterprise” under the Investments Law, and will be
entitled to investment grants from the State of Israel in the amount of 24% on
property and equipment located at its Dimona plant.
  F-35
 Table of Contents
  AROTECH CORPORATION
AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 In
U.S. dollars
  NOTE
14:–                     INCOME
TAXES (Cont.)
 
 The
expansion program is in the amount of approximately $945,000. This program has
received final approval.
  Taxable
income derived from the approved enterprise is subject to a reduced tax rate
during seven years beginning from the year in which taxable income is first
earned (tax exemption for the first two-year period and 25% tax rate for the
five remaining years).
  Those
benefits are limited to 12 years from the year that the program began
operations, or 14 years from the year in which the approval was granted,
whichever is earlier.
  The main
tax benefits available to Epsilor are reduced tax rates.
  3.                 Additional
Approved Enterprise information:
  Epsilor
is entitled to claim accelerated depreciation in respect of machinery and
equipment used by the “Approved Enterprise” for the first five years of
operation of these assets.
  Income
from sources other than the “Approved Enterprise” during the benefit period will
be subject to tax at the regular corporate tax rate of 26% in 2009 and 25% in
2010 and thereafter.
  If
retained tax-exempt profits attributable to the “approved enterprise” are
distributed, they would be taxed at the corporate tax rate applicable to such
profits as if Epsilor had not elected the alternative system of benefits,
currently 25% for an “approved enterprise.”
  Dividends
paid from the profits of an approved enterprise are subject to tax at the rate
of 15% in the hands of their recipient. As of December 31, 2009, there are no
tax exempt profits earned by Epsilor’s “approved enterprises” by Israel law that
will be distributed as a dividend and accordingly no deferred tax liability was
recorded as of December 31, 2009. Furthermore, management has indicated that it
has no intention of declaring any dividend.
  On April
1, 2005, an amendment to the Investment Law came into effect (the “Amendment”)
and has significantly changed the provisions of the Investment Law. The
Amendment limits the scope of enterprises which may be approved by the
Investment Center by setting criteria for the approval of a facility as a
Privileged Enterprise, such as provisions generally requiring that at least 25%
of the Privileged Enterprise’s income will be derived from export.
  However,
the Investment Law provides that terms and benefits included in any certificate
of approval already granted will remain subject to the provisions of the law as
they were on the date of such approval. Therefore, the existing Approved
Enterprise of the Israeli subsidiaries (program one) will generally not be
subject to the provisions of the Amendment. As a result of the Amendment,
tax-exempt income generated under the provisions of the Amended Investment Law,
will subject the Company to taxes upon distribution or liquidation and the
Company may be required to record deferred tax liability with respect to such
tax-exempt income. As of December 31, 2009, the Company did not generate income
under the provision of the amended Investment Law.
  F-36
 Table of Contents
  AROTECH CORPORATION
AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 In
U.S. dollars
  NOTE
14:–                     INCOME
TAXES (Cont.)
 
 c.                 Other
tax information about the Israeli subsidiaries:
  1.                 Tax
benefits under the Law for the Encouragement of Industry (Taxation),
1969:
  EFL and
Epsilor are “industrial companies,” as defined by this law and, as such, are
entitled to certain tax benefits, mainly accelerated depreciation, as prescribed
by regulations published under the inflationary adjustments law, the right to
claim amortization of know-how, patents and certain other intangible property
rights as deductions for tax purposes.
  2.                 Tax
rates applicable to income from other sources:
  Income
from sources other than the “Approved Enterprise,” is taxed at the regular rate
of 26% in 2009 and 25% in 2010 and thereafter. See also Note 14.e.
  3.                 Tax
loss carryforwards:
  As of
December 31, 2009, EFL has operating and capital loss carryforwards for Israeli
tax purposes of approximately $111.3 million, which are available, indefinitely
(but nonetheless fully reserved), to offset future taxable income.
  d.                 Tax
rates applicable to the income of the Group companies:
  The
corporate tax rate in Israel is 26% for 2009 and 25% for 2010 and thereafter,
although this is subject to being changed by the Israeli
parliament.
  e.                 Deferred
income taxes:
  Deferred
income taxes reflect tax credit carryforwards and the net tax effects of
temporary differences between the carrying amounts of assets and liabilities for
financial reporting purposes and amounts used for income tax purposes.
Significant components of the Company’s deferred tax assets are as
follows:
 
 Significant
      components of deferred tax assetsDecember
      31,2009
              
              
              2008Operating
      loss carryforward
              
              $
              34,958,554
              
              
              $
              34,958,606Other
      temporary differences
              
              
              5,942,973
              
              
              
              2,894,915Net
      deferred tax asset before valuation allowance
              
              
              40,901,527
              
              
              
              37,853,521Valuation
      allowance
              
              
              (40,860,122
              )
              
              
              (37,781,407
              )Total
      deferred tax asset
              
              $
              41,405
              
              
              $
              72,114Deferred
      tax liability
              
              $
              2,990,000
              
              
              $
              2,430,000
 
 Operating
      loss carryforward – Domestic and ForeignDecember
      31,2009
              
              
              2008Domestic
              
              $
              8,538,666
              
              
              $
              8,470,576Foreign
              
              
              26,419,889
              
              
              
              26,488,030$
              34,958,554
              
              
              $
              34,958,606
  F-37
 Table of Contents
  AROTECH CORPORATION
AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 In
U.S. dollars
  NOTE
14:–                     INCOME
TAXES (Cont.)
 
 The
Company has not recorded any deferred taxes on the cumulative undistributed
earnings of other non-U.S. subsidiaries because the earnings are intended to be
indefinitely re-invested in those operations and the Company is unable, at this
time, to estimate the amount. Accrued income taxes on the undistributed earnings
of domestic subsidiaries and affiliates are not provided because dividends
received from domestic companies are expected to be non-taxable.
  The
Company provided valuation allowances in respect of deferred tax assets
resulting from tax loss carryforwards and other temporary differences.
Management currently believes that it is more likely than not that the deferred
tax assets related to the loss carryforwards and other temporary differences
will not be realized. The change in the valuation allowance during 2009 was $3.1
million.
  f.                 Profit
(loss) before taxes on income and affiliated interests in earnings of a
subsidiary are as follows:
  Year
      ended December 312009
              
              
              2008Domestic
              
              $
              (2,300,061
              )
              
              $
              (1,929,564
              )Foreign
              
              
              51,218
              
              
              
              (881,524
              )$
              (2,248,843
              )
              
              $
              (2,811,088
              )
  g.                 Taxes
on income were comprised of the following:
  Year
      ended December 312009
              
              
              2008Current
      state and local taxes
              
              $
              252,426
              
              
              $
              499,196Deferred
      taxes
              
              
              590,709
              
              
              
              570,595Taxes
      in respect of prior years
              
              
              (38,169
              )
              
              
              (42,923
              )$
              804,966
              
              
              $
              1,026,868Domestic
              
              $
              776,040
              
              
              $
              926,182Foreign
              
              
              28,926
              
              
              
              100,686$
              804,966
              
              
              $
              1,026,868
  F-38
 Table of Contents
  AROTECH CORPORATION
AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 In
U.S. dollars
  NOTE
14:–                     INCOME
TAXES (Cont.)
 
 h.                 A
reconciliation between the theoretical tax expense, assuming all income is taxed
at the statutory tax rate applicable to income of the Company and the actual tax
expense as reported in the Statement of Operations is as follows:
  Year
      ended December 31,2009
              
              
              2008Loss
      before taxes and noncontrolling interest, as reported in the consolidated
      statements of operations
              
              $
              (2,248,843
              )
              
              $
              (2,811,088
              )Statutory
      tax rate
              
              
              34
              %
              
              
              34
              %Theoretical
      income tax on the above amount at the U.S. statutory tax
    rate
              
              $
              (764,607
              )
              
              $
              (955,770
              )Deferred
      taxes on losses for which valuation
                allowance was provided
              
              
              1,161,957
              
              
              
              1,872,798Non-deductible
      credits  (expenses)
              
              
              162,650
              
              
              
              (352,029
              )Foreign
      non-deductible expenses
              
              
              72,800
              
              
              
              32,400State
      taxes, net of federal benefit
              
              
              216,040
              
              
              
              361,182Foreign
      income in tax rates other than U.S rate
              
              
              (11,196
              )
              
              
              (35,782
              )Taxes
      in respect of prior years
              
              
              (38,169
              )
              
              
              (42,923
              )Others
              
              
              5,491
              
              
              
              146,992Actual
      tax expense
              
              $
              804,966
              
              
              $
              1,026,868
   NOTE
15:–                    SELECTED
STATEMENTS OF OPERATIONS DATA
  Financial
expenses, net:
  Year
      ended December 31,2009
              
              
              2008Financial
      expenses:Interest,
      bank charges and fees
              
              $
              (715,606
              )
              
              $
              (579,913
              )Bonds
      discount amortization
              
              
              (662,417
              )
              
              
              (51,537
              )Foreign
      currency translation differences
              
              
              (129,468
              )
              
              
              (291,869
              )Other
              
              
              –
              
              
              
              (99
              )(1,507,491
              )
              
              
              (923,418
              )Financial
      income:Interest
              
              
              243,212
              
              
              
              97,851Other
              
              
              12,894
              
              
              
              11,478Total
              
              $
              (1,251,385
              )
              
              $
              (814,089
              )
  F-39
 Table of Contents
 AROTECH CORPORATION
AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 In
U.S. dollars
  NOTE
16:–                    SEGMENT
INFORMATION
  a.                 General:
  The
Company operates primarily in three business segments (see Note 1.a. for a brief
description of the Company’s business).
  The
Company’s reportable operating segments have been determined in accordance with
the Company’s internal management structure, which is organized based on
operating activities. The accounting policies of the operating segments are the
same as those described in the summary of significant accounting policies. The
Company evaluates performance based upon two primary factors, one is the
segment’s operating income and the other is based on the segment’s contribution
to the Company’s future strategic growth.
  b.                 The
following is information about reported segment gains, losses and
assets:
  Training
      and Simulation
              
              
              Armor
              
              
              Battery
      and
                Power
      Systems
              
              
              All
      Others
              
              
              Total2009Revenues
      from outside customers
              
              $
              39,206,173
              
              
              $
              17,507,298
              
              
              $
              17,820,980
              
              
              $
              –
              
              
              $
              74,534,451Depreciation
      , amortization and impairment expenses (1)
              
              
              (1,327,231
              )
              
              
              (181,657
              )
              
              
              (1,031,304
              )
              
              
              (179,068
              )
              
              
              (2,719,260
              )Direct
      expenses (2)
              
              
              (32,938,826
              )
              
              
              (17,148,480
              )
              
              
              (16,861,855
              )
              
              
              (6,668,454
              )
              
              
              (73,617,615
              )Segment
      net income (loss)
              
              
              4,940,116
              
              
              
              177,161
              
              
              
              (72,179
              )
              
              
              (6,847,522
              )
              
              
              (1,802,424
              )Financial
      expenses
              
              
              (1,342
              )
              
              
              (214,042
              )
              
              
              (70,819
              )
              
              
              (965,182
              )
              
              
              (1,251,385
              )Net
      income (loss)
              
              $
              4,938,774
              
              
              $
              (36,881
              )
              
              $
              (142,998
              )
              
              $
              (7,812,704
              )
              
              $
              (3,053,809
              )Segment
      assets (3)
              
              $
              45,933,659
              
              
              $
              12,432,348
              
              
              $
              23,618,194
              
              
              $
              2,133,678
              
              
              $
              84,117,8792008Revenues
      from outside customers
              
              $
              36,032,703
              
              
              $
              17,762,439
              
              
              $
              15,153,827
              
              
              $
              –
              
              
              $
              68,948,969Depreciation
      , amortization and impairment expenses (1)
              
              
              (1,573,017
              )
              
              
              (175,733
              )
              
              
              (1,033,374
              )
              
              
              (199,662
              )
              
              
              (2,981,786
              )Direct
      expenses (2)
              
              
              (30,141,747
              )
              
              
              (18,457,799
              )
              
              
              (14,368,970
              )
              
              
              (6,022,534
              )
              
              
              (68,991,050
              )Segment
      net income (loss)
              
              
              4,317,939
              
              
              
              (871,093
              )
              
              
              (248,517
              )
              
              
              (6,222,196
              )
              
              
              (3,023,867
              )Financial
      expenses
              
              
              (195
              )
              
              
              (357,517
              )
              
              
              (313,671
              )
              
              
              (142,706
              )
              
              
              (814,089
              )Net
      income (loss)
              
              $
              4,317,744
              
              
              $
              (1,228,610
              )
              
              $
              (562,188
              )
              
              $
              (6,364,902
              )
              
              $
              (3,837,956
              )Segment
      assets (3)
              
              $
              48,181,444
              
              
              $
              12,572,672
              
              
              $
              24,037,512
              
              
              $
              5,003,171
              
              
              $
              89,794,799
 _______________________
 (1)
              Includes
      depreciation of property and equipment and amortization expenses of
      intangible assets.
 (2)
              Including,
      inter alia, sales
      and marketing, general and administrative and tax
  expenses.
 (3)
              Consisting
      of all assets.
  F-40
 Table of Contents
  AROTECH CORPORATION
AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 In
U.S. dollars
  NOTE
16:–                    SEGMENT
INFORMATION (Cont.)
 
 c.                 Summary
information about geographic areas:
  The
following presents total revenues according to the locations of the Company’s
end customers for the years ended December 31, 2009 and 2008, and long-lived
assets as of December 31, 2009 and 2008:
  2009
              
              
              2008Total
                revenues
              
              
              Long-lived
      assets
              
              
              Total
                revenues
              
              
              Long-lived
      assetsU.S.
      dollarsU.S.A.
              
              $
              54,960,149
              
              
              $
              31,216,469
              
              
              $
              49,386,798
              
              
              $
              31,794,288Israel
              
              
              9,947,724
              
              
              
              11,737,637
              
              
              
              13,443,119
              
              
              
              12,382,351Japan
              
              
              3,228,035
              
              
              
              –
              
              
              
              –
              
              
              
              –Singapore
              
              
              1,804,992
              
              
              
              –
              
              
              
              –
              
              
              
              –India
              
              
              1,200,711
              
              
              
              –
              
              
              
              1,854,052
              
              
              
              –Germany
              
              
              552,208
              
              
              
              –
              
              
              
              951,533
              
              
              
              –England
              
              
              527,405
              
              
              
              –
              
              
              
              389,518
              
              
              
              –Trinidad
              
              
              368,562
              
              
              
              –
              
              
              
              –
              
              
              
              –Canada
              
              
              278,535
              
              
              
              –
              
              
              
              –
              
              
              
              –Taiwan
              
              
              204,098
              
              
              
              –
              
              
              
              –
              
              
              
              –Egypt
              
              
              –
              
              
              
              –
              
              
              
              538,774
              
              
              
              –Other
              
              
              1,462,032
              
              
              
              –
              
              
              
              2,385,175
              
              
              
              –$
              74,534,451
              
              
              $
              42,954,106
              
              
              $
              68,948,969
              
              
              $
              44,176,639
  d.                 Revenues
from major customers (as a percentage of consolidated revenues):
  Year
      ended December 31,2009
              
              
              2008Training
      and Simulation:Customer A
              
              
              32
              %
              
              
              37
              %Battery
      and Power Systems:Customer B
              
              
              4
              %
              
              
              9
              %Customer C
              
              
              5
              %
              
              
              3
              %Armor:Customer D
              
              
              13
              %
              
              
              13
              %Customer E
              
              
              5
              %
              
              
              6
              %
  F-41
 Table of Contents
 
 AROTECH CORPORATION
AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 In
U.S. dollars
  NOTE
16:–                    SEGMENT
INFORMATION (Cont.)
 
 e.                 Revenues
from major products:
  Year
      ended December 31,2009
              
              
              2008Water
      activated batteries
              
              $
              2,484,217
              
              
              $
              1,861,959Batteries
      and chargers
              
              
              15,336,763
              
              
              
              13,291,868Car,
      aircraft and other armoring
              
              
              17,507,298
              
              
              
              17,762,439Simulators
              
              
              39,206,173
              
              
              
              36,032,703Total
              
              $
              74,534,451
              
              
              $
              68,948,969
 
 NOTE
17:–                     ACCUMULATED
OTHER COMPREHENSIVE INCOME
  Accumulated
other comprehensive income consists of currency translation adjustments of
$1,537,000 and $1,526,000 at December 31, 2009 and 2008, respectively, and
unrealized gains on marketable securities of zero and $2,000 at December 31,
2009 and 2008, respectively.
   NOTE
18:–                     AFFILIATED
COMPANIES
  The
Company has investments in two affiliated companies, Center for Transportation
Safety, Inc. (25% ownership) and Concord Safety Solutions, Pvt. Ltd. (33%
ownership), both of which are accounted for under the equity method of
accounting.  The value of Center for Transportation Safety has been
reduced to zero. The Company’s interest in the net losses of the affiliated
companies totaled zero and $452,166 in 2009 and 2008, respectively.
  F-42
 Table of Contents
   FINANCIAL
STATEMENT SCHEDULE
  Arotech
Corporation and Subsidiaries
  Schedule
II – Valuation and Qualifying Accounts
  For the
Years Ended December 31, 2009 and 2008
  Description
              
              Balance
      at
                beginning
                of
      period
              
              
              Additions
                charged
      to
                costs
      and
                expenses*
              
              
              Balance
      at
                end
      of
                periodYear
      ended December 31, 2009Allowance
      for doubtful accounts
              
              $
              19,000
              
              
              $
              28,000
              
              
              $
              47,000Allowance
      for slow moving inventory
              
              
              1,879,000
              
              
              
              12,000
              
              
              
              1,891,000Allowance
      for settlements
              
              
              –
              
              
              
              1,250,000
              
              
              
              1,250,000Valuation
      allowance for deferred taxes
              
              
              37,781,000
              
              
              
              3,079,000
              
              
              
              40,860,000Totals
              
              $
              39,679,000
              
              
              $
              4,369,000
              
              
              $
              44,048,000Year
      ended December 31, 2008Allowance
      for doubtful accounts
              
              $
              25,000
              
              
              $
              (6,000
              )
              
              $
              19,000Allowance
      for slow moving inventory
              
              
              1,724,000
              
              
              
              155,000
              
              
              
              1,879,000Valuation
      allowance for deferred taxes
              
              
              37,753,000
              
              
              
              28,000
              
              
              
              37,781,000Totals
              
              $
              39,502,000
              
              
              $
              177,000
              
              
              $
              39,679,000
 
 *The 2009
and 2008 valuation allowance includes an adjustment to the prior year provision
calculation due to changes recognized in the preparation of the actual
returns.
 
 
  F-43
 Table of Contents