t


UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549





FORM
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,
      2008.r
              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.Yes r   No
x




Indicate by check markif the registrant is not required to file reports pursuant to Section 13
or Section 15(d) of the Act.Yes
r No
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 r




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. r




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: r    
  Accelerated filer: r    
   Non-accelerated filer: r    
   Smaller reporting company: x




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




The
aggregate market value of the registrant’s voting stock held by non-affiliates
of the registrant as of June 30, 2008 was approximately $24,954,770 (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: 13,637,639 as of
3/31/09




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




Tableof
Contents






PART
      I
                            
                            PageITEM
      1.
                            BUSINESS
                            1ITEM
      1A.
                            RISK FACTORS
                            7ITEM
      1B.
                            UNRESOLVED STAFF COMMENTS
                            16ITEM
      2.
                            PROPERTIES
                            16ITEM
      3.
                            LEGAL PROCEEDINGS
                            16ITEM
      4.
                            SUBMISSION OF MATTERS TO A VOTE OF SECURITY
      HOLDERS
                            16PART
      IIITEM
      5.
                            MARKET FOR REGISTRANT’S COMMON EQUITY, RE­LATED STOCKHOLDER
      MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
                            17ITEM
      6.
                            SELECTED FINANCIAL DATA
                            17ITEM
      7.
                            MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDI­TION
      AND RESULTS OF OPERATION
                            17ITEM
      8.
                            FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
                            28ITEM
      9.
                            CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
      FINANCIAL DISCLOSURE
                            28ITEM
      9A.
                            CONTROLS AND PROCEDURES
                            28ITEM
      9B.
                            OTHER INFORMATION
                            28PART
      IIIITEM
      10.
                            DIRECTORS AND EXECUTIVE OFFICERS OF THE
      REGISTRANT
                            29ITEM
      11.
                            EXECUTIVE COMPENSATION
                            33ITEM
      12.
                            SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
      AND RELATED STOCKHOLDER MATTERS
                            41ITEM
      13.
                            CERTAIN RELATIONSHIPS AND RELATED
    TRANSACTIONS
                            42ITEM
      14.
                            PRINCIPAL ACCOUNTING FEES AND SERVICES
                            43PART
      IVITEM
      15.
                            EXHIBITS, FINANCIAL STATEMENT SCHEDULES
                            43SIGNATURES
                            45






Table of Contents




PART
I


ITEM1.     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:




Ø
            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”).




Ø
            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




·
            We
      provide ballistic armor kits for rotary and fixed wing aircraft, marine
      armor and specialized personal armor through our subsidiary Armour of
      America, located in Auburn, Alabama, which we merged into our MDT Armor
      subsidiary in June of 2008 (“AoA”).




Ø
            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”).




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, RTI, and
MDT Armor. Additionally, we operate under the trade names of IES Interactive
(IES) 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. IES’s and FAAC’s home offices and facilities are located in Ann Arbor,
Michigan, and the offices and facilities of FAAC’s subsidiary, Realtime
Technologies, are located in Royal Oak, Michigan. The facilities of EFB, MDT
Armor and AoA are located in Auburn, Alabama.




Table of Contents




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 2008 and 2007, revenues
from our Training and Simulation Division were approximately $36.0 million and
$27.8 million, respectively.




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




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




Ø
            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




Ø
            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 2008, our Vehicle Simulations group
accounted for approximately 68% of our Training and Simulation Division’s
revenues.




We
believe that we have held near a 100% 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.




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. In 2008, our Military Operations group accounted for
18% of our Training and Simulation Division’s revenues.




FAAC is
the sole provider of validated weapon simulations used in US air-combat
training. 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. We also
provide an instructor operator station, mission operator station and real-time,
database driven electronic combat environment for the special operational forces
aircrew training system.




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 2008, our Use of Force group accounted for
14% 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.




2
 Table of Contents




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.




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 2008 and 2007, revenues from our Armor Division were approximately $17.7
million and $18.7 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 vehicles,
vans, SUVs and small buses. We also provide ballistic armor kits for rotary and
fixed wing aircraft, marine armor, personnel armor, and armor for architectural
applications.




We
operate through three business units: MDT Protective Industries Ltd., located in
Lod, Israel (in which we acquired a majority interest in 2002 and the remaining
minority interest early in 2008), MDT Armor Corporation, which we established in
2003 in Auburn, Alabama and Armour of America, which we acquired in 2004 and
relocated to Auburn, Alabama, merging it into MDT Armor in June
2008.




We are a
leading supplier to the Israeli military, Israeli Special Forces and special
services. We provide products to the US 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
2006 and 2007, we received over $25.0 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 did
not receive any David orders in 2008.




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




3
 Table of Contents




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.




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 2008 and 2007, revenues from our Battery and Power Systems
Division were approximately $15.2 million and $11.2 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
that we purchased early in 2004.




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.




4
 Table of Contents




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, AEA Battery
Systems (a wholly owned subsidiary of AEA Technology plc) 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.




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 2008 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.




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.




5
 Table of Contents




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.




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, 2008 and 2007, our backlog for
the following years was approximately $36.6 million and $48.7 million,
respectively, divided among our divisions as follows:




Division
                
                2008
                
                
                2007Training
      and Simulation Division
                
                $
                16,503,000
                
                
                $
                21,670,000Armor
      Division
                
                
                7,874,000
                
                
                
                14,164,000Battery
      and Power Systems Division
                
                
                12,226,000
                
                
                
                12,861,000TOTAL:
                
                $
                36,603,000
                
                
                $
                48,695,000






6
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Major
Customers




During
2008 and 2007, including all of our divisions, various branches of the United
States military accounted for approximately 54% and 52% 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.




Research
and Development




During
the years ended December 31, 2008 and 2007, our gross research and product
development expenditures were approximately $1.7 million and $1.9 million,
respectively.




EFL has
certain contingent royalty obligations to the Office of the Chief Scientist of
the Israel Ministry of Industry and Trade and the Israel-U.S. Binational
Industrial Research and Development Foundation (BIRD-F), which apply (in respect
of continuing operations) only to our inactive Electric Vehicle program. As of
December 31, 2008, our total outstanding contingent liability in this connection
was approximately $10.6 million.




Employees




As of
February 28, 2009, we had 450 employees worldwide, most of whom were full-time
employees. 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.




ITEM1A.     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, 2008, we had an accumulated deficit of
approximately $167.2 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 $8.7
million as of December 31, 2008 (not including trade payables, other account
payables, seller-financed mortgages, capital leases, and accrued severance pay),
of which $5.1 million is subordinated convertible notes and $3.6 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.




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 2009 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 are due on each of February 13, 2009, May 15, 2009, August
14, 2009, November 13, 2009, February 15, 2010, 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. We paid the principal payment due February 13, 2009 in
cash. 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.




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 $2,500,000 10% Senior Subordinated Convertible Note from an
unaffiliated company. This 10% Senior Subordinated Convertible Note is due
December 31, 2009. The issuer is required to pay interest on a quarterly basis
starting in November, 2008 and pay the entire principal by December 31, 2009. 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, 2008, we had recorded goodwill of $32.3 million. On January 1,
2002, we adopted SFAS No. 142, “Goodwill and Other Intangible Assets.” SFAS No.
142 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 at the end of the quarter ended
June 30, 2008. 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.




In view
of the above factors, management felt that in the current market as of June 30,
2008, our stock was undervalued, especially when compared to the estimated
future cash flows of the underlying entities.




Due to
the extreme volatility in the stock market, changing current market conditions
and the effect on our common stock price during the year ended December 31,
2008, we decided to update the goodwill impairment studies originally conducted
as of June 30, 2008. Consistent with the June 30, 2008 analysis, we used the
discounted future cash flow method to determine the value of our company and its
subsidiaries. We believe that our stock price has historically traded at a much
higher value and that the current stock price and resultant market
capitalization amount are a short term condition. We concluded that the
collective value of its individual business units on a longer term horizon
exceeds the value of the short term market assessments of our common
stock.




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 Table of Contents




The
results of the updated assessments confirmed the previously conducted studies as
of June 30, 2008 that there is no impairment of goodwill as of December 31,
2008.




If the
value of our market capitalization were to remain at current depressed levels
for an extended additional period of time, we would have to re-assess the value
of our goodwill at that time, and there can be no assurance that we would reach
the same conclusion regarding the non-existence of an impairment of goodwill at
that time.




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.




If
we are unable to manage our growth, our operating results will be
impaired.




As a
result of our acquisitions, we have experienced a period of significant growth
and development activity which has placed a significant strain on our personnel
and resources. Our activity has resulted in increased levels of responsibility
for both existing and new management personnel. Many of our management personnel
have had limited or no experience in managing growing companies. We have sought
to manage our current and anticipated growth through the recruitment of
additional management and technical personnel and the implementation of internal
systems and controls. However, our failure to manage growth effectively could
adversely affect our results of operations.




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.




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.




10
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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.




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 2009, 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
the last two fiscal years we operated at a loss but had positive cash flow.
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 2008 and 2007, 28% and 22%, 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.




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.




11
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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.




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.




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.


12
 Table of Contents




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.




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.




A
reduction of U.S. force levels in Iraq may affect our results of
operations.




Since the
invasion of Iraq by the U.S. and other forces in March 2003, we have received
orders from the U.S. military for armoring of vehicles and military batteries.
These orders are the result, in substantial part, of the particular combat
situations encountered by the U.S. military in Iraq. We cannot be certain to
what degree the U.S. military would continue placing orders for our products if
the U.S. military were to reduce its force levels or withdraw completely from
Iraq. A significant reduction in orders from the U.S. military could have a
material adverse effect on our business, financial condition, results of
operations and liquidity.


13
 Table of Contents


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.




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




Our stock
price is currently below $1.00, and has been so since October 6, 2008. 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. However, given the
current extraordinary market conditions, Nasdaq has temporarily suspended its
$1.00 minimum bid price rule. This suspension is currently scheduled to expire
on Sunday, April 19, 2009. There can be no assurance that our bid price will go
back over $1.00 prior to such date, or that Nasdaq will extend its current
suspension beyond April 19, 2009.




In
general, if our bid price were to go 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.


14
 Table of Contents




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;




·
            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.




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 29% 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.


15
 Table of Contents




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 2008, the inflation adjusted NIS appreciated against
the dollar.





ITEM1B.     UNRESOLVED STAFF
COMMENTS




None.




ITEM2.        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 renting approximately 6,600 square feet in a third
building, on a month to month basis. FAAC, through its subsidiary Realtime
Technologies, Inc., acquired at the beginning of 2008, leases approximately
3,900 square feet in Royal Oak, Michigan pursuant to a lease terminating at the
end of April 2009.




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, 2010. Additionally, we have purchased 16,700 square feet of
space used by MDT Armor and AoA 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 2009 and 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.




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.




ITEM3.      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. Trial has been held in this matter, and
we are awaiting a decision.




Class
Action Litigation




In May
2007, two purported class action complaints (the “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. A similar case filed in the United States District Court for the Eastern
District of Michigan in March 2007 was withdrawn by the plaintiff in June 2007.
The 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 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 Complaint seeks an unspecified amount of damages. A lead
plaintiff has been named, and the plaintiff’s consolidated amended complaint was
filed in September 2007. Our motion to dismiss the Complaint as a matter of law
was denied in March 2009.




Although
the ultimate outcome of this matter cannot be determined with certainty, we
believe that the allegations stated in the 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.     SUBMISSION OF MATTERS TO A VOTE
OF SECURITY HOLDERS




None.






16
 Table of Contents




PART
II




ITEM5. MARKET
FOR REGISTRANT’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,
2008
                    
                    High
                    
                    
                    LowFourth Quarter
                    
                    $
                    1.13
                    
                    
                    $
                    0.39Third Quarter
                    
                    $
                    2.07
                    
                    
                    $
                    1.02Second Quarter
                    
                    $
                    2.70
                    
                    
                    $
                    2.00First Quarter
                    
                    $
                    2.73
                    
                    
                    $
                    1.66Year Ended December 31,
2007
                    
                    High
                    
                    
                    LowFourth Quarter
                    
                    $
                    3.63
                    
                    
                    $
                    1.94Third Quarter
                    
                    $
                    3.70
                    
                    
                    $
                    2.52Second Quarter
                    
                    $
                    3.73
                    
                    
                    $
                    2.15First Quarter
                    
                    $
                    4.87
                    
                    
                    $
                    3.03




As of
February 28, 2009 we had approximately 324 holders of record of our common
stock.




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.




ITEM6. SELECTED
FINANCIAL DATA




Not
applicable.




ITEM7. 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.




17
 Table of Contents




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:




Ø
            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);




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




Ø
            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).




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
Statement of Position 81-1 “Accounting for Performance of Construction – Type
and Certain Production – Type Contracts” 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.




We
account for our other revenues from IES simulators in accordance with the
provisions of SOP 97-2, “Software Revenue Recognition,” issued by the American
Institute of Certified Public Accountants and as amended by SOP 98-4 and SOP
98-9 and related interpretations. 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 Financial Accounting Standards Board
(“FASB”) Statement No. 123(R) (“SFAS No. 123(R)”), “Share-Based Payment,” using
the modified prospective transition method. Under SFAS No. 123(R), 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.




18
 Table of Contents




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.




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 Statement of Financial Accounting Standards No. 109, “Accounting for
Income Taxes” (“Statement 109”), 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. Pursuant to SFAS No. 142, “Goodwill and Other Intangible Assets,”
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 should not be netted against our deferred tax assets (which primarily
relate to net operating loss carryforwards) 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 Financial Accounting Standards
Board Interpretation No.48, Accounting for Uncertainty in Income Taxes (“FIN
48”), an interpretation of Statement 109. FIN 48 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. FIN 48 applies to all tax positions related to income
taxes subject to Statement 109. 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.




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 2008, no
significant changes were made to the underlying assumptions related to estimates
of inventory valuation or the methodology applied.




19
 Table of Contents




Goodwill




As of
December 31, 2008, we had recorded goodwill of $32.3 million. Under Financial
Accounting Standards Board Statement No. 142, “Goodwill and Other Intangible
Assets” (SFAS 142), 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 in accordance with SFAS 142, 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 at the end of the quarter ended
June 30, 2008. 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.




In view
of the above factors, management felt that in the current market as of June 30,
2008, our stock was undervalued, especially when compared to the estimated
future cash flows of the underlying entities.




Due the
extreme volatility in the stock market and the effect on our common stock price
during the year ended December 31, 2008, we decided to update the goodwill
impairment studies originally conducted as of June 30, 2008. Because of current
market conditions and overall depressed stock values, we used the discounted
future cash flow method in an effort to determine more accurately the true value
of us and our subsidiaries. We based the determination on our belief that our
stock price had historically traded at a much higher value and that the current
stock price and resultant market capitalization amount are a short term
condition. We concluded that the collective value of its individual business
units on a longer term horizon exceeds the value of the short term market
assessment of our common stock.




The
results of the updated assessments confirmed the previously conducted studies as
of June 30, 2008 that there is no impairment of goodwill as of December 31,
2008.




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.




20
 Table of Contents




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.




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 operating losses for the years ended December 31, 2008 and 2007. 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 2008 and 2007 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 2009, 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 2008.
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 intangible assets in 2008 and 2007 in the amount of
$1.7 million and $1.4 million, respectively.




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. When a debenture is
converted, however, the entire remaining unamortized beneficial conversion
feature expense is immediately recognized in the quarter in which the debenture
is converted. Similarly, when we issue warrants in connection with convertible
securities, we record debt discount for financial expenses that is amortized
ratably over the term of the convertible securities; when the convertible
securities are converted, the entire remaining unamortized debt discount is
immediately recognized in the quarter in which the convertible securities are
converted.




During
2008 and 2007, 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 life
of the period of the restriction.




21
 Table of Contents




As a
result of the application of the above accounting rules, we incurred non-cash
charges related to stock-based compensation in 2008 and 2007 in the amount of
$1.0 million and $1.3 million, respectively.




As a
result of options granted to employeesand the adoption of
Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based
Payments,” we incurred non-cash charges related to stock-based compensation in
2008 and 2007 in the amount of $68,000 and $86,000, respectively.




Under the
terms of our convertible notes that we had issued in 2005, which have since been
paid in full, we had the option in respect of scheduled principal repayments to
force conversion of the payment amount at a conversion price based upon the
weighted average trading price of our common stock during the 20 trading days
prior to the conversion, less a discount of 8%.




During
2007, we converted the remaining $6,976,097 of principal remaining outstanding
under our secured convertible notes by forcing conversion of this principal
amount into 930,125 shares of our common stock.




Additionally,
in an effort to improve our cash situation and our shareholders’ equity, we have
periodically induced holders of certain of our warrants to exercise their
warrants by lowering the exercise price of the warrants in exchange for
immediate exercise of such warrants, and by issuing to such investors new
warrants. Under such circumstances, we record a deemed dividend in an amount
determined based upon the fair value of the new warrants (using the
Black-Scholes pricing model). As and to the extent that we engage in similar
warrant repricings and issuances in the future, we would incur similar non-cash
charges.




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 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 SFAS No. 150 and EITF Issues
No. 00-19, 00-27 and 05-2.




As part
of the securities purchase agreement, we issued to the purchasers of our 10%
senior convertible notes due August 15, 2011, 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 classified as equity based on
relative fair value.




The fair
value of these warrants was determined using Black-Scholes pricing model,
assuming a risk-free interest rate of 2.78%, a volatility factor 75%, dividend
yields of 0% and a contractual life of 3.0 years.




In
connection with these convertible notes, we recorded a deferred debt discount of
$412,000 arising from the fair value allocation of the warrants according to APB
No. 14, which is being amortized from the date of issuance to the stated
redemption date – August 15, 2011 – or to the actual conversion date, if
earlier, as financial expenses using the effective interest method.




Principle
payments are due on the convertible notes as follows:




Year
                    
                    Amount2009
                    
                    $
                    1,818,1802010
                    
                    
                    1,818,1802011
                    
                    
                    1,363,640$
                    5,000,000




Concurrent
with the Securities Purchase Agreement dated August 14, 2008, we purchased a
$2,500,000 Senior Subordinated Convertible Note from an unaffiliated company,
DEI Services Corporation. This 10% Senior Subordinated Convertible Note is due
December 31, 2009. The 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.




Interest
on the outstanding principal amount of this note commenced accruing on the
issuance date and is payable quarterly, in arrears, on November 15, February 15,
May 15 and August 15 of each year with the first payment due November 15,
2008.




Interest
on this note will be recognized as a reduction of financial expenses and will be
shown on an accrual basis.  Related fees and costs will be recorded as
general and administrative expense.




During
2008 and 2007, we recorded expenses of $52,000 and $19,000, respectively,
attributable to amortization related to warrants issued to the holders of
convertible notes. During 2007, we also recorded expenses of $280,000,
attributable to financial expenses in connection with convertible note principle
repayment. Additionally, during 2007, we recorded expenses of $44,000,
attributable to amortization of deferred charges related to debt discount
resulting from the warrants that were issued in 2008.


22
 Table of Contents


Overview
of Operating Performance and Backlog




Overall,
our net loss before minority interest earnings, earnings from an affiliated
company and tax expenses for 2008 was $2.4 million on revenues of $68.9 million,
compared to a net loss of $2.8 million on revenues of $57.7 million during 2007.
As of December 31, 2008, our overall backlog totaled $36.6 million.




In our
Training and Simulation Division, revenues increased from approximately $27.8
million in 2007 to $36.0 million in 2008. As of December 31, 2008, our backlog
for our Training and Simulation Division totaled $16.5 million.




In our
Armor Division, revenues decreased from approximately $18.7 million in 2007 to
approximately $17.7 million in 2008. As of December 31, 2008, our backlog for
our Armor Division totaled $7.9 million.




In our
Battery and Power Systems Division, revenues increased from approximately $11.2
million in 2007 to approximately $15.2 million in 2008. As of December 31, 2008,
our backlog for our Battery and Power Systems Division totaled $12.2
million.




Results
of Operations




Preliminary
Note




Summary




Following
is a table summarizing our results of operations for the years ended December
31, 2008 and 2007, after which we present a narrative discussion and
analysis:




Year
      Ended December 31,2008
                          
                          
                          2007(as
      restated;see
      Note 19 to Consolidated
                            FinancialStatements)Revenues:Training
      and Simulation Division
                          
                          $
                          36,032,703
                          
                          
                          $
                          27,760,858Armor
      Division
                          
                          
                          17,762,439
                          
                          
                          
                          18,724,107Battery
      and Power Systems Division
                          
                          
                          15,153,827
                          
                          
                          
                          11,234,596$
                          68,948,969
                          
                          
                          $
                          57,719,561Cost
      of revenues:Training
      and Simulation Division
                          
                          $
                          22,017,653
                          
                          
                          $
                          15,528,023Armor
      Division
                          
                          
                          15,932,478
                          
                          
                          
                          15,906,071Battery
      and Power Systems Division
                          
                          
                          12,227,778
                          
                          
                          
                          8,205,718$
                          50,177,909
                          
                          
                          $
                          39,639,812Research
      and development expenses:Training
      and Simulation Division
                          
                          $
                          797,112
                          
                          
                          $
                          629,430Armor
      Division
                          
                          
                          247,462
                          
                          
                          
                          115,500Battery
      and Power Systems Division
                          
                          
                          613,094
                          
                          
                          
                          1,132,233$
                          1,657,668
                          
                          
                          $
                          1,877,163Sales
      and marketing expenses:Training
      and Simulation Division
                          
                          $
                          3,232,367
                          
                          
                          $
                          2,956,995Armor
      Division
                          
                          
                          754,645
                          
                          
                          
                          634,237Battery
      and Power Systems Division
                          
                          
                          712,858
                          
                          
                          
                          570,768All
      Other
                          
                          
                          –
                          
                          
                          
                          2,464$
                          4,699,870
                          
                          
                          $
                          4,164,464General
      and administrative expenses:Training
      and Simulation Division
                          
                          $
                          4,068,614
                          
                          
                          $
                          3,400,013Armor
      Division
                          
                          
                          1,590,549
                          
                          
                          
                          1,295,079Battery
      and Power Systems Division
                          
                          
                          1,239,288
                          
                          
                          
                          1,658,968All
      Other
                          
                          
                          7,195,313
                          
                          
                          
                          6,804,237$
                          14,093,764
                          
                          
                          $
                          13,158,297Escrow
      Adjustment:All
      Other
                          
                          $
                          (1,448,074
                          )
                          
                          $
                          –$
                          (1,448,074
                          )
                          
                          $
                          –   23
 Table of Contents
  Year
      Ended December 31,2008
                                                                                                        
                                                                                                        
                                                                                                        2007(as
      restated;see
      Note 19 to Consolidated
                                                                                                          FinancialStatements)
 Other
      income:Training
      and Simulation Division
                              
                              $
                              34,714
                              
                              
                              $
                              122,934Armor
      Division
                              
                              
                              63,099
                              
                              
                              
                              152,206Battery
      and Power Systems Division
                              
                              
                              27
                              
                              
                              
                              –All
      Other
                              
                              
                              325,043
                              
                              
                              
                              342,812$
                              422,883
                              
                              
                              $
                              617,952Financial
      expense:Training
      and Simulation Division
                              
                              $
                              195
                              
                              
                              $
                              14,610Armor
      Division
                              
                              
                              357,517
                              
                              
                              
                              93,292Battery
      and Power Systems Division
                              
                              
                              313,671
                              
                              
                              
                              176,834All
      Other
                              
                              
                              142,706
                              
                              
                              
                              621,152$
                              814,089
                              
                              
                              $
                              905,888Tax
      expenses (credits):Training
      and Simulation Division
                              
                              $
                              68,608
                              
                              
                              $
                              69,930Armor
      Division
                              
                              
                              58,147
                              
                              
                              
                              2,639Battery
      and Power Systems Division
                              
                              
                              100,113
                              
                              
                              
                              (28,653
                              )All
      Other
                              
                              
                              800,000
                              
                              
                              
                              565,000$
                              1,026,868
                              
                              
                              $
                              608,916Amortization
      of intangible assets:Training
      and Simulation Division
                              
                              $
                              1,212,958
                              
                              
                              $
                              776,736Armor
      Division
                              
                              
                              13,350
                              
                              
                              
                              95,907Battery
      and Power Systems Division
                              
                              
                              509,240
                              
                              
                              
                              509,239$
                              1,735,548
                              
                              
                              $
                              1,381,882Loss
      from affiliated company:Training
      and Simulation Division
                              
                              $
                              (352,166
                              )
                              
                              $
                              (40,230
                              )Armor
      Division
                              
                              
                              (100,000
                              )
                              
                              
                              –$
                              (452,166
                              )
                              
                              $
                              (40,230
                              )Minority
      interest in profit of subsidiaries:Armor
      Division
                              
                              $
                              –
                              
                              
                              $
                              (62,296
                              )$
                              –
                              
                              
                              $
                              (62,296
                              )Net
      income (loss):Training
      and Simulation Division
                              
                              $
                              4,317,744
                              
                              
                              $
                              4,467,825Armor
      Division
                              
                              
                              (1,228,610
                              )
                              
                              
                              671,292Battery
      and Power Systems Division
                              
                              
                              (562,188
                              )
                              
                              
                              (990,511
                              )All
      Other
                              
                              
                              (6,364,902
                              )
                              
                              
                              (7,650,041
                              )$
                              (3,837,956
                              )
                              
                              $
                              (3,501,435
                              )






24
 Table of Contents




Fiscal
Year 2008 compared to Fiscal Year 2007 (as restated)




Revenues. During 2008, we (through our
subsidiaries) recognized revenues as follows:




Ø
            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.




Ø
            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.




Ø
            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.




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




Revenues
for 2008 totaled $68.9 million, compared to $57.7 million in 2007, an increase
of $11.2 million, or 19.5%. This increase was primarily attributable to the
following factors:




Ø
            Increased
      revenues from our Training and Simulation Division ($8.2 million more in
      2008 versus 2007), which includes $2.6 million in revenues from our newly
      acquired subsidiary RTI and an increase of approximately $5.0 million in
      sales of military vehicle
simulators.




Ø
            Increased
      revenues from our Battery and Power Systems Division ($4.0 million more in
      2008 versus 2007), primarily due to increased military and commercial
      battery sales at Epsilor.




These
increases were offset to some extent by decreased revenues from our Armor
Division ($1.0 million less in 2008 versus 2007).




In 2008,
revenues were $36.0 million for the Training and Simulation Division (compared
to $27.8 million in 2007, an increase of $8.2 million, or 29.8%, due primarily
to increased sales of military operations and vehicle simulators); $15.2 million
for the Battery and Power Systems Division (compared to $11.2 million in 2007,
an increase of $4.0 million, or 34.9%, due primarily to increased sales of our
battery products at Epsilor); and $17.7 million for the Armor Division (compared
to $18.7 million in 2007, a decrease of $1.0 million, or 5.1%, due primarily to
decreased revenues from MDT and MDT Armor, mostly in respect of orders for the
“David” Armored Vehicle).




Cost of
revenues. Cost of revenues totaled $50.2 million during 2008, compared to
$39.6 million in 2007, an increase of $10.6 million, or 26.6%, 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 2008 were $22.0 million for the Training
and Simulation Division (compared to $15.5 million in 2007, an increase of $6.5
million, or 41.8%, due primarily to increased revenues and a product mix that
resulted in slightly lower margins); $12.2 million for the Battery and Power
Systems Division (compared to $8.2 million in 2007, an increase of $4.0 million,
or 49.0%, due primarily to increased revenues and price increases in raw
materials along with increased labor costs); and $15.9 million for the Armor
Division (compared to $15.9 million in 2007, unchanged, due primarily to
increased material and labor costs offset by the reduced production of the
“David” Armored Vehicle).




Amortization of
intangible assets. Amortization of intangible
assets totaled $1.7 million in 2008, compared to $1.4 million in 2007, an
increase of $354,000, or 25.6%, due primarily to increase in intangibles
relating to our purchases of RTI and the minority interest of MDT along with an
increase in capitalized technology.




Research and
development expenses. Research and development
expenses for 2008 were $1.7 million, compared to $1.9 million during 2007, a
decrease of $219,000, or 11.7%, due primarily to increased costs  at
FAAC for expenses associated with the improvements to our simulator products, an
increase in costs in our Armor division for expenses associated with
improvements to our armoring products along with development expenses associated
with our Concord Safety Solutions joint venture in India offset by a significant
reduction of expenses in our Battery division.




Selling and
marketing expenses. Selling and marketing
expenses for 2008 were $4.7 million, compared to $4.2 million 2007, an increase
of $535,000, or 12.9%. Expenses increased in each division and this increase was
primarily attributable to the overall increase in revenues and their associated
sales and marketing expenses.




General and
administrative expenses. General and administrative
expenses for 2008 were $14.1 million, compared to $13.2 million in 2007, an
increase of $935,000, or 7.1%. This increase was primarily attributable to the
charges relating to acquisition transaction costs of $435,000 that were expensed
in 2008 and increased costs associated with the addition of RTI, including a
$250,000 payment of an earnout as required under the terms of the agreement
pursuant to which we purchased RTI, offset by reduced stock compensation
expenses and reduced legal expenses.




Escrow
adjustment. 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,
granting the Seller’s counterclaim for $70,000 in compensation, awarding the
Company the entire $3.0 million, along with $135,000 in attorneys’ fees and
interest of approximately $325,000. The net impact of the settlement was
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.




25
 Table of Contents




Financial
expenses, net.
Financial expenses totaled approximately $814,000 in 2008 compared to $906,000
in 2007, a decrease of $92,000, or 10.1%. The difference was due primarily to
reduced interest expenses.




Loss from
affiliated company.The investment in the Center for Transportation
Safety Inc. and the investment in Concord Safety Solutions Pvt. Ltd were reduced
by an aggregate of $452,000 in 2008.




Income
taxes. We and certain of our subsidiaries incurred net operating losses
during 2008 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 2008, we were able to offset federal taxes against our accumulated
loss carry forward. We recorded a total of $1.0 million in tax expenses in 2008,
compared to $609,000 in tax expenses in 2007, 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 $565,000 in both 2007 and
2008.




Net
loss.  Due to the factors cited above, net loss increased to
$3.8 million in 2008 from $3.5 million in 2007, a difference of $337,000, or
9.6%.




Liquidity
and Capital Resources




As of
December 31, 2008, we had $4.3 million in cash, $382,000 in restricted
collateral securities and $49,000 in available-for-sale marketable securities,
as compared to at December 31, 2007, when we had $3.4 million in cash, $320,000
in restricted collateral securities, $1.5 million in an escrow receivable and
$47,000 in available-for-sale marketable securities. We also had $3.1 million
available in unused bank lines of credit with our main bank, under a $7.5
million credit facility under our FAAC subsidiary, which is secured by our
assets and the assets of our other subsidiaries and guaranteed by us. The entire
amount of the remaining $3.1 million of credit on the primary line was available
at year end.




We used
available funds in 2008 primarily for sales and marketing, continued research
and development expenditures, and other working capital needs. We increased our
investment in fixed assets by $1.2 million during the year ended December 31,
2008. Our net fixed assets amounted to $5.1 million as at year end.




Net cash
used in operating activities for 2008 was $(677,000) and net cash provided by
operating activities for 2007 was $923,000, an increase of $1.6 million. This
increase in cash used was primarily the result of changes in working
capital.




Net cash
used in investing activities for 2008 and 2007 was $2.3 million and $1.6
million, respectively, an increase of $778,000. This increase was primarily the
result of the purchase of $2.5 million in convertible notes, the acquisition of
RTI and the purchase of the minority interest in MDT, offset by the escrow
payment from the judgment in the AoA arbitration.




Net cash
provided by financing activities for 2008 and 2007 was $3.9 million and $1.6
million, respectively, an increase of $2.3 million. This increase was primarily
due to the new senior notes offset by the change in short-term bank
debt.




As of
December 31, 2008, we had (based on the contractual amount of the debt and not
on the accounting valuation of the debt, not taking into consideration trade
payables, other accounts payables and accrued severance pay) approximately $3.6
million in bank debt and $5.1 million in long term senior subordinated notes
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.




Effective
Corporate Tax Rate




We and
certain of our subsidiaries incurred net operating losses during the years ended
December 31, 2008 and 2007, 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 2008, we were able to offset federal taxes against our net
operating loss carryforward, which amounted to approximately $35.0 million as of
December 31, 2008. 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 2008,
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
27% in 2008 (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, 2008, we had a U.S. net operating loss carryforward of
approximately $24.9 million that is available to offset future taxable income
under certain circumstances, expiring primarily from 2009 through 2026, and
foreign net operating and capital loss carryforwards of approximately $106
million, which are available indefinitely to offset future taxable income
under certain circumstances.




26
 Table of Contents




Contractual
Obligations




The
following table lists our contractual obligations and commitments as of December
31, 2008, not including trade payables and other accounts payable:




Payment
      Due by PeriodContractual
      Obligations
                  
                  Total
                  
                  
                  Less
      Than 1 Year
                  
                  
                  1-3
      Years
                  
                  
                  3-5
      Years
                  
                  
                  More
      than 5 YearsLong-term
      debt
                  
                  $
                  6,072,775
                  
                  
                  $
                  1,845,285
                  
                  
                  $
                  3,242,967
                  
                  
                  $
                  71,710
                  
                  
                  $
                  912,813Short-term
      debt*
                  
                  $
                  3,607,890
                  
                  
                  $
                  3,607,890
                  
                  
                  $
                  –
                  
                  
                  $
                  –
                  
                  
                  $
                  –Operating
      lease obligations**
                  
                  $
                  3,916,964
                  
                  
                  $
                  724,821
                  
                  
                  $
                  1,028,113
                  
                  
                  $
                  859,614
                  
                  
                  $
                  1,304,416Capital
      lease obligations
                  
                  $
                  234,166
                  
                  
                  $
                  85,394
                  
                  
                  $
                  111,908
                  
                  
                  $
                  36,864
                  
                  
                  $
                  –Severance
      obligations***
                  
                  $
                  5,161,448
                  
                  
                  $
                  –
                  
                  
                  $
                  5,161,448
                  
                  
                  $
                  –
                  
                  
                  $
                  –
  *Primarily in short-term bank debt.
 **Includes operating lease obligations related to rent.
 *** Includes obligations
related to special severance pay arrangements in addition to the severance
amounts due to certain employees pursuant to Israeli severance pay law (the
amount shown in the table above with payment due during the next 1-3 years might
not be paid in the period stated in the event the employment agreements to which
such severance obligations relate are extended).


27
 Table of Contents
  ITEM8. 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-39




ITEM9. CHANGES
IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
DISCLOSURE




Not
applicable.




ITEM9A. CONTROLS
AND PROCEDURES




Evaluation
of Disclosure Controls and Procedures




As of
December 31, 2008, 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, 2008, 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, 2008. 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.




Based on
management’s assessment and these criteria, our management concluded that our
internal control over financial reporting was effective as of December 31,
2008.




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 to which this Annual Report on Form 10-K
relates that have materially affected, or are reasonably likely to materially
affect, our internal control over financial reporting.




ITEM9B. OTHER
INFORMATION




None.




28
 Table of Contents




PART
III




ITEM10. 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, 2009 were as
follows:




Name
                      
                      Age
                      
                      PositionRobert
      S. Ehrlich
                      
                      70
                      
                      Chairman
      of the Board and Chief Executive OfficerSteven
      Esses
                      
                      45
                      
                      President,
      Chief Operating Officer and DirectorThomas
      J. Paup
                      
                      60
                      
                      Vice
      President – Finance and Chief Financial OfficerDr.
      Jay M. Eastman
                      
                      60
                      
                      DirectorEdward
      J. Borey
                      
                      58
                      
                      DirectorSeymour
      Jones
                      
                      77
                      
                      DirectorElliot
      Sloyer
                      
                      44
                      
                      DirectorMichael
      E.
      Marrus
                      
                      45
                      
                      Director




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 2009
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 and
Sloyer 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.




Robert S. Ehrlichhas been our
Chairman of the Board since January 1993 and our President and Chief Executive
Officer since October 2002. In December 2005, Mr. Ehrlich ceased to hold the
title of President. 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. Mr.
Ehrlich received a B.S. and J.D. from Columbia University in New York, New
York.




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. From 1995 to 2000, Mr. Esses
founded Dunkin’ Donuts in Israel and held the position of Managing Director and
CEO. Prior thereto, he was 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.




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.




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 January 1983, Dr. Eastman was Director of the
University of Rochester’s Laboratory for Laser Energetics, where he was a member
of the staff from September 1975 to 1981. Dr. Eastman holds a B.S. and a Ph.D.
in Optics from the University of Rochester in New York.




Edward J. Borey has served as
a director 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.




29
 Table of Contents




Seymour Joneshas served as a
director since July 2005. Mr. Jones is a clinical professor of accounting at New
York University Stern School of Business. Professor Jones teaches courses in
auditing, tax and legal aspects of entrepreneurism. He is also the Associate
Director of Ross Institute of Accounting Research at Stern School of Business.
Professor Jones has been with NYU Stern for ten years. His primary research
areas include audit committees, auditing, entrepreneurship, financial reporting,
and fraud. Professor Jones has been principal author of numerous books including
Conflict of
Interest,The Cooper
& Lybrand Guide to Growing Your Business, The Emerging Businessand
The Bankers Guide to Audit
Reports and Financial Statements. Before joining NYU Stern, Professor
Jones was senior partner at Coopers & Lybrand and S.D. Leidesdorf & Co.
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.




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.




Michael E. Marrus has served
as a director since October 2007. Mr. Marrus is an investment banker who until
February 2009 was a Managing Director of Collins Stewart LLC, the US operations
of Collins Stewart plc, a London based corporate broker traded on the London
Stock Exchange. Prior to Collins Stewart, Mr. Marrus was a Managing Director of
C. E. Unterberg, Towbin, an investment banking firm that was acquired by Collins
Stewart plc. Prior to joining Unterberg, Towbin in 1998, 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.




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 and
Sloyer. We have determined that Prof. Jones qualifies as an “audit committee
financial expert” under applicable SEC and Nasdaq regulations. Prof. Jones, as
well as all the other members of the Audit Committee, is “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.




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.




30
 Table of Contents




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.




Director
Compensation




Non-employee
members of our Board of Directors are paid a cash retainer of $7,000 (plus
expenses) 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, 2008:




DIRECTOR
COMPENSATION




Name
                                                          
                                                          Fees
      Earned or Paid in Cash
                                                            ($)
                                                          
                                                          Stock
      Awards(1)
                                                            ($)
                                                          
                                                          
                                                          Total
                                                            ($)Dr.
      Jay M. Eastman
                                                          
                                                          $
                                                          32,000
                                                          
                                                          $
                                                          15,000
                                                          (2)
                                                          
                                                          $
                                                          47,000Edward
      J. Borey
                                                          
                                                          $
                                                          32,000
                                                          
                                                          $
                                                          15,000
                                                          (3)
                                                          
                                                          $
                                                          47,000Seymour
      Jones
                                                          
                                                          $
                                                          36,000
                                                          
                                                          $
                                                          15,000
                                                          (4)
                                                          
                                                          $
                                                          51,000Elliot
      Sloyer
                                                          
                                                          $
                                                          32,000
                                                          
                                                          $
                                                          25,000
                                                          (5)
                                                          
                                                          $
                                                          57,000Michael
      E.
      Marrus
                                                          
                                                          $
                                                          32,000
                                                          
                                                          $
                                                          25,000
                                                          (6)
                                                          
                                                          $
                                                          57,000Jack
      Rosenfeld (7)
                                                          
                                                          $
                                                          30,000
                                                          
                                                          $
                                                          15,000
                                                          
                                                          
                                                          $
                                                          45,000Lawrence
      M. Miller (7)
                                                          
                                                          $
                                                          30,000
                                                          
                                                          $
                                                          15,000
                                                          
                                                          
                                                          $
                                                          45,000
   (1)
            This
      column reflects the compensation cost for the year ended December 31, 2008
      of each director’s restricted stock, calculated in accordance with SFAS
      123R.(2)
            As
      of December 31, 2008, Dr. Eastman held 8,785 restricted shares of our
      common stock.(3)
            As
      of December 31, 2008, Mr. Borey held 8,785 restricted shares of our common
      stock.(4)
            As
      of December 31, 2008, Prof. Jones held 8,785 restricted shares of our
      common stock.(5)
            As
      of December 31, 2008, Mr. Sloyer held 10,978 restricted shares of our
      common stock.(6)
            As
      of December 31, 2008, Mr. Marrus held 10,978 restricted shares of our
      common stock.(7)
            This
      individual retired as a director as of October 27,
  2008.






31
 Table of Contents




Significant
Employees




Our
significant employees as of February 28, 2009, and their ages as of December 31,
2008, are as follows:




Name
                      
                      Age
                      
                      PositionDean
      Krutty
                      
                      43
                      
                      President,
      Training and Simulation DivisionJonathan
      Whartman
                      
                      54
                      
                      President,
      Armor DivisionRonen
      Badichi
                      
                      43
                      
                      President,
      Battery and Power Systems DivisionYaakov
      Har-Oz
                      
                      51
                      
                      Senior
      Vice President, General Counsel and SecretaryWilliam
      Graham
                      
                      49
                      
                      Vice
      President of Government AffairsNorman
      Johnson
                      
                      56
                      
                      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.




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 2008. 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.




32
 Table of Contents




ITEM11.        EXECUTIVE
COMPENSATION




Cash
and Other Compensation




Summary
Compensation Table




The
following table, which should be read in conjunction with the explanations
provided above, shows the compensation that we paid (or accrued) to our
executive officers during the fiscal years ended December 31, 2008 and
2007:




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
                                                                
                                                                2008
                                                                
                                                                $
                                                                400,000
                                                                
                                                                
                                                                $
                                                                90,000
                                                                
                                                                
                                                                $
                                                                –
                                                                
                                                                $
                                                                518,017
                                                                (3)
                                                                
                                                                $
                                                                1,008,0172007
                                                                
                                                                $
                                                                400,000
                                                                
                                                                
                                                                $
                                                                175,000
                                                                
                                                                
                                                                $
                                                                753,783
                                                                
                                                                $
                                                                241,411
                                                                (4)
                                                                
                                                                $
                                                                1,570,194Thomas
      J. Paup
                                                                  Vice
      President – Finance and Chief Financial Officer
                                                                
                                                                2008
                                                                
                                                                $
                                                                160,000
                                                                
                                                                
                                                                $
                                                                48,000
                                                                
                                                                
                                                                $
                                                                –
                                                                
                                                                $
                                                                6,188
                                                                (5)
                                                                
                                                                $
                                                                214,1882007
                                                                
                                                                $
                                                                143,100
                                                                
                                                                
                                                                $
                                                                71,550
                                                                
                                                                
                                                                $
                                                                138,067
                                                                
                                                                $
                                                                2,908
                                                                (5)
                                                                
                                                                $
                                                                355,625Steven
      Esses
                                                                  President,
      Chief Operating Officer and a director
                                                                
                                                                2008
                                                                
                                                                $
                                                                167,352
                                                                (6)
                                                                
                                                                $
                                                                75,000
                                                                
                                                                
                                                                $
                                                                –
                                                                
                                                                $
                                                                136,588
                                                                (7)
                                                                
                                                                $
                                                                378,9402007
                                                                
                                                                $
                                                                72,816
                                                                (8)
                                                                
                                                                $
                                                                138,520
                                                                (9)
                                                                
                                                                $
                                                                259,891
                                                                
                                                                $
                                                                106,528
                                                                (10)
                                                                
                                                                $
                                                                577,755





(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 2007 and 2008, 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 SFAS 123R, but excluding any impact of assumed forfeiture rates. 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 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. 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.(3)
                                                Of
      this amount, $82,802 represents payments to Israeli pension and education
      funds; $30,192 represents 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; and
      $131,771 represents the increase of our accrual for severance pay that
      would be payable to Mr. Ehrlich under the laws of the State of Israel if
      we were to terminate his employment.(4)
                                                Of
      this amount, $69,137 represents payments to Israeli pension and education
      funds; $13,289 represents 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; $44,047 represents the
      increase of the accrual for vacation days redeemable by Mr. Ehrlich; and
      $29,859 represents the increase of our accrual for severance pay that
      would be payable to Mr. Ehrlich under the laws of the State of Israel if
      we were to terminate his employment.(5)
                                                Represents
      the increase in our accrual for Mr. Paup for accrued but unused vacation
      days.(6)
                                                Does
      not include $153,668 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, $29,671 represents payments to Israeli pension and education
      funds; $42,701 represents the effect of exchange rate differences on
      salary and bonus payments; and $(21,158)represents the
      decrease of our accrual for severance pay that would be payable to Mr.
      Esses if we were to terminate his employment.(8)
                                                Does
      not include $194,598that 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)
                                                Does
      not include $24,756 that we paid as a bonus 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.(10)
                                                Of
      this amount, $15,744 represents payments to Israeli pension and education
      funds; and $4,177 represents the increase of our accrual for severance pay
      that would be payable to Mr. Esses if we were to terminate his
      employment.






33
 Table of Contents




Executive
Loans




In 1999,
2000 and 2002, we extended certain loans to 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 12/31/08
                    
                    Terms
      of LoanRobert
      S. Ehrlich
                    
                    12/28/99
                    
                    $
                    167,975
                    
                    
                    $
                    201,570
                    
                    Ten-year
      non-recourse loan to purchase our stock, secured by the shares of stock
      purchased.Robert
      S. Ehrlich
                    
                    02/09/00
                    
                    $
                    789,991
                    
                    
                    $
                    818,357
                    
                    Twenty-five-year
      non-recourse loan to purchase our stock, secured by the shares of stock
      purchased.Robert
      S. Ehrlich
                    
                    06/10/02
                    
                    $
                    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 2008.




Grants
of Restricted Stock




We did
not grant any restricted stock to our executive officers during
2008.




Stock
Option Exercises and Vesting of Restricted Stock Awards




Our
executive officers did not exercise any stock options during 2008. The following
table presents awards of restricted stock that vested during the year ended
December 31, 2008.




STOCK
VESTED




Name
                
                Number
      of Shares
                  Acquired
      on Vesting
                  (#)
                
                
                Value
      Realized
                  on
      Vesting(1)
                  ($)Robert
      S.
      Ehrlich
                
                
                106,667
                
                
                $
                43,733Steven
      Esses
                
                
                45,000
                
                
                $
                18,450Thomas
      J.
      Paup
                
                
                21,459
                
                
                $
                8,798
  (1)
              Reflects
      the aggregate market value of the shares of restricted stock determined
      based on a per share price of $0.41, the closing price of our common stock
      on the Nasdaq Global Market on December 31, 2008, which was the last
      trading day of 2008.




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,
2008.




34
 Table of Contents




OUTSTANDING
EQUITY AWARDS AT FISCAL YEAR-END




Option
      Awards
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                Stock
      AwardsNumber
      of Securities Underlying
                                                                                                                                                                  Un­exercised
      Options(1)
                                                                                                                                                                  (#)
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                Equity
      Incentive
                                                                                                                                                                  Plan
      AwardsName
                                                                                                                                                                
                                                                                                                                                                Exercisable
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                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
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                106,666
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                $
                                                                                                                                                                43,733
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                80,000
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                $
                                                                                                                                                                32,8004,687
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                0
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                $
                                                                                                                                                                5.46
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                04/01/121,116
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                0
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                $
                                                                                                                                                                5.46
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                07/01/124,687
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                0
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                $
                                                                                                                                                                5.46
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                10/01/126,294
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                0
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                $
                                                                                                                                                                5.46
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                01/01/13Thomas
      J. Paup
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                –
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                –
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                –
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                –
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                32,291
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                $
                                                                                                                                                                13,239
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                42,916
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                $
                                                                                                                                                                17,596Steven
      Esses
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                714
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                0
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                $
                                                                                                                                                                8.54
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                12/31/12
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                120,000
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                $
                                                                                                                                                                49,200
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                90,000
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                $
                                                                                                                                                                36,9001,785
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                0
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                $
                                                                                                                                                                11.62
                                                                                                                                                                
                                                                                                                                                                
                                                                                                                                                                07/22/12
  (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 $0.41, the closing price of our common stock
      on the Nasdaq Global Market on December 31, 2008, which was the last
      trading day of 2008.




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
and 2009. Additionally, the board may at its discretion raise Mr. Ehrlich’s base
salary. The employment agreement also grants Mr. Ehrlich a retention bonus in
the amount of 200,000 shares of restricted stock, vesting one-third on each of
December 31, 2007, 2008 and 2009.




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, 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 EBITDA, which is determined by taking net profit and adding back in
interest expense (income), net (after deduction of minority interest),
depreciation of fixed assets, taxes (after deduction of minority interest), and
amortization of inventory adjustments and of intangible assets, capitalized
software costs and technology impairment. We did not achieve the targets set by
the Compensation Committee for 2008, and accordingly the incentive bonus for
2008 was not paid. New targets will be chosen for 2009 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.




35
 Table of Contents




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 2008 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.




Pursuant
to the terms of our employment agreement 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. As of
December 31, 2008, a total of $587,905 had been deposited into accounts with two
capital management funds. 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.




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 25,000 shares on
December 31, 2010, with each such vesting being contingent solely on Mr. Esses
being employed by us on the scheduled vesting date, (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, and (iii)
50,000 shares on January 1, 2011, with such vesting being contingent upon Mr.
Esses succeeding to the position of Chief Executive Officer by such date. We did
not achieve the targets set by the Compensation Committee for 2008, and
accordingly the 25,000 performance shares for 2008 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, 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 EBITDA,
which is determined by taking net profit and adding back in interest expense
(income), net (after deduction of minority interest), depreciation of fixed
assets, taxes (after deduction of minority interest), and amortization of
inventory adjustments and of intangible assets, capitalized software costs and
technology impairment. We did not achieve the targets set by the Compensation
Committee for 2008, and accordingly the incentive bonus for 2008 was not paid.
New targets will be chosen for 2009 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.
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.


36
 Table of Contents




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 2008 under various circumstances appears under “Potential Payments and
Benefits upon Termination of Employment – Steven Esses,” below.




Pursuant
to the terms of our employment agreement 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. As of
December 31, 2008, a total of $100,000 had been deposited into accounts with two
capital management funds. 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.




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. Mr. Paup
waived his inflation adjustment for 2008. 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 targets set by the Compensation Committee for
2008, and accordingly the incentive bonus for 2008 was not paid. New targets
will be chosen for 2009 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 targets set by the Compensation
Committee for 2008, and accordingly the 10,834 performance shares for 2008 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. In all of the above cases, “monthly salary” mean what
Mr. Paup’s salary would have been had he not waived his inflation adjustment.
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.




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, 2008 (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.




37
 Table of Contents




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, 2008 (the last business day of
the fiscal year) under the various scenarios described in the column headings as
explained in the footnotes below.




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
                          
                          
                          77,340
                          
                          
                          
                          77,340
                          
                          
                          
                          77,340
                          
                          
                          
                          77,340
                          
                          
                          
                          77,340
                          
                          
                          
                          77,340Recuperation
      pay(7)
                          
                          
                          363
                          
                          
                          
                          363
                          
                          
                          
                          363
                          
                          
                          
                          363
                          
                          
                          
                          363
                          
                          
                          
                          363Benefits: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
                          
                          
                          1,167
                          
                          
                          
                          –
                          
                          
                          
                          1,167
                          
                          
                          
                          1,167
                          
                          
                          
                          1,167
                          
                          
                          
                          –Contractual
      severance
                          
                          
                          1,625,400
                          
                          
                          
                          –
                          
                          
                          
                          1,625,400
                          
                          
                          
                          1,625,400
                          
                          
                          
                          1,625,400
                          
                          
                          
                          –Statutory
      severance(10)
                          
                          
                          715,388
                          
                          
                          
                          –
                          
                          
                          
                          715,388
                          
                          
                          
                          715,388
                          
                          
                          
                          715,388
                          
                          
                          
                          –Accelerated
      vesting of restricted stock
                          
                          
                          168,800
                          
                          
                          
                          –
                          
                          
                          
                          168,800
                          
                          
                          
                          168,800
                          
                          
                          
                          –
                          
                          
                          
                          –TOTAL:
                          
                          $
                          2,629,568
                          
                          
                          $
                          118,813
                          
                          
                          $
                          2,629,568
                          
                          
                          $
                          2,629,568
                          
                          
                          $
                          2,460,768
                          
                          
                          $
                          118,813





(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) the insolvency or the filing (by
      any party, including us) of a petition for the winding-up of us; (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 of us; 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 318 (approximately $86) 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, 2008, 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, 2008, 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.






38
 Table of Contents




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, 2008 (the last business day of
the fiscal year) under the various scenarios described in the column headings as
explained in the footnotes below.




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
                  
                  $
                  13,946
                  
                  
                  $
                  13,946
                  
                  
                  $
                  13,946
                  
                  
                  $
                  13,946
                  
                  
                  $
                  13,946
                  
                  
                  $
                  13,946
                  
                  
                  $
                  13,946
                  
                  
                  $
                  13,946
                  
                  
                  $
                  13,946Vacation
                  
                  
                  64,721
                  
                  
                  
                  64,721
                  
                  
                  
                  64,721
                  
                  
                  
                  64,721
                  
                  
                  
                  64,721
                  
                  
                  
                  64,721
                  
                  
                  
                  64,721
                  
                  
                  
                  64,721
                  
                  
                  
                  64,721Sick
      leave(11)
                  
                  
                  17,455
                  
                  
                  
                  17,455
                  
                  
                  
                  –
                  
                  
                  
                  17,455
                  
                  
                  
                  17,455
                  
                  
                  
                  17,455
                  
                  
                  
                  17,455
                  
                  
                  
                  17,455
                  
                  
                  
                  –Recuperation
      pay(12)
                  
                  
                  254
                  
                  
                  
                  254
                  
                  
                  
                  254
                  
                  
                  
                  254
                  
                  
                  
                  254
                  
                  
                  
                  254
                  
                  
                  
                  254
                  
                  
                  
                  254
                  
                  
                  
                  254Benefits:Manager’s
      insurance(13)
                  
                  
                  2,209
                  
                  
                  
                  2,209
                  
                  
                  
                  2,209
                  
                  
                  
                  2,209
                  
                  
                  
                  2,209
                  
                  
                  
                  2,209
                  
                  
                  
                  2,209
                  
                  
                  
                  2,209
                  
                  
                  
                  2,209Continuing
      education fund(14)
                  
                  
                  1,415
                  
                  
                  
                  1,415
                  
                  
                  
                  1,415
                  
                  
                  
                  1,415
                  
                  
                  
                  1,415
                  
                  
                  
                  1,415
                  
                  
                  
                  1,415
                  
                  
                  
                  1,415
                  
                  
                  
                  1,415Tax
      gross-up on automobile
                  
                  
                  1,167
                  
                  
                  
                  1,167
                  
                  
                  
                  –
                  
                  
                  
                  1,167
                  
                  
                  
                  1,167
                  
                  
                  
                  1,167
                  
                  
                  
                  1,167
                  
                  
                  
                  1,167
                  
                  
                  
                  –Contractual
      severance
                  
                  
                  356,432
                  
                  
                  
                  356,432
                  
                  
                  
                  –
                  
                  
                  
                  356,432
                  
                  
                  
                  356,432
                  
                  
                  
                  356,432
                  
                  
                  
                  356,432
                  
                  
                  
                  356,432
                  
                  
                  
                  –Statutory
      severance(15)
                  
                  
                  70,738
                  
                  
                  
                  70,738
                  
                  
                  
                  –
                  
                  
                  
                  70,738
                  
                  
                  
                  70,738
                  
                  
                  
                  70,738
                  
                  
                  
                  70,738
                  
                  
                  
                  70,738
                  
                  
                  
                  –Benefits
                  
                  
                  75,000
                  
                  
                  
                  75,000
                  
                  
                  
                  –
                  
                  
                  
                  75,000
                  
                  
                  
                  150,000
                  
                  
                  
                  150,000
                  
                  
                  
                  150,000
                  
                  
                  
                  150,000
                  
                  
                  
                  –TOTAL:
                  
                  $
                  603,337
                  
                  
                  $
                  603,337
                  
                  
                  $
                  82,545
                  
                  
                  $
                  603,337
                  
                  
                  $
                  603,337
                  
                  
                  $
                  603,337
                  
                  
                  $
                  603,337
                  
                  
                  $
                  603,337
                  
                  
                  $
                  82,545





(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) the insolvency or the filing (by any party,
      including us) of a petition for the winding-up of us; (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 of us; 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 $12,800 in accrued but unpaid consulting fees due
      at December 31, 2008 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 318 (approximately $86) 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, 2008, 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, 2008, 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.


39
 Table of Contents




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, 2008 (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
                  
                  $
                  6,666
                  
                  
                  $
                  6,666
                  
                  
                  $
                  6,666
                  
                  
                  $
                  6,666Vacation
                  
                  
                  11,692
                  
                  
                  
                  11,692
                  
                  
                  
                  11,692
                  
                  
                  
                  11,692Contractual
      severance
                  
                  
                  –
                  
                  
                  
                  –
                  
                  
                  
                  160,000
                  
                  
                  
                  80,000TOTAL:
                  
                  $
                  18,358
                  
                  
                  $
                  18,358
                  
                  
                  $
                  178,358
                  
                  
                  $
                  98,358




(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 of us; 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.








40
 Table of Contents




ITEM12. 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, 2009, of those persons owning of record or known by us to own
beneficially more than 5% of our common stock (of which there were none) 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)Dimensional
      Fund Advisors LP
                                    
                                    
                                    681,759
                                    (4)
                                    
                                    
                                    5.0
                                    %Robert
      S. Ehrlich
                                    
                                    
                                    606,393
                                    (5)
                                    
                                    
                                    4.4
                                    %Steven
      Esses
                                    
                                    
                                    349,284
                                    (6)
                                    
                                    
                                    2.6
                                    %Thomas
      J. Paup
                                    
                                    
                                    139,166
                                    (7)
                                    
                                    
                                    1.0
                                    %Dr.
      Jay M. Eastman
                                    
                                    
                                    10,430
                                    (8)
                                    
                                    
                                    *Edward
      J. Borey
                                    
                                    
                                    11,572
                                    (9)
                                    
                                    
                                    *Prof.
      Seymour Jones
                                    
                                    
                                    10,430
                                    (10)
                                    
                                    
                                    *Elliot
      Sloyer
                                    
                                    
                                    43,720
                                    (11)
                                    
                                    
                                    *Michael
      E. Marrus
                                    
                                    
                                    13,720
                                    (12)
                                    
                                    
                                    *All
      of our directors and executive officers as a group (8
    persons)
                                    
                                    
                                    1,184,715
                                    (13)
                                    
                                    
                                    8.7
                                    %





*
                              Less
      than one percent.(1)
                              The
      address of each named beneficial owner other than Dimensional Fund
      Advisors LP 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 13,637,639 shares of common stock outstanding as of February 28, 2009.
      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)
                              Dimensional
      Fund Advisors LP (“Dimensional”), Palisades West, Building One, 6300 Bee
      Cave Road, Austin, Texas, 78746, an investment advisor registered under
      Section 203 of the Investment Advisors Act of 1940, furnishes investment
      advice to four investment companies registered under the Investment
      Company Act of 1940, and serves as investment manager to certain other
      commingled group trusts and separate accounts. These investment companies,
      trusts and accounts are the “Funds.” In its role as investment advisor or
      manager, Dimensional possesses investment and/or voting power over our
      securities that are owned by the Funds, and may be deemed to be the
      beneficial owner of our shares held by the Funds. However, all such
      securities are owned by the Funds. Dimensional disclaims beneficial
      ownership of such securities. All information in this footnote and in the
      text to which this footnote relates is based on a Schedule 13G filed with
      the Securities and Exchange Commission on February 6, 2008, as amended on
      February 9, 2009.(5)
                              Consists
      of 382,667 shares held directly by Mr. Ehrlich, 186,666 shares of unvested
      restricted stock (the vesting of 80,000 of which is subject to future
      performance criteria), 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,
2009.(6)
                              Consists
      of 136,785 shares held directly by Mr. Esses, 210,000 shares of unvested
      restricted stock (the vesting of 90,000 of which is subject to future
      performance criteria), and 2,499 shares issuable upon exercise of options
      exercisable within 60 days of February 28, 2009.(7)
                              Consists
      of 63,959 shares held directly by Mr. Paup and 75,207 shares of unvested
      restricted stock (the vesting of 42,916 of which is subject to future
      performance criteria).(8)
                              Consists
      of 1,645 shares owned directly by Dr. Eastman and 8,785 shares of unvested
      restricted stock.(9)
                              Consists
      of 2,787 shares owned directly by Mr. Borey and 8,785 shares of unvested
      restricted stock.(10)
                              Consists
      of 1,645 shares owned directly by Prof. Jones and 8,785 shares of unvested
      restricted stock.(11)
                              Consists
      of 32,742 shares owned directly by Mr. Sloyer and 10,978 shares of
      unvested restricted stock.(12)
                              Consists
      of 2,742 shares owned directly by Mr. Marrus and 10,978 shares of unvested
      restricted stock.(13)
                              Includes
      24,461 shares issuable upon exercise of options exercisable within 60 days
      of February 28, 2009 and 520,184 shares of unvested restricted stock (the
      vesting of 212,916 of which is subject to future performance
      criteria).




41
 Table of Contents




Securities
Authorized for Issuance Under Equity Compensation Plans




The
following table sets forth certain information, as of December 31, 2008, with
respect to our 1998, 2004 and 2007 stock option plans, as well as any other
stock options and warrants previously issued by us (including individual
compensation arrangements) as compensation for goods and services:




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)
                
                
                951,564
                
                
                $
                6.28
                
                None





(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.(2)
              All
      of the plans are currently over-subscribed and will be revised based on a
      new equity compensation plan that is in development that will be voted on
      at our next annual meeting of
stockholders.




ITEM13. 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, 2008, the aggregate
amount outstanding pursuant to this promissory note was $201,570.




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
$789,991, bearing annual interest (i) as to $329,163, at 1% over the
then-current federal funds rate announced from time to time by the Wall Street Journal, and (ii)
as to $460,828, at 4% over the then-current percentage increase in the Israeli
consumer price index between the date of the loan and the date of the annual
interest calculation, 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, 2008, the aggregate amount outstanding pursuant
to this promissory note was $818,357.




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, 2008, 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, 2008, and is extended automatically for additional terms
of two years each unless either Sampen or we terminate the agreement
sooner.




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.


42
 Table of Contents




ITEM14. 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.




Ø
            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, 2008 and 2007 totaled
      approximately $514,000 and $428,000,
  respectively.




Ø
            Audit-Related
      Fees.  BDO billed us $23,000 and $16,000 for the fiscal
      years ended December 31, 2008 and 2007, respectively, for assurance and
      related services that are reasonably related to the performance of the
      audit or review of our financial
statements.




Ø
            Tax
      Fees.  BDO
      billed or expected to bill us an aggregate of $25,000 for each of the
      fiscal years ended December 31, 2008 and 2007, for tax services,
      principally advice regarding the preparation of income tax
      returns.




Ø
            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.






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 31 above and
      the financial pages following page 48 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(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**
                10.9.1
                
                Amendment letter dated April 9, 2009 between us, EFL and
      Robert S. Ehrlich†
      (15)
                10.10
                
                Amended
      and Restated Employment Agreement, dated April 14, 2008 and effective as
      of January 1, 2008, between EFL and Steven Esses**
                10.10.1
                
                Amendment letter dated April 9, 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**
                10.12.1
                
                Amendment letter dated April 9, 2009 between us 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 minority 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




43
 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






44
 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, on April10, 2009.




AROTECH
CORPORATION





By: /s/  Robert S.
Ehrlich


Name: Robert
S. Ehrlich


Title: Chairman
and Chief Executive Officer





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
                                                  Robert
      S. Ehrlich
                                                Chairman
      Chief Executive Officer and Director
                                                  (Principal
      Executive Officer)
                                                April 9, 2009/s/  Thomas J.
      Paup
                                                  Thomas
      J. Paup
                                                Vice
      President – Finance
                                                  (Principal
      Financial Officer)
                                                April 9, 2009/s/  Norman
      Johnson
                                                  Norman
      Johnson
                                                Controller
                                                  (Principal
      Accounting Officer)
                                                April 9, 2009/s/  Steven
      Esses
                                                  Steven
      Esses
                                                President,
      Chief Operating Officer
                                                  and
      Director
                                                April 9, 2009/s/  Jay M.
      Eastman
                                                  Dr.
      Jay M. Eastman
                                                Director
                                                April 9, 2009_____________________
                                                  Edward J. Borey
                                                Director
                                                April
      __, 2009/s/  Seymour
      Jones
                                                  Seymour
      Jones
                                                Director
                                                April 9, 2009/s/  Elliot
      Sloyer
                                                  Elliot
      Sloyer
                                                Director
                                                April 9, 2009/s/  Michael E.
      Marrus
                                                  Michael
      E. Marrus
                                                Director
                                                April 9,
2009








45
 Table of Contents




Reportof Independent Registered Public Accounting
Firm
  
  To the
Board of Directors and Shareholders of Arotech Corporation:
  We have
audited the accompanying consolidated balance sheets of Arotech Corporation and
subsidiaries as of December 31, 2008 and 2007 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
schedule.  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, 2008 and 2007, and the results of its operations
and its cash flows for the years then ended, in conformity with
accounting principles generally accepted in the United States of
America.
 
 As
discussed in Note 19 to the financial statements, the 2007 financial statements
have been restated to correct a misstatement related to a deferred tax
liability.
  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 Seidman, LLP
 Grand
Rapids, Michigan
 April 7,
2009
   Table of Contents
 AROTECHCORPORATION AND ITS SUBSIDIARIES
 CONSOLIDATED
BALANCE SHEETS
 In
U.S. dollars
 
  December
      31,2008
                        
                        
                        2007(as
      restated;see
      Note 19)ASSETSCURRENT
      ASSETS:Cash
      and cash equivalents
                        
                        $
                        4,301,359
                        
                        
                        $
                        3,447,671Restricted
      collateral deposits
                        
                        
                        381,586
                        
                        
                        
                        320,454Escrow
      receivable
                        
                        
                        –
                        
                        
                        
                        1,479,826Available
      for sale marketable securities
                        
                        
                        49,204
                        
                        
                        
                        47,005Trade
      receivables (net of allowance for doubtful accounts in the amounts of
      $19,000 and $25,000 as of December 31, 2008 and 2007,
      respectively)
                        
                        
                        19,346,084
                        
                        
                        
                        14,583,213Unbilled
      receivables
                        
                        
                        4,769,264
                        
                        
                        
                        3,271,594Other
      accounts receivable and prepaid expenses
                        
                        
                        3,625,955
                        
                        
                        
                        1,614,614Inventories
                        
                        
                        9,678,960
                        
                        
                        
                        7,887,820Total
      current assets
                        
                        
                        42,152,412
                        
                        
                        
                        32,652,197DEFERRED
      TAX ASSET
                        
                        
                        72,114
                        
                        
                        
                        77,709SEVERANCE
      PAY FUND
                        
                        
                        2,888,867
                        
                        
                        
                        2,815,040OTHER
      LONG-TERM RECEIVABLES
                        
                        
                        463,780
                        
                        
                        
                        309,190PROPERTY
      AND EQUIPMENT, NET
                        
                        
                        5,058,263
                        
                        
                        
                        5,079,796INVESTMENT
      IN AFFILIATED COMPANY
                        
                        
                        40,987
                        
                        
                        
                        352,168OTHER
      INTANGIBLE ASSETS, NET
                        
                        
                        6,867,873
                        
                        
                        
                        7,837,076GOODWILL
                        
                        
                        32,250,503
                        
                        
                        
                        31,358,131Total
      long term assets
                        
                        
                        47,642,387
                        
                        
                        
                        47,829,110Total
      Assets
                        
                        $
                        89,794,799
                        
                        
                        $
                        80,481,307
  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
      31,2008
                        
                        
                        2007(as
      restated;see
      Note 19)LIABILITIES
      AND STOCKHOLDERS’ EQUITYCURRENT
      LIABILITIES:Trade
      payables
                        
                        $
                        9,664,558
                        
                        
                        $
                        4,233,288Other
      accounts payable and accrued expenses
                        
                        
                        5,858,959
                        
                        
                        
                        4,889,729Current
      portion of capitalized leases
                        
                        
                        62,833
                        
                        
                        
                        67,543Current
      portion of promissory notes due to purchase of
subsidiaries
                        
                        
                        –
                        
                        
                        
                        151,450Current
      portion of long term debt
                        
                        
                        1,861,187
                        
                        
                        
                        103,844Short
      term bank credit
                        
                        
                        3,607,890
                        
                        
                        
                        4,557,890Deferred
      revenues
                        
                        
                        3,789,020
                        
                        
                        
                        2,903,166Total
      current liabilities
                        
                        
                        24,844,447
                        
                        
                        
                        16,906,910LONG
      TERM LIABILITIESAccrued
      severance pay
                        
                        
                        5,161,448
                        
                        
                        
                        4,853,231Long
      term portion of capitalized leases
                        
                        
                        122,090
                        
                        
                        
                        86,989Long
      term debt
                        
                        
                        3,866,727
                        
                        
                        
                        1,088,498Deferred
      tax liability
                        
                        
                        2,430,000
                        
                        
                        
                        1,865,000Other
      long term liabilities
                        
                        
                        146,738
                        
                        
                        
                        110,255Total
      long-term liabilities
                        
                        
                        11,727,003
                        
                        
                        
                        8,003,973COMMITMENTS
      AND CONTINGENT LIABILITIES (Note 11)MINORITY
      INTEREST
                        
                        
                        –
                        
                        
                        
                        83,816STOCKHOLDERS’
      EQUITY:Share
      capital –Common
      stock – $0.01 par value each;Authorized:
      250,000,000 shares as of December 31, 2008 and 2007; Issued and
      Outstanding: 13,637,639 shares and 13,544,819 shares as of December 31,
      2008 and 2007, respectively;
                        
                        
                        136,377
                        
                        
                        
                        135,448Preferred
      shares – $0.01 par value each;Authorized:
      1,000,000 shares as of December 31, 2008 and 2007; No shares issued and
      outstanding as of December 31, 2008 and 2007
                        
                        
                        –
                        
                        
                        
                        –Additional
      paid-in capital
                        
                        
                        220,124,075
                        
                        
                        
                        218,551,110Accumulated
      deficit
                        
                        
                        (167,205,514
                        )
                        
                        
                        (163,367,558
                        )Notes
      receivable from shareholders
                        
                        
                        (1,357,788
                        )
                        
                        
                        (1,333,833
                        )Accumulated
      other comprehensive income
                        
                        
                        1,526,199
                        
                        
                        
                        1,501,441Total
      stockholders’ equity
                        
                        
                        53,223,349
                        
                        
                        
                        55,486,608$
                        89,794,799
                        
                        
                        $
                        80,481,307
  The
accompanying notes are an integral part of the consolidated financial
statements.
  F-3
 Table of Contents
  AROTECHCORPORATION AND ITS SUBSIDIARIES
 CONSOLIDATED
STATEMENTS OF OPERATIONS
 In
U.S. dollars
 
  2008
                        
                        
                        2007(as
      restated;see
      Note 19)Revenues
                        
                        $
                        68,948,969
                        
                        
                        $
                        57,719,561Cost
      of revenues, exclusive of amortization of intangibles
                        
                        
                        50,177,909
                        
                        
                        
                        39,639,812Research
      and development
                        
                        
                        1,657,668
                        
                        
                        
                        1,877,163Selling
      and marketing expenses
                        
                        
                        4,699,870
                        
                        
                        
                        4,164,464General
      and administrative expenses
                        
                        
                        14,093,764
                        
                        
                        
                        13,158,297Amortization
      of intangible assets
                        
                        
                        1,735,548
                        
                        
                        
                        1,381,882Escrow
      adjustment
                        
                        
                        (1,448,074
                        )
                        
                        
                        –Total
      operating costs and expenses
                        
                        
                        70,916,685
                        
                        
                        
                        60,221,618Operating
      loss
                        
                        
                        (1,967,716
                        )
                        
                        
                        (2,502,057
                        )Other
      income
                        
                        
                        422,883
                        
                        
                        
                        617,952Financial
      expenses, net
                        
                        
                        (814,089
                        )
                        
                        
                        (905,888
                        )Loss
      before minority interest in earnings of a subsidiaries, earnings from
      affiliated company, and income tax expenses
                        
                        
                        (2,358,922
                        )
                        
                        
                        (2,789,993
                        )Income
      taxes
                        
                        
                        (1,026,868
                        )
                        
                        
                        (608,916
                        )Losses
      from affiliated companies
                        
                        
                        (452,166
                        )
                        
                        
                        (40,230
                        )Minority
      interest in earnings of subsidiaries
                        
                        
                        –
                        
                        
                        
                        (62,296
                        )Net
      loss
                        
                        $
                        (3,837,956
                        )
                        
                        $
                        (3,501,435
                        )Basic
      and diluted net loss per share
                        
                        $
                        (0.30
                        )
                        
                        $
                        (0.31
                        )Weighted
      average number of shares used in computing basic and diluted net loss per
      share
                        
                        
                        12,605,786
                        
                        
                        
                        11,274,387
 The
accompanying notes are an integral part of the consolidated financial
statements.
  F-4
 Table of Contents
  AROTECHCORPORATION AND ITS SUBSIDIARIES
 STATEMENTS OF CHANGES IN
STOCKHOLDERS’ EQUITY(as restated; see Note 19)
 In
U.S. dollars
 
 
 Common
      stockShares
                                            
                                            Amount
                                            
                                            Additional
                                              paid-in
                                              capital
                                            
                                            Accumulated
                                              deficit
                                            
                                            Treasury
                                              stock
                                            
                                            Notes
                                              receivable
                                              from
                                              stockholders
                                            
                                            Accumulated
                                              other
                                              comprehensive
                                              income
      (loss)
                                            
                                            Total
                                              comprehensive
                                              income
      (loss)
                                            
                                            Total
                                              stockholders’
                                              equityBalance
      as of January 1, 2007 as previously reported
                                            
                                            12,023,242
                                            
                                            $
                                            120,232
                                            
                                            $
                                            217,735,860
                                            
                                            $
                                            (159,466,123
                                            )
                                            $
                                            (3,537,106
                                            )
                                            $
                                            (1,304,179
                                            )
                                            $
                                            511,154
                                            
                                            $
                                            –
                                            
                                            $
                                            54,059,838Prior
      period adjustment
                                            
                                            –
                                            
                                            
                                            –
                                            
                                            
                                            –
                                            
                                            
                                            (400,000
                                            )
                                            
                                            –
                                            
                                            
                                            –
                                            
                                            
                                            –
                                            
                                            
                                            –
                                            
                                            
                                            (400,000
                                            )Balance
      as of January 1, 2007, as adjusted
                                            
                                            12,023,242
                                            
                                            $
                                            120,232
                                            
                                            $
                                            217,735,860
                                            
                                            $
                                            (159,866,123
                                            )
                                            $
                                            (3,537,106
                                            )
                                            $
                                            (1,304,179
                                            )
                                            $
                                            511,154
                                            
                                            $
                                            –
                                            
                                            $
                                            53,659,838Principal
      installment of convertible debenture payment in shares
                                            
                                            930,125
                                            
                                            
                                            9,301
                                            
                                            
                                            2,873,454
                                            
                                            
                                            –
                                            
                                            
                                            –
                                            
                                            
                                            –
                                            
                                            
                                            –
                                            
                                            
                                            –
                                            
                                            
                                            2,882,755Treasury
      shares cancellation
                                            
                                            (39,666
                                            )
                                            
                                            (396
                                            )
                                            
                                            (3,536,710
                                            )
                                            
                                            –
                                            
                                            
                                            3,537,106
                                            
                                            
                                            –
                                            
                                            
                                            –
                                            
                                            
                                            –
                                            
                                            
                                            –Stock
      based compensation
                                            
                                            –
                                            
                                            
                                            –
                                            
                                            
                                            1,417,521
                                            
                                            
                                            –
                                            
                                            
                                            –
                                            
                                            
                                            –
                                            
                                            
                                            –
                                            
                                            
                                            –
                                            
                                            
                                            1,417,521Stock
      options and restricted stock
                                            
                                            631,118
                                            
                                            
                                            6,311
                                            
                                            
                                            31,331
                                            
                                            
                                            –
                                            
                                            
                                            –
                                            
                                            
                                            –
                                            
                                            
                                            –
                                            
                                            
                                            –
                                            
                                            
                                            37,642Interest
      accrued on notes receivable from shareholders
                                            
                                            –
                                            
                                            
                                            –
                                            
                                            
                                            29,654
                                            
                                            
                                            –
                                            
                                            
                                            
                                            
                                            
                                            (29,654
                                            )
                                            
                                            –
                                            
                                            
                                            –
                                            
                                            
                                            –Other
      comprehensive loss – foreign currency translation
    adjustment
                                            
                                            –
                                            
                                            
                                            –
                                            
                                            
                                            –
                                            
                                            
                                            –
                                            
                                            
                                            –
                                            
                                            
                                            –
                                            
                                            
                                            988,740
                                            
                                            
                                            988,740
                                            
                                            
                                            988,740Other
      comprehensive loss – unrealized gain on available for sale marketable
      securities
                                            
                                            –
                                            
                                            
                                            –
                                            
                                            
                                            –
                                            
                                            
                                            –
                                            
                                            
                                            –
                                            
                                            
                                            –
                                            
                                            
                                            1,547
                                            
                                            
                                            1,547
                                            
                                            
                                            1,547Net
      loss as restated
                                            
                                            –
                                            
                                            
                                            –
                                            
                                            
                                            –
                                            
                                            
                                            (3,501,435
                                            )
                                            
                                            –
                                            
                                            
                                            –
                                            
                                            
                                            –
                                            
                                            
                                            (3,501,435
                                            )
                                            
                                            (3,501,435
                                            )Total
      comprehensive loss as restated
                                            
                                            –
                                            
                                            
                                            –
                                            
                                            
                                            –
                                            
                                            
                                            –
                                            
                                            
                                            –
                                            
                                            
                                            –
                                            
                                            
                                            –
                                            
                                            $
                                            (2,511,148
                                            )
                                            
                                            –Balance
      as of December 31, 2007 as restated
                                            
                                            13,544,819
                                            
                                            $
                                            135,448
                                            
                                            $
                                            218,551,110
                                            
                                            $
                                            (163,367,558
                                            )
                                            $
                                            –
                                            
                                            $
                                            (1,333,833
                                            )
                                            $
                                            1,501,441
                                            
                                            
                                            
                                            
                                            $
                                            55,486,608
 
 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 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
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    1,039,270Stock
      options and restricted stock
                                    
                                    
                                    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 loss – foreign currency translation
    adjustment
                                    
                                    
                                    –
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    –
                                    
                                    
                                    
                                    23,103
                                    
                                    
                                    
                                    23,103
                                    
                                    
                                    
                                    23,103Other
      comprehensive loss – 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-6
 Table of Contents
 AROTECHCORPORATION AND ITS SUBSIDIARIES
 CONSOLIDATED
STATEMENTS OF CASH FLOWS
 In
U.S. dollars
 
 
 2008
                          
                          
                          2007Cash
      flows from operating activities:
                          
                          
                          
                          
                          (as
      restated;see
      Note 19)Net
      loss
                          
                          $
                          (3,837,956
                          )
                          
                          $
                          (3,501,435
                          )Adjustments
      required to reconcile net loss to net cash used in operating
      activities:Minority
      interest in loss of subsidiary
                          
                          
                          –
                          
                          
                          
                          62,296Loss
      from affiliated companies
                          
                          
                          452,168
                          
                          
                          
                          40,230Depreciation
                          
                          
                          1,246,238
                          
                          
                          
                          1,376,749Amortization
      of intangible assets and capitalized software costs
                          
                          
                          1,735,548
                          
                          
                          
                          1,381,822Escrow
      adjustment
                          
                          
                          (1,845,977
                          )
                          
                          
                          –Accrued
      severance pay, net
                          
                          
                          234,390
                          
                          
                          
                          245,599Compensation
      related to shares issued to employees, consultants and
      directors
                          
                          
                          1,039,270
                          
                          
                          
                          1,417,521Financial
      expenses in connection with convertible debenture principle
      repayment
                          
                          
                          –
                          
                          
                          
                          280,382Amortization
      related to warrants issued to the holders of convertible debentures and
      beneficial conversion feature
                          
                          
                          –
                          
                          
                          
                          18,745Amortization
      of deferred charges related to convertible debentures
    issuance
                          
                          
                          –
                          
                          
                          
                          44,253Amortization
      of debt discount
                          
                          
                          51,537
                          
                          
                          
                          –Capital
      gain (loss) from sale of property and equipment
                          
                          
                          (11,379
                          )
                          
                          
                          56,224Increase
      in trade receivables
                          
                          
                          (4,570,057
                          )
                          
                          
                          (6,802,248
                          )Decrease
      (increase) in other accounts receivable and prepaid
    expenses
                          
                          
                          234,402
                          
                          
                          
                          (706,569
                          )Decrease
      in deferred taxes
                          
                          
                          570,595
                          
                          
                          
                          545,323Increase
      in inventories
                          
                          
                          (1,760,946
                          )
                          
                          
                          (36,000
                          )Decrease
      (increase) in unbilled receivables
                          
                          
                          (1,432,369
                          )
                          
                          
                          3,630,939Increase
      in deferred revenues
                          
                          
                          885,854
                          
                          
                          
                          1,581,854Increase
      in trade payables
                          
                          
                          5,420,310
                          
                          
                          
                          1,425,156Increase
      (decrease) in other accounts payable and accrued expenses
                          
                          
                          911,112
                          
                          
                          
                          (137,834
                          )Net
      cash provided by (used in) operating activities
                          
                          $
                          (677,260
                          )
                          
                          $
                          923,007Cash
      flows from investing activities:Purchase
      of property and equipment
                          
                          
                          (1,191,822
                          )
                          
                          
                          (1,594,426
                          )Purchase
      of convertible notes
                          
                          
                          (2,500,000
                          )
                          
                          
                          –Increase
      in capitalized software costs
                          
                          
                          –
                          
                          
                          
                          (15,750
                          )Proceeds
      from escrow settlement
                          
                          
                          3,325,803
                          
                          
                          
                          –Acquisition
      of subsidiary, net of cash acquired
                          
                          
                          (1,037,884
                          )
                          
                          
                          –Acquisition
      of minority interest
                          
                          
                          (660,500
                          )
                          
                          
                          –Investment
      in affiliated company
                          
                          
                          (140,987
                          )
                          
                          
                          –Repayment
      of promissory notes related to acquisition of subsidiaries
                          
                          
                          (151,450
                          )
                          
                          
                          (302,900
                          )Proceeds
      from sale of property and equipment
                          
                          
                          87,521
                          
                          
                          
                          36,061Decrease
      (increase) in restricted cash
                          
                          
                          (63,331
                          )
                          
                          
                          322,682Net
      cash used in investing activities
                          
                          $
                          (2,332,650
                          )
                          
                          $
                          (1,554,333
                          )
 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
 
  2008
                    
                    
                    2007(as
      restated;see
      Note 19)Forward
                    
                    $
                    (3,009,910
                    )
                    
                    $
                    (631,326
                    )Cash
      flows from financing activities:Proceeds
      from exercise of options
                    
                    
                    –
                    
                    
                    
                    37,642Repayment
      of long term loans
                    
                    
                    (166,165
                    )
                    
                    
                    549,874Increase
      (decrease) in short term bank credit
                    
                    
                    (950,000
                    )
                    
                    
                    1,061,883Increase
      in long term debt
                    
                    
                    5,000,000
                    
                    
                    
                    –Net
      cash provided by financing activities
                    
                    $
                    3,883,835
                    
                    
                    $
                    1,649,399Increase
      in cash and cash equivalents
                    
                    
                    873,925
                    
                    
                    
                    1,018,073Cash
      accretion (erosion) due to exchange rate differences
                    
                    
                    (20,237
                    )
                    
                    
                    60,726Cash
      and cash equivalents at the beginning of the year
                    
                    
                    3,447,671
                    
                    
                    
                    2,368,872Cash
      and cash equivalents at the end of the year
                    
                    $
                    4,301,359
                    
                    
                    $
                    3,447,671Supplementary
      information on non-cash and other transactions:Stock
      issued for acquisition
                    
                    $
                    100,000
                    
                    
                    $
                    –Assets
      recorded for capital lease addition
                    
                    $
                    106,029
                    
                    
                    $
                    –Mortgage
      note payable (seller financed) issued for purchase of
    building
                    
                    $
                    –
                    
                    
                    $
                    1,115,000Interest
      paid during the period
                    
                    $
                    455,051
                    
                    
                    $
                    662,789Taxes
      on income paid during the period
                    
                    $
                    333,144
                    
                    
                    $
                    298,109Relative
      fair value of warrants issued in connections with convertible
      note
                    
                    $
                    412,300
                    
                    
                    $
                    –Payment
      of principal installment of convertible debentures in
    shares
                    
                    $
                    –
                    
                    
                    $
                    2,882,753
  The
accompanying notes are an integral part of the consolidated financial
statements.
  F-8
 Table of Contents
 AROTECHCORPORATION AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 
 In
U.S. dollars
 NOTE
1:–  GENERAL
  a.                 Corporate
structure:
  Arotech
Corporation (“Arotech” or the “Company”) and its wholly-owned subsidiaries
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 Corporation (“FAAC”), based in Ann Arbor, Michigan, and FAAC’s subsidiary
Realtime Technologies, Inc. (“Realtime”), which is  based in Royal
Oak, Michigan; Electric Fuel Battery Corporation (“EFB”), based in Auburn,
Alabama; Electric Fuel Ltd. (“EFL”), based in Beit Shemesh, Israel; Epsilor
Electronic Industries, Ltd. (“Epsilor”), based in Dimona, Israel; MDT Protective
Industries, Ltd. (“MDT”), based in Lod, Israel; and MDT Armor Corporation (“MDT
Armor”), based in Auburn, Alabama.
  Revenues
derived from the Company’s largest customers in 2008 and 2007 are described in
Note 16.d.
  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 is 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 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, granting the
Seller’s counterclaim for $70,000 in compensation, awarding the Company the
entire $3.0 million, along with $135,000 in attorneys’ fees and interest of
approximately $325,000. The net impact of the settlement was 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.
  d.                 Purchase
of the Minority 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 the 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 purchase price included a payment of
$241,237 to the former president of MDT as compensation for a right granted to
him by MDT Armor that potentially would have given him the right to receive 5%
of MDT Armor’s annual profit. The payment for this right was recorded as general
and administrative expense in the first quarter of 2008.
   F-9
 Table of Contents
  AROTECH
CORPORATION AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 
 In
U.S. dollars
 NOTE
1:–  GENERAL (Cont.)
  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 $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:
  SFAS No.
142 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 the Company’s reportable units with their carrying value. The
Company’s reporting units are the training and simulation segment, the Armor
segment and Epsilor, a component within the Battery and Power
segment.  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
2008 and 2007, the Company evaluated all goodwill at mid-year and determined
that there was no impairment.
  The
Company completed its annual goodwill impairment review at the end of the
quarter ended June 30, 2008. 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 as of June 30,
2008, the Company’s stock was undervalued, especially when compared to the
estimated future cash flows of the underlying entities.
   F-10
 Table of Contents
  AROTECH
CORPORATION AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 
 In
U.S. dollars
 NOTE
1:–  GENERAL (Cont.)
 Due to
the extreme volatility in the stock market, changing current market conditions
and the effect on the Company’s common stock price during the year ended
December 31, 2008, the Company decided to update the goodwill impairment studies
originally conducted as of June 30, 2008. Consistent with the June 30, 2008
analysis, the Company used the discounted future cash flow method to determine
the value of the Company and its subsidiaries. The Company believes that its
stock price has historically traded at a much higher value and that the current
stock price and resultant market capitalization amount are a short term
condition. The Company concluded that the collective value of its individual
business units on a longer term horizon exceeds the value of the short term
market assessments of the Company’s common stock.
  The
results of the updated assessments confirmed the previously conducted studies as
of June 30, 2008 that there is no impairment of goodwill as of December 31,
2008.
  The
Company and its subsidiaries’ long-lived assets and certain identifiable
intangibles are reviewed for impairment in accordance with Statement of
Financial Accounting Standard No. 144, “Accounting for the Impairment or
Disposal of Long-Lived Assets” (“SFAS No. 144”), 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 a consulting agreement with Sampen Corporation that it executed in
March 2005, effective as of January 1, 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 attains 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.
  During
the years ended December 31, 2008 and 2007 the Company paid Sampen a total of
$178,424 and $219,354, 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 this promissory
note was $201,570.
  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 $789,991, bearing annual interest (i) as to $329,163, at 1%
over the then-current federal funds rate announced from time to time by the
Wall Street Journal,
and (ii) as to $460,828, at 4% over the then-current percentage increase in the
Israeli consumer price index between the date of the loan and the date of the
annual interest calculation, 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, 2008, the aggregate amount
outstanding pursuant to this promissory note was $818,357.
  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, 2008, the aggregate amount outstanding pursuant to
this promissory note was $46,593.
   F-11
 Table of Contents
  AROTECH
CORPORATION AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 
 In
U.S. dollars
 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.
  b.                 Financial
statements in U.S. dollars:
  A
majority of the revenues of the Company and most of its subsidiaries and its
subsidiaries’ affiliates is generated in U.S. dollars. In addition, a
substantial portion of the Company’s and most of its subsidiaries 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 and most of
its subsidiaries operate. Thus, the functional and reporting currency of the
Company and 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 in accordance with Statement of Financial Accounting Standards No.
52 “Foreign Currency Translation” (“SFAS No. 52”). All transaction, gains and
losses from the remeasured monetary balance sheet items are 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 has 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 and majority 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
collateral deposits
  Restricted
cash is primarily invested in highly liquid deposits which are used as a
security for the Company’s guarantee performance, its liability to a former
shareholder of its acquired subsidiary and for the company’s liability for
interest payments related to its convertible debentures.
  f.                 Marketable
securities
  The
Company and its subsidiaries account for investments in debt and equity
securities in accordance with Statement of Financial Accounting Standard No.
115, “Accounting for Certain Investments in Debt and Equity Securities” (“SFAS
No. 115”). Management 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.
  At
December 31, 2008 the Company and its subsidiaries classified its investment in
marketable securities as available-for-sale.
  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-12
 Table of Contents
  AROTECH
CORPORATION AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 
 In
U.S. dollars
 NOTE
2:–  SIGNIFICANT ACCOUNTING POLICIES (Cont.)
 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
2008 and 2007, the Company wrote off $154,463 and $150,681, of obsolete
inventory respectively, 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 (no investment grants were received during 2008 and
2007).
  Depreciation
is calculated by the straight-line method over the estimated useful lives of the
assets:
  Depreciable
      life (in years)Computers
      and related equipment
                    3
      to 5Motor
      vehicles
                    5
      to 7Demo
      inventory
                    5Office
      furniture and equipment
                    10Machinery
      and equipment
                    10Buildings
                    30Leasehold
      improvements
                    By
      the shorter of the term of the lease or the life of the
    asset
 
 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
2008 and 2007, the Company and its subsidiaries 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).
  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.)
  Revenues
from the Battery and Power Systems Division products and Armor Division are
recognized in accordance with SEC Staff Accounting Bulletin No. 104, “Revenue
Recognition” 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
in accordance with Statement Of Position 81-1, “Accounting for Performance of
Construction-Type and Certain Production-Type Contracts,” 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, 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. 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, which do not require significant customization, are recognized
in accordance with Statement of Position 97-2, “Software Revenue
Recognition,” (“SOP 97-2”). SOP 97-2 generally requires revenue earned on
software arrangements involving multiple elements to be allocated to each
element based on the relative fair value of the elements. The Company has
adopted Statement of Position 98-9, “Modification of SOP 97-2, Software Revenue
Recognition with Respect to Certain Transactions” (“SOP 98-9”). According to SOP
No. 98-9, revenues are allocated to the different elements in the arrangement
under the “residual method” when Vendor Specific Objective Evidence (“VSOE”) of
fair value exists for all undelivered elements and no VSOE exists for the
delivered elements. Under the residual method, at the outset of the arrangement
with the customer, the Company defers revenue for the fair value of its
undelivered elements (maintenance and support) and recognizes revenue for the
remainder of the arrangement fee attributable to the elements initially
delivered in the arrangement (software product) when all other criteria in SOP
97-2 have been met.
  Revenue
from such simulators is 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 VSOE
of fair value of the maintenance, training and support services is determined
based on the price charged when sold separately or when renewed.
  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 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. The Company estimates the costs that may be incurred under its basic
limited warranty and records deferred revenue in the amount of such costs as 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.
  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.)
  l.                 Research
and development cost:
  SFAS No.
86, “Accounting for the Costs of Computer Software to be Sold, Leased or
Otherwise Marketed,” requires capitalization of 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,
when applicable. 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
the: (i) 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, 2008.
  m.                 Income
taxes:
  The
Company and its subsidiaries account for income taxes in accordance with
Statement of Financial Accounting Standards No. 109, “Accounting for Income
Taxes” (“SFAS No. 109”). This Statement prescribes the use of the liability
method, whereby deferred tax assets and liability account balances are
determined based on differences between financial reporting and tax bases 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
and its subsidiaries provide a valuation allowance, if necessary, to reduce
deferred tax assets to its estimated realizable value.
  n.                 Concentrations
of credit risk:
  Financial
instruments that potentially subject the Company and its subsidiaries to
concentrations of credit risk consist principally of cash and cash equivalents,
restricted collateral deposits, 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 and its subsidiaries are mainly derived from sales to
customers located primarily in the United States, Europe and Israel. 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 include investments in
debentures of U.S.and Israeli corporations
and state and local governments. Management believes that those corporations and
states are institutions that are financially sound, that the portfolio is well
diversified, and accordingly, that minimal credit risk exists with respect to
these marketable securities.
  The
Company and its subsidiaries 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 potential shares of common stock
considered outstanding during the year, in accordance with Statement of
Financial Standards No. 128, “Earnings Per Share.”
  All
outstanding stock options, non vested restricted stock and warrants 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 options and
warrants excluded from the calculations of diluted net loss per share was
1,697,266 and 1,791,562, for the years ended December 31, 2008 and 2007,
respectively.
  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.)
  p.                 Accounting
for stock-based compensation
  Effective
January 1, 2006, the Company started to account for stock options and awards
issued to employees in accordance with the fair value recognition provisions of
Financial Accounting Standards Board (“FASB”) Statement No. 123(R) (“SFAS No.
123(R)”), “Share-Based Payment,” using the modified prospective transition
method. Under SFAS No. 123(R), stock-based awards to employees are required to
be 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, which affect the calculated
values.
  The
Company did not grant any options in 2007 or 2008.  The Company
assumed a 20% forfeiture rate for 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 and its subsidiaries
in estimating their fair value disclosures for financial
instruments:
  The
carrying amounts of cash and cash equivalents, restricted collateral deposits,
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 is based on the quoted market
price.
  Long-terms
promissory notes are estimated by discounting the future cash flows using
current interest rates for loans or 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 an accrual. The value of these policies is
recorded as an asset in the Company’s balance sheet.
  In
addition and 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 for this special severance pay in accordance with EITF 88-1:
“Determination of Vested Benefit Obligation for a Defined Benefit Pension Plan”
As of December 31, 2008 and 2007, the accumulated severance pay in that regard
amounted to $2,160,428 and $2,081,586, respectively.
  Pursuant
to the terms of the employment agreement between the Company and its Chief
Executive Officer, funds to secure payment of the Chief Executive Officer’s
contractual severance are to be deposited for the benefit of the Chief Executive
Officer, with payments to be made pursuant to an agreed-upon schedule. As of
December 31, 2008, a total of $587,905 had been deposited. 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.
  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 surrendered value of these policies and
includes immaterial profits.
  Severance
expenses for the years ended December 31, 2008 and 2007 amounted to $202,627 and
$334,749, respectively.
  s.                 Advertising
costs:
  The
Company and its subsidiaries expense advertising costs as incurred. Advertising
expense for the years ended December 31, 2008 and 2007 was approximately
$100,347 and $92,775, respectively.
  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.)
  t.                 New
accounting pronouncements:
  In
December 2007, the Financial Accounting Standards Board (FASB) issued Statement
of Financial Accounting Standards (SFAS) No. 141(R), Business Combinations, to
further enhance the accounting and financial reporting related to business
combinations. SFAS No. 141(R) establishes principles and requirements for how
the acquirer in a business combination (1) recognizes and measures in its
financial statements the identifiable assets acquired, the liabilities assumed,
and any noncontrolling interest in the acquiree, (2) recognizes and measures the
goodwill acquired in the business combination or a gain from a bargain purchase,
and (3) determines what information to disclose to enable users of the financial
statements to evaluate the nature and financial effects of the business
combination. SFAS No. 141(R) applies prospectively to business combinations for
which the acquisition date is on or after the beginning of the first annual
reporting period beginning on or after December 15, 2008. Therefore, the effects
of the Company’s adoption of SFAS No. 141(R) will depend upon the extent and
magnitude of acquisitions after December 31, 2008.
  In
September 2006, the FASB issued SFAS No. 157, Fair Value Measurements. This
Statement defines fair value, establishes a framework for measuring fair value
and expands disclosures about fair value measurements. SFAS No. 157 applies to
other accounting pronouncements that require or permit fair value measurements,
the Board having previously concluded in those accounting pronouncements that
fair value is the relevant measurement attribute. The Statement does not require
any new fair value measurements and was initially effective for the Company
beginning January 1, 2008. In February 2008, the FASB issued FASB Staff Position
(FSP) FAS 157-2. FSP FAS 157-2 defers the effective date of SFAS No. 157 until
January 1, 2009 for nonfinancial assets and nonfinancial liabilities except
those items recognized or disclosed at fair value on an annual or more
frequently recurring basis. On January 1, 2008, the Company adopted the
provisions of SFAS No. 157 for its financial assets and liabilities. The
adoption of the standard did not have a material impact on the Company’s
financial statements. The Company elected to defer the adoption of SFAS No.
157 for its non-financial assets and liabilities until January 1, 2009. The
Company is currently evaluating the impact that the deferred provisions of this
standard will have on its financial statements.
  In
February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial
Assets and Financial Liabilities. This Statement permits entities to choose to
measure eligible items at fair value at specified election dates. For items for
which the fair value option has been elected, unrealized gains and losses are to
be reported in earnings at each subsequent reporting date. The fair value option
is irrevocable unless a new election date occurs, may be applied instrument by
instrument, with a few exceptions, and applies only to entire instruments and
not to portions of instruments. SFAS No. 159 provides an opportunity to mitigate
volatility in reported earnings caused by measuring related assets and
liabilities differently without having to apply complex hedge accounting. SFAS
No. 159 was effective for the Company beginning January 1, 2008. The adoption of
the standard did not have a material impact on the Company’s financial
statements.
  In
December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in
Consolidated Financial Statements – an amendment of ARB No. 51, to create
accounting and reporting standards for the noncontrolling interest in a
subsidiary and for the deconsolidation of a subsidiary. SFAS No. 160 establishes
accounting and reporting standards that require (1) the ownership interest in
subsidiaries held by parties other than the parent to be clearly identified and
presented in the consolidated balance sheet within equity, but separate from the
parent’s equity, (2) the amount of consolidated net income attributable to the
parent and the noncontrolling interest to be clearly identified and presented on
the face of the consolidated statement of income, (3) changes in a parent’s
ownership interest while the parent retains its controlling financial interest
in its subsidiary to be accounted for consistently, (4) when a subsidiary is
deconsolidated, any retained noncontrolling equity investment in the former
subsidiary to be initially measured at fair value, and (5) entities to provide
sufficient disclosures that clearly identify and distinguish between the
interests of the parent and the interests of the noncontrolling owners. SFAS No.
160 applies to fiscal years, and interim periods within those fiscal years,
beginning on or after December 15, 2008, and prohibits early adoption.
Management has not completed its review of the new guidance; however, the effect
of the Statement’s implementation is not expected to be material to the
Company’s results of operations or financial position.
  In March
2008, the FASB issued SFAS No. 161, Disclosures about Derivative
Instruments and Hedging Activities. SFAS No.161 requires expanded disclosures
regarding the location and amounts of derivative instruments in an entity’s
financial statements, how derivative instruments and related hedged items are
accounted for under SFAS No. 133, Accounting for Derivative Instruments and
Hedging Activities, and how derivative instruments and related hedged items
affect an entity’s financial position, operating results and cash flows. SFAS
No. 161 is effective for fiscal years beginning after November 15, 2008. Since
SFAS No. 161 affects only disclosures, it is not expected to impact the
Company’s financial position or results of operations upon
adoption.
  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.)
 In
May 2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally
Accepted Accounting Principles.” SFAS No. 162 is intended to improve financial
reporting by identifying a consistent framework, or hierarchy, for selecting
accounting principles to be used in preparing financial statements that are
presented in conformity with generally accepted accounting principles in the
United States for non-governmental entities. SFAS No. 162 is effective 60 days
following approval by the SEC of the Public Company Accounting Oversight Board’s
amendments to AU Section 411, “The Meaning of Present Fairly in Conformity With
Generally Accepted Accounting Principles.” The Company does not expect that the
adoption of SFAS No. 162 will materially impact its financial position or
results of operations.
  In
May 2008, the FASB issued FASB Staff Position No. APB 14-1, Accounting
for Convertible Debt Instruments That May Be Settled in Cash upon Conversion
(Including Partial Cash Settlement) (“FSP No. APB 14-1”). FSP No. APB
14-1 clarifies that convertible debt instruments that may be settled in cash
upon conversion (including partial cash settlement) are not addressed by
paragraph 12 of APB Opinion No. 14, Accounting for Convertible Debt and
Debt Issued with Stock Purchase Warrants” Additionally, FSP No. APB 14-1
specifies that issuers of such instruments should separately account for the
liability and equity components in a manner that will reflect the entity’s
nonconvertible debt borrowing rate when interest cost is recognized in
subsequent periods. FSP No. APB 14-1 is effective for financial statements
issued for fiscal years and interim periods beginning after December 15,
2008. The Company does not expect the adoption of this pronouncement will
materially impact its financial position or results of operations.
  In
June 2008, the FASB ratified the consensus reached on Emerging Issues Task
Force Issue No. 07-05, Determining Whether an Instrument (or Embedded
Feature) Is Indexed to an Entity’s Own Stock (“EITF Issue No. 07-5”). EITF
Issue No. 07-05 clarifies the determination of whether an instrument (or an
embedded feature) is indexed to an entity’s own stock, which would qualify as a
scope exception under SFAS No. 133, Accounting for Derivative Instruments
and Hedging Activities. EITF Issue No. 07-05 is effective for financial
statements issued for fiscal years beginning after December 15, 2008. Early
adoption for an existing instrument is not permitted. The adoption of this
pronouncement will require the warrants and conversation option of the
convertible debt to be accounted for as liabilities and marked to fair value at
each reporting period.
  In June
2008, the FASB issued FASB Staff Position No. EITF 03-6-1, Determining Whether
Instruments Granted in Share-Based Payment Transactions Are Participating
Securities (FSP No. EITF 03-6-1), 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 earnings per share pursuant to the
two-class method described in SFAS No. 128, Earnings per Share. This Staff
Position is effective for financial statements issued for fiscal years beginning
after December 15, 2008, and interim periods within those years. All
prior-period earnings per share data presented are to be adjusted
retrospectively (including interim financial statements, summaries of earnings,
and selected financial data) to conform with the provisions of this Staff
Position, with early application not permitted. The Company is currently
evaluating the effect that the adoption of FSP No. EITF 03-6-1 will have on
its financial position, results of operations and cash flows.
  In
September 2008 the FASB issued FSP FAS 133-1 and FIN 45-4, Disclosures about
Credit Derivatives and Certain Guarantees: An Amendment of FASB Statement No.
133 and FASB Interpretation No. 45; and Clarification of the Effective Date of
FASB Statement No. 161. This FSP amends FASB Statement No. 133, Accounting for
Derivative Instruments and Hedging Activities, to require disclosures by sellers
of credit derivatives, including credit derivatives embedded in a hybrid
instrument. This FSP also amends FASB Interpretation No. 45, Guarantor’s
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others, to require an additional disclosure about
the current status of the payment/performance risk of a guarantee. Further, this
FSP clarifies the Board’s intent about the effective date of FASB Statement No.
161, Disclosures about Derivative Instruments and Hedging Activities. The
Company does not expect the adoption of this pronouncement to materially impact
its financial position or results of operations.
  u.                 Reclassification:
  Certain
prior period amounts have been reclassified to conform to the current period
presentation.
   F-18
 Table of Contents
  AROTECH
CORPORATION AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 
 In
U.S. dollars
  NOTE
3:– RESTRICTED
COLLATERAL DEPOSITS
  December
      31,2008
                    
                    
                    2007Short-term:Deposits
      in connection with MDT projects
                    
                    $
                    381,586
                    
                    
                    $
                    254,668Deposits
      in connection with EFL projects
                    
                    
                    –
                    
                    
                    
                    65,786Total
      Restricted Collateral
                    
                    $
                    381,586
                    
                    
                    $
                    320,454
  NOTE
4: – AVAILABLE FOR SALE MARKETABLE SECURITIES
  The
following is a summary of investments in marketable securities as of December
31, 2008 and 2007:
  Cost
                    
                    
                    Unrealized
      gains
                    
                    
                    Estimated
      fair value2008
                    
                    
                    2007
                    
                    
                    2008
                    
                    
                    2007
                    
                    
                    2008
                    
                    
                    2007Available
      for sale marketable securities
                    
                    $
                    47,005
                    
                    
                    $
                    41,166
                    
                    
                    $
                    2,199
                    
                    
                    $
                    5,839
                    
                    
                    $
                    49,204
                    
                    
                    $
                    47,005
  NOTE
5:–  OTHER ACCOUNTS RECEIVABLE AND PREPAID EXPENSES
  December
      31,2008
                      
                      
                      2007Government
      authorities
                      
                      $
                      114,090
                      
                      
                      $
                      259,036Employees
                      
                      
                      45,458
                      
                      
                      
                      60,950Prepaid
      expenses
                      
                      
                      623,561
                      
                      
                      
                      790,158Loan
      to non-affiliated entity
                      
                      
                      2,531,250
                      
                      
                      
                      –Other
                      
                      
                      311,596
                      
                      
                      
                      504,470Total
                      
                      $
                      3,625,955
                      
                      
                      $
                      1,614,614
  In August
2008, the Company purchased a $2,500,000 10% Senior Subordinated Convertible
Note from an unaffiliated company. This 10% Senior Subordinated Convertible Note
is due December 31, 2009. The issuer is required to pay interest on a quarterly
basis starting in November, 2008 and pay the entire principal by December 31,
2009. The 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.
 
 Management
has determined that the Senior Subordinated Convertible Note, in the event of an
impairment, would be valued using Level 2 inputs under SFAS 157, using inputs
related to interest rates, term of the note and relative risk on similar notes
available in the marketplace.
 
 NOTE
6:–  INVENTORIES
  December
      31,2008
                    
                    
                    2007Raw
      and packaging materials
                    
                    $
                    6,798,662
                    
                    
                    $
                    6,043,170Work
      in progress
                    
                    
                    2,251,734
                    
                    
                    
                    1,583,790Finished
      products
                    
                    
                    628,564
                    
                    
                    
                    260,860Total
                    
                    $
                    9,678,960
                    
                    
                    $
                    7,887,820
  F-19
 Table of Contents
  AROTECH
CORPORATION AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 
 In
U.S. dollars
  NOTE
7:–  PROPERTY AND EQUIPMENT, NET
  a.                 Composition
of property and equipment is as follows:
  December
      31,2008
                    
                    
                    2007Cost:Computers and related
      equipment
                    
                    $
                    2,408,734
                    
                    
                    $
                    2,494,370Motor vehicles
                    
                    
                    529,685
                    
                    
                    
                    561,737Office furniture and
      equipment
                    
                    
                    1,030,199
                    
                    
                    
                    1,194,132Machinery, equipment
      and  installations
                    
                    
                    5,499,776
                    
                    
                    
                    4,485,959Buildings
                    
                    
                    1,172,072
                    
                    
                    
                    1,172,072Land
                    
                    
                    115,538
                    
                    
                    
                    115,538Leasehold
      improvements
                    
                    
                    973,360
                    
                    
                    
                    846,271Demo inventory
                    
                    
                    1,424,831
                    
                    
                    
                    1,150,129$
                    13,154,195
                    
                    
                    $
                    12,020,208Accumulated
      depreciation:Computers and related
      equipment
                    
                    
                    2,163,444
                    
                    
                    
                    2,061,044Motor vehicles
                    
                    
                    290,839
                    
                    
                    
                    249,627Office furniture and
      equipment
                    
                    
                    648,278
                    
                    
                    
                    536,472Machinery, equipment and
      installations
                    
                    
                    3,671,997
                    
                    
                    
                    3,132,202Buildings
                    
                    
                    55,097
                    
                    
                    
                    25,045Leasehold
      improvements
                    
                    
                    611,139
                    
                    
                    
                    407,030Demo
      inventory
                    
                    
                    655,138
                    
                    
                    
                    528,9928,095,932
                    
                    
                    
                    6,940,412Property
      and equipment, net
                    
                    $
                    5,058,263
                    
                    
                    $
                    5,079,796
  b.                 Depreciation
expense amounted to $1,246,238 and $1,376,749 for the years ended December 31,
2008 and 2007, 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.
  F-20
 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
  a.           Goodwill
  A summary
of the goodwill by business segment is as follows:
  12/31/07
                    
                    
                    Additions
                    
                    
                    Adjustments
      (currency)
                    
                    
                    12/31/08Simulation
                    
                    $
                    24,235,419
                    
                    
                    $
                    200,222
                    
                    
                    $
                    –
                    
                    
                    $
                    24,435,641Battery
                    
                    
                    5,946,649
                    
                    
                    
                    –
                    
                    
                    
                    68,820
                    
                    
                    
                    6,015,469Armor
                    
                    
                    1,176,063
                    
                    
                    
                    607,100
                    
                    
                    
                    16,230
                    
                    
                    
                    1,799,393Total
                    
                    $
                    31,358,131
                    
                    
                    $
                    807,322
                    
                    
                    $
                    85,050
                    
                    
                    $
                    32,250,503
  b.           Other
intangible assets:
  December
      31,2008
                      
                      
                      2007Useful
      life
                      
                      Cost
                      
                      
                      Net
      Book Value
                      
                      
                      Cost
                      
                      
                      Net
      Book ValueTechnology
                      4-8
      years
                      
                      $
                      7,068,000
                      
                      
                      $
                      2,297,036
                      
                      
                      $
                      6,405,000
                      
                      
                      $
                      2,305,000Capitalized
      software costs
                      1-3
      years
                      
                      
                      1,720,991
                      
                      
                      
                      100,408
                      
                      
                      
                      1,720,991
                      
                      
                      
                      442,816Trademarks
                      10
      years
                      
                      
                      28,000
                      
                      
                      
                      25,200
                      
                      
                      
                      –
                      
                      
                      
                      –Backlog
                      1-10
      years
                      
                      
                      744,000
                      
                      
                      
                      55,800
                      
                      
                      
                      682,000
                      
                      
                      
                      –Covenants
      not to compete
                      5
      years
                      
                      
                      99,000
                      
                      
                      
                      –
                      
                      
                      
                      99,000
                      
                      
                      
                      –Customer
      list
                      2-10
      years
                      
                      
                      7,602,045
                      
                      
                      
                      3,186,342
                      
                      
                      
                      7,548,645
                      
                      
                      
                      3,846,117Certification
                      3
      years
                      
                      
                      246,969
                      
                      
                      
                      –
                      
                      
                      
                      246,969
                      
                      
                      
                      –17,509,005
                      
                      
                      $
                      5,664,786
                      
                      
                      
                      16,702,605
                      
                      
                      $
                      6,593,933Exchange
      differences
                      
                      
                      
                      404,088
                      
                      
                      
                      
                      
                      
                      
                      444,143Less
      - accumulated amortization
                      
                      
                      
                      (11,844,220
                      )
                      
                      
                      
                      
                      
                      
                      (10,108,672
                      )Amortized
      cost
                      
                      
                      
                      6,068,873
                      
                      
                      
                      
                      
                      
                      
                      7,038,076Trademarks
                      
                      
                      
                      799,000
                      
                      
                      
                      
                      
                      
                      
                      799,000Net
      book value
                      
                      
                      $
                      6,867,873
                      
                      
                      
                      
                      
                      
                      $
                      7,837,076
   F-21
 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.)
  Amortization
expense amounted to $1,735,548 and $1,381,822 for the years ended December 31,
2008 and 2007, respectively, including amortization of capitalized software
costs of $342,408 and $552,689, respectively.
  c. Estimated
amortization expenses for the years ended:
  Year
      ended December 31,2009
                      
                      $
                      1,452,7412010
                      
                      
                      1,315,4182011
                      
                      
                      1,315,0542012
                      
                      
                      725,4542013
                      
                      
                      725,4032014
      and forward
                      
                      
                      130,716Total
                      
                      $
                      5,664,786
  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.
  NOTE
9:– SHORT-TERM BANK CREDIT AND LOANS
  The
Company and/or certain of its subsidiaries have $8.4 million authorized in
credit lines from certain banks, of which $877,000 is denominated in NIS and
carries various approximate interest rates of prime rate + 2.6 to 4.3% and $7.5
million is denominated in U.S. dollars (the Company’s primary line which expires
in December, 2009) and carries an interest rate of lender’s prime rate + 0.25%.
The interest rate charged by the bank for this latter line was 3.5% at December
31, 2008. As of December 31, 2008, $4.4 million was utilized from the Company’s
primary line, out of which $744,000 is related to four letters of credit issued
to customers of two of the Company’s subsidiaries.  The entire amount
of the remaining $3.1 million of credit on the primary line was available at
year end.
  These
lines of credit are secured by the accounts receivable, inventory and marketable
securities of the relevant subsidiary of the Company.
  NOTE
10:– OTHER ACCOUNTS PAYABLE AND ACCRUED EXPENSES
  December
      31,2008
                    
                    
                    2007Employees
      and payroll accruals
                    
                    $
                    1,557,628
                    
                    
                    $
                    1,531,157Accrued
      vacation pay
                    
                    
                    675,142
                    
                    
                    
                    530,850Accrued
      expenses
                    
                    
                    1,759,873
                    
                    
                    
                    1,813,947Government
      authorities
                    
                    
                    333,390
                    
                    
                    
                    401,826Advances
      from customers
                    
                    
                    1,532,926
                    
                    
                    
                    611,949Total
                    
                    $
                    5,858,959
                    
                    
                    $
                    4,889,729
    F-22
 Table of Contents
  AROTECH
CORPORATION AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 
 In
U.S. dollars
 NOTE
11:– COMMITMENTS AND CONTINGENT LIABILITIES
  a.                 Royalty
commitments:
  1.                 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 (linked to the U.S. dollars. 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.
  Royalties
paid or accrued for the years ended December 31, 2008 and 2007 to the OCS
amounted to $11,821 and $15,063, respectively.
  As of
December 31, 2008, the total contingent liability to the OCS was approximately
$10.6 million. The Company regards the probability of this contingency coming to
pass in any material amount to be low.
  2.                 EFL,
in cooperation with a U.S. participant, has received approval from the
Israel-U.S. Bi-national Industrial Research and Development Foundation
(“BIRD-F”) for 50% funding of a project for the development of a hybrid
propulsion system for transit buses. The maximum approved cost of the project is
approximately $1.8 million, and the EFL’s share in the project costs is
anticipated to amount to approximately $1.1 million, which will be reimbursed by
BIRD-F at the aforementioned rate of 50%. Royalties at rates of 2.5%-5% of sales
are payable up to a maximum of 150% of the grant received, linked to the U.S.
Consumer Price Index. Accelerated royalties are due under certain
circumstances.
  EFL is
obligated to pay royalties only on sales of products in respect of which BIRD-F
participated in their development. Should the project fail, EFL will not be
obligated to pay any royalties.
  No
royalties were paid or accrued to the BIRD-F in each of the three years in the
period ended December 31, 2008.
  As of
December 31, 2008, the total contingent liability to pay BIRD-F (150%) was
approximately $772,000 The Company regards the probability of this contingency
coming to pass in any material amount to be low.
  b.                 Lease
commitments:
  The
Company and its subsidiaries rent their 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:
  Future
      Minimum Rental Payments
                        
                        December
      312009
                        
                        $
                        724,8212010
                        
                        
                        510,1192011
                        
                        
                        517,9942012
                        
                        
                        523,3322013
                        
                        
                        336,282Thereafter
                        
                        
                        1,304,416Total
                        
                        $
                        3,916,964
  Total
rent expenses for the years ended December 31, 2008 and 2007 were $805,518 and
$890,406, 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.
   F-23
 Table of Contents
  AROTECH
CORPORATION AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 
 In
U.S. dollars
 NOTE
11:– COMMITMENTS AND CONTINGENT LIABILITIES (Cont.)
 The table
below details the original value, depreciation and net book value of the assets
included. The net book value is included the property and equipment totals in
the balance sheet.
  Leased
      Assets
                      
                      December
      31,2008
                      
                      
                      2007Equipment
                      
                      $
                      355,561
                      
                      
                      $
                      249,532Less:
      Accumulated Depreciation
                      
                      
                      (179,429
                      )
                      
                      
                      (97,789
                      )Net
      book value
                      
                      $
                      176,132
                      
                      
                      $
                      151,743
  The table
below details the remaining liability of the capital lease
obligations.
  Liabilities
                      
                      December
      31, 2008Obligations
      under capital leases:Current
                      
                      $
                      85,394Non-current
                      
                      
                      148,772Total
      minimum payments
                      
                      
                      234,166Less:
      Interest
                      
                      
                      (49,243
                      )Present
      value of payments
                      
                      $
                      184,923
  The table
below details the future lease payments due as of December 31,
2008.
  Future
      Minimum Lease Payments
                          
                          December
      31,2009
                          
                          $
                          85,3942010
                          
                          
                          64,9592011
                          
                          
                          46,9492012
                          
                          
                          30,2942013
      and forward
                          
                          
                          6,570Total
      minimum lease payments
                          
                          $
                          234,166
  c.                 Guarantees:
  The
Company obtained bank guarantees in the amount of $144,000 in connection (i)
obligations of two of the Company’s subsidiaries to the Israeli customs
authorities, (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, and
(iii) the obligation of one of the Company’s subsidiaries to secure a required
letter of credit required under a long term contract. In addition, the Company
has four outstanding letters of credit totaling $744,000 for the benefit of its
subsidiaries’ customers.
  F-24
 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 its assets, in favor of the State of Israel.
  The
Company has $8.4 million in credit liens secured by the assets of the Company
and its subsidiaries and guaranteed by the Company and its
subsidiaries.
  Epsilor
has recorded a lien on all of its assets in favor of its banks to secure lines
of credit and loans received. In addition the company has a specific pledge on
assets in respect of which government guaranteed loan 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. Trial has been held in this matter, and
the Company is awaiting a decision.
  2.  Class
Action Litigation
  In May
2007, two purported class action complaints (the “Complaint”) were filed in the
United States District Court for the Eastern District of New York against the
Company and certain of its officers and directors. These two cases were
consolidated in June 2007. A similar case filed in the United States District
Court for the Eastern District of Michigan in March 2007 was withdrawn by the
plaintiff in June 2007. The Complaint seeks class status on behalf of all
persons who purchased the Company’s securities between November 9, 2004 and
November 14, 2005 (the “Period”) and alleges violations by the Company and
certain of its 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 its business and prospects during
the Period. The Complaint also alleges that the Company did not have adequate
systems of internal operational or financial controls, and that its financial
statements and reports were not prepared in accordance with GAAP and SEC rules.
The Complaint seeks an unspecified amount of damages. The Company’s motion to
dismiss the Complaint as a matter of law was denied in March 2009.
  Although
the ultimate outcome of this matter cannot be determined with certainty, the
Company believes that the allegations stated in the Complaint are without merit
and the Company and its officers and directors named in the Complaint intend to
defend themselves vigorously against such allegations.
  NOTE
12:– CONVERTIBLE
DEBT, DETACHABLE WARRANTS AND OTHER LONG TERM
DEBT
  a.                 Subordinated
convertible notes due August 14, 2011
  In August
2008, the Company issued $5.0 million in 10% 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 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.
  Principal
payments of $454,545 are due on each of February 13, 2009, May 15, 2009, August
14, 2009, November 13, 2009, February 15, 2010, 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 the Company’s common stock. The Company paid the principal payment due
February 13, 2009 in cash. In the event the Company elects to make payments of
principal on its convertible 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.
  F-25
 Table of Contents
  AROTECH
CORPORATION AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 
 In
U.S. dollars
 NOTE
12:– COMMITMENTS AND CONTINGENT LIABILITIES
(Cont.)
  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. As a result, the Company would need to file an additional
registration statement with the SEC to register for resale more shares of its
common stock in order to continue requiring conversion of the Company’s Notes
upon principal payment becoming due.
  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 $1,000,000 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, 2008 would be $75,000 and would
decrease 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, 2008, the Company was in compliance with all requirements of this
agreement.
  The debt
discount associated with this transaction will be charged to financial expense
over the term of the Notes using the effective interest method. (See discussion
on warrants in Note 13.b.)  The net amount due on the notes as of
December 31, 2008, net of this discount, was $4,639,237.
  b.                 Senior
Secured Convertible Notes due March 31, 2008
  Pursuant
to the terms of a Securities Purchase Agreement dated September 29, 2005 (the
“Purchase Agreement”) by and between the Company and certain institutional
investors, the Company issued and sold to the investors an aggregate of $17.5
million principal amount of senior secured convertible notes (“Notes”) having a
final maturity date of March 31, 2008.
  As a
result of a prepayment conversion in April 2006, the Company made the final
payment in respect of the Notes in July 2007.
  During
2007, the Company recorded expenses of $18,745 attributable to amortization
related to warrants issued to the holders of the Notes and the beneficial
conversion feature. During 2007 the Company also recorded expenses of $280,382
attributable to debt discount at time of payment, in connection with convertible
debenture principle repayment of the Notes. Additionally, during 2007 the
Company recorded expenses of $44,253 attributable toamortization
of deferred charges related to issuance of the Notes.
  During
2007, the Company issued a total of 930,125 shares in payment of these
notes.
  c.                 Other
Long Term Debt:
  1.                 Mortgage
Note, Auburn, Alabama:
  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. 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 Payments
                        
                        December
      31,2009
                        
                        $
                        27,1052010
                        
                        
                        29,3552011
                        
                        
                        31,7922012
                        
                        
                        34,4232013
                        
                        
                        37,287Thereafter
                        
                        
                        912,813$
                        1,072,775
  The
Company has additional long term debt outstanding of $15,902, primarily vehicle
loans. This amount is payable in 2009.
   F-26
 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:
  1.                 As
part of a securities purchase agreement entered into in August 2008, the Company
issued to the purchasers of its 10% senior convertible notes due August 15,
2011, 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
classified as equity based on their relative value of $412,300.
  The fair
value of these warrants was determined using Black-Scholes pricing model,
assuming a risk-free interest rate of 2.78%, a volatility factor 75%, dividend
yields of 0% and a contractual life of 3.0 years.
  2.                 
As of December 31, 2008, the Company’s outstanding warrants totaled 714,658 with
expiration dates through August 15, 2011 and with exercise prices ranging from
$2.24 to $30.80.
  c.                 The
Company has adopted the following stock option plans, whereby options and
restricted shares may be granted for purchase of shares of the Company’s common
stock. Under the terms of the employee plans, the Board of Directors or the
designated committee grants options and determines the vesting period and the
exercise terms:
  1.                 1998
Employee Option Plan – as amended, 339,286 shares reserved for issuance, no new
options are issuable under this Plan as of December 31, 2008. Pursuant to the
terms of this Plan, no new options were issuable under this Plan after December
31, 2008.
  2.                 1995
Non-Employee Director Plan – 71,429 shares reserved for issuance, of which
71,429 stock options were issued and outstanding as of December 31, 2008.
Pursuant to the terms of this Plan, no new options were issuable under this Plan
after September 28, 2005.
  3.                 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,
2008.
  4.                 2007
Non-Employee Director Equity Compensation Plan – 750,000 shares reserved for
issuance, of which 670,410 were available for future grants to outside directors
as of December 31, 2008.
  5.                 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.
  6.                 A
summary of the status of the Company’s plans and other share options and
restricted shares (except for options granted to consultants) granted as of
December 31, 2008 and 2007, and changes during the years ended on those dates,
is presented below:
  Stock
Options:
   2008
                                    
                                    
                                    2007Amount
                                    
                                    
                                    Weighted
      average
                                      exercise
      price
                                    
                                    
                                    Amount
                                    
                                    
                                    Weighted
      average
                                      exercise
      price$
                                    
                                    
                                    
                                    
                                    
                                    $Options
      outstanding at be­ginning of year
                                    
                                    
                                    291,390
                                    
                                    
                                    $
                                    6.03
                                    
                                    
                                    
                                    623,693
                                    
                                    
                                    $
                                    8.22Changes
      during year:Granted
                                    
                                    
                                    –
                                    
                                    
                                    $
                                    –
                                    
                                    
                                    
                                    –
                                    
                                    
                                    $
                                    –Exercised
                                    
                                    
                                    –
                                    
                                    
                                    $
                                    –
                                    
                                    
                                    
                                    –
                                    
                                    
                                    $
                                    –Forfeited
                                    
                                    
                                    (54,484
                                    )
                                    
                                    $
                                    5.52
                                    
                                    
                                    
                                    (332,303
                                    )
                                    
                                    $
                                    10.14Options
      outstanding at end of year
                                    
                                    
                                    236,906
                                    
                                    
                                    $
                                    6.14
                                    
                                    
                                    
                                    291,390
                                    
                                    
                                    $
                                    6.03Options
      vested at end of year (1)
                                    
                                    
                                    203,908
                                    
                                    
                                    $
                                    6.69
                                    
                                    
                                    
                                    217,057
                                    
                                    
                                    $
                                    7.14Options
      expected to vest
                                    
                                    
                                    32,998
                                    
                                    
                                    $
                                    2.77
                                    
                                    
                                    
                                    74,333
                                    
                                    
                                    $
                                    2.77
  F-27
 Table of Contents
  AROTECH
CORPORATION AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 
 In
U.S. dollars
  NOTE
13:– STOCKHOLDERS’ EQUITY (Cont.)
  (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 2008 and 2007 was $1,039,270 and
$1,417,521, respectively.
  The
calculated intrinsic value of vested and unvested options for 2008 and 2007 was
less than zero.
  Restricted
Shares:
  2008
                                                
                                                
                                                2007Shares
                                                
                                                
                                                Weighted
                                                  average
      fair value at grant date
                                                
                                                
                                                Shares
                                                
                                                
                                                Weighted
                                                  average
      fair value at grant date$
                                                
                                                
                                                
                                                
                                                
                                                $Nonvested
      at the beginning of the year
                                                
                                                
                                                994,452
                                                
                                                
                                                $
                                                2.42
                                                
                                                
                                                
                                                863,572
                                                
                                                
                                                $
                                                2.51Changes
      during year:Granted
                                                
                                                
                                                38,472
                                                
                                                
                                                $
                                                2.73
                                                
                                                
                                                
                                                631,118
                                                
                                                
                                                $
                                                2.36Vested
                                                
                                                
                                                (244,538
                                                )
                                                
                                                $
                                                2.39
                                                
                                                
                                                
                                                (500,238
                                                )
                                                
                                                $
                                                2.62Forfeited
                                                
                                                
                                                (75,073
                                                )
                                                
                                                $
                                                2.22
                                                
                                                
                                                
                                                -
                                                
                                                
                                                $
                                                –Nonvested
      at the end of the year
                                                
                                                
                                                713,313
                                                
                                                
                                                $
                                                2.41
                                                
                                                
                                                
                                                994,452
                                                
                                                
                                                $
                                                2.42Restricted
      shares vested at end of year
                                                
                                                
                                                793,347
                                                
                                                
                                                $
                                                2.53
                                                
                                                
                                                
                                                548,809
                                                
                                                
                                                $
                                                2.51
  Under the
plans discussed above, 38,472 restricted shares and 41,118 restricted shares
were granted to the Company’s directors in 2008 and 2007, respectively.
Additionally, 590,000 restricted shares were granted to the officers of the
company during 2007.  The officers were not granted any shares in
2008.
  7.                 
The options outstanding as of December 31, 2008 have been separated into ranges
of exercise price, as follows:
  Total
      options outstanding
                                    
                                    
                                    Vested
      options outstandingRange
      of
                                      exercise
                                      prices
                                    
                                    
                                    Amount
                                      outstanding
      at
                                      December
      31,
                                      2008
                                    
                                    
                                    Weighted
                                      average
                                      remaining
                                      contractual
      life
                                    
                                    
                                    Weighted
                                      average
                                      exercise
      price
                                    
                                    
                                    Amount
                                      exercisable
      at
                                      December
      31, 2008
                                    
                                    
                                    Weighted
                                      average
                                      exercise
      price$
                                    
                                    
                                    
                                    
                                    
                                    Years
                                    
                                    
                                    $
                                    
                                    
                                    
                                    
                                    
                                    $0.00-4.99
                                    
                                    
                                    
                                    99,000
                                    
                                    
                                    
                                    2.97
                                    
                                    
                                    $
                                    2.77
                                    
                                    
                                    
                                    66,002
                                    
                                    
                                    $
                                    2.775.00-9.99
                                    
                                    
                                    
                                    102,752
                                    
                                    
                                    
                                    3.09
                                    
                                    
                                    $
                                    5.86
                                    
                                    
                                    
                                    102,752
                                    
                                    
                                    $
                                    5.8610.00-34.99
                                    
                                    
                                    
                                    35,154
                                    
                                    
                                    
                                    3.42
                                    
                                    
                                    $
                                    16.49
                                    
                                    
                                    
                                    35,154
                                    
                                    
                                    $
                                    16.49Total
                                    
                                    
                                    
                                    236,906
                                    
                                    
                                    
                                    3.09
                                    
                                    
                                    $
                                    6.14
                                    
                                    
                                    
                                    203,908
                                    
                                    
                                    $
                                    6.69
   F-28
 Table of Contents
  AROTECH
CORPORATION AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 
 In
U.S. dollars
  NOTE
13:– STOCKHOLDERS’ EQUITY (Cont.)
  8.                 Options
issued to consultants:
  The
Company’s outstanding options to consultants are as follows:
  2008
                            
                            
                            2007Amount
                            
                            
                            Weighted
      average exercise price
                            
                            
                            Amount
                            
                            
                            Weighted
      average exercise price$
                            
                            
                            
                            
                            
                            $Options
      outstanding at beginning of year
                            
                            
                            11,870
                            
                            
                            $
                            54.39
                            
                            
                            
                            11,870
                            
                            
                            $
                            54.39Changes
      during year:Granted
                            
                            
                            –
                            
                            
                            
                            –
                            
                            
                            
                            –
                            
                            
                            
                            –Exercised
                            
                            
                            –
                            
                            
                            
                            –
                            
                            
                            
                            –
                            
                            
                            
                            –Forfeited
      or cancelled
                            
                            
                            (4,553
                            )
                            
                            $
                            32.12
                            
                            
                            
                            –
                            
                            
                            
                            –Options
      outstanding at end of year
                            
                            
                            7,317
                            
                            
                            $
                            68.24
                            
                            
                            
                            11,870
                            
                            
                            $
                            54.39Options
      vested at end of year
                            
                            
                            7,317
                            
                            
                            $
                            68.24
                            
                            
                            
                            11,870
                            
                            
                            $
                            54.39
  In
connection with the grant of stock options to consultants, the Company did not
recognize any expenses for the years ended December 31, 2008 and
2007.
  9.                 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, 2008 was $407,755, of which $25,571
was for stock options and $382,184 was for restricted shares. The weighted
average period over which this compensation cost is expected to be recognized is
approximately 1.5 years.
  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.
   F-29
 Table of Contents
  AROTECH
CORPORATION AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 
 In
U.S. dollars
  NOTE
14:–  INCOME TAXES
  a.                 Taxation
of U.S. parent company (Arotech) and other U.S. subsidiaries:
  As of
December 31, 2008, Arotech has operating loss carryforwards for U.S. federal
income tax purposes of approximately $24.9 million, which are available to
offset future taxable income, if any, expiring in 2009 through 2027. 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 FIN 48 on January 1, 2007. As a result of the
implementation of FIN 48, the Company did not record a liability for
unrecognized tax positions. The adoption of FIN 48 did not impact the Company’s
financial condition, results of operations or cash flows. At December 31, 2008,
the Company had net deferred tax assets of $37.9 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 may have occurred. The Company completed a
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 FIN 48 as of December 31, 2008 after the completion of the
Section 382 analysis. 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. Pursuant to SFAS No. 142, “Goodwill and Other
Intangible Assets,” 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.
  Due to
the fact that the aforementioned deferred tax liability could have an indefinite
life, it should not be netted against the Company’s deferred tax assets (which
primarily relate to net operating loss carryforwards) when determining the
required valuation allowance. Doing so would result in the understatement of the
valuation allowance and related deferred income tax expense.
  At least
three years of the Company’s federal returns are still open for examination, so
it is possible that the amount of this liability could change in future
accounting periods.
  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 2004, although carryforward
losses that were generated prior to 2004 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 2003.
  On July
12, 2007, the Governor of Michigan signed into law the Michigan Business Tax
(MBT), which was effective January 1, 2008. This is a combined income tax and
modified gross receipts tax and replaces the Michigan Single Business
Tax.  The impact of the MBT on the Company’s financial position was
not material.
  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”):
   F-30
 Table of Contents
  AROTECH
CORPORATION AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 
 In
U.S. dollars
  NOTE
14:–  INCOME TAXES (Cont.)
  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
investments 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. Hence, this approved program will expire 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 investments grants from the State of Israel in the amount of 24% on
property and equipment located at its Dimona plant.
  The
expansion program is in the amount of approximately $945,000. This program has
not yet 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.                 As
stated above for each specific program:
  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, 2008 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, 2008.
Furthermore, management has indicated that it has no intention of declaring any
dividend.
  F-31
 Table of Contents
  AROTECH
CORPORATION AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 
 In
U.S. dollars
  NOTE
14:–  INCOME TAXES (Cont.)
  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, 2008, the Company did not generate income
under the provision of the amended Investment Law.
  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 27% in 2008, 26% in 2009 and 25% in 2010 and thereafter. See also Note
14.e.
  3.                 Tax
loss carryforwards:
  As of
December 31, 2008, EFL has operating and capital loss carryforwards for Israeli
tax purposes of approximately $105 million, which are available, indefinitely,
to offset future taxable income.
  d.                 Tax
rates applicable to the income of the Group companies:
  The
corporate tax rate in Israel was 29% in 2007 and 27% in 2008. Current law has
set the rate at 26% for 2009 and 25% for 2010 and thereafter, although this is
subject to being changed by the Israeli parliament.
  e.                 Deferred
income taxes:
   F-32
 Table of Contents
  AROTECH
CORPORATION AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 
 In
U.S. dollars
  NOTE
14:–  INCOME TAXES (Cont.)
  Deferred
income taxes reflect 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 resulting from tax loss carryforward are as
follows:
 December
      31,2008
                    
                    
                    2007(as
      restated;see
      Note 19)Operating
      loss carryforward
                    
                    $
                    34,958,606
                    
                    
                    $
                    33,741,900Other
      temporary differences
                    
                    
                    2,894,915
                    
                    
                    
                    4,088,598Net
      deferred tax asset before valuation allowance
                    
                    
                    37,853,521
                    
                    
                    
                    37,830,498Valuation
      allowance
                    
                    
                    (37,781,407
                    )
                    
                    
                    (37,752,789
                    )Total
      deferred tax asset
                    
                    $
                    72,114
                    
                    
                    $
                    77,709Deferred
      tax liability
                    
                    $
                    2,430,000
                    
                    
                    $
                    1,865,000
 
 December
      31,2008
                              
                              
                              2007(as
      restated;see
      Note 19)Domestic
                              
                              $
                              8,470,576
                              
                              
                              $
                              7,216,709Foreign
                              
                              
                              26,488,030
                              
                              
                              
                              26,525,191$
                              34,958,606
                              
                              
                              $
                              33,741,900
 
 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 and its subsidiaries 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 as of
December 31, 2008 was $28,000
  f.                 Loss
before taxes on income and minorities interests in earnings of a
subsidiary:
  Year
      ended December 312008
                    
                    
                    2007(as
      restated;see
      Note 19)Domestic
                    
                    $
                    (1,929,564
                    )
                    
                    $
                    (2,464,512
                    )Foreign
                    
                    
                    (881,524
                    )
                    
                    
                    (365,711
                    )$
                    (2,811,088
                    )
                    
                    $
                    (2,830,223
                    )
   F-33
 Table of Contents
  AROTECH
CORPORATION AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 
 In
U.S. dollars
  NOTE
14:–  INCOME TAXES (Cont.)
  g.                 Taxes
on income were comprised of the following:
  Year
      ended December 312008
                    
                    
                    2007(as
      restated;see
      Note 19)Current
      state and local taxes
                    
                    $
                    499,196
                    
                    
                    $
                    111,162Deferred
      taxes
                    
                    
                    570,595
                    
                    
                    
                    545,323Taxes
      in respect of prior years
                    
                    
                    (42,923
                    )
                    
                    
                    (47,569
                    )$
                    1,026,868
                    
                    
                    $
                    608,916Domestic
                    
                    $
                    926,182
                    
                    
                    $
                    634,930Foreign
                    
                    
                    100,686
                    
                    
                    
                    (26,014
                    )$
                    1,026,868
                    
                    
                    $
                    608,916
  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 31,2008
                          
                          
                          2007(as
      restated;see
      Note 19)Loss
      before taxes and minority interest, as reported in the consolidated
      statements of operations
                          
                          $
                          (2,811,088
                          )
                          
                          $
                          (2,830,223
                          )Statutory
      tax rate
                          
                          
                          34
                          %
                          
                          
                          34
                          %Theoretical
      income tax on the above amount at the U.S. statutory tax
    rate
                          
                          $
                          (955,770
                          )
                          
                          $
                          (962,276
                          )Deferred
      taxes on losses for which valuation allowance was provided
                          
                          
                          1,872,798
                          
                          
                          
                          1,400,412Non-deductible
      credits  (expenses)
                          
                          
                          (352,029
                          )
                          
                          
                          126,864Foreign
      non-deductible expenses
                          
                          
                          32,400
                          
                          
                          
                          27,748State
      taxes
                          
                          
                          361,182
                          
                          
                          
                          69,930Foreign
      income in tax rates other then U.S rate
                          
                          
                          (35,782
                          )
                          
                          
                          (5,969
                          )Taxes
      in respect of prior years
                          
                          
                          (42,923
                          )
                          
                          
                          (47,569
                          )Others
                          
                          
                          146,992
                          
                          
                          
                          (224
                          )Actual
      tax expense
                          
                          $
                          1,026,868
                          
                          
                          $
                          608,916
  
 F-34
 Table of Contents
  AROTECH
CORPORATION AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 
 In
U.S. dollars
  NOTE
15:– SELECTED STATEMENTS OF OPERATIONS DATA
  Financial
income (expenses), net:
 Year
      ended December 31,2008
                                
                                
                                2007Financial
      expenses:Interest,
      bank charges and fees
                                
                                $
                                (579,913
                                )
                                
                                $
                                (662,789
                                )Expenses
      in connection with convertible debenture principle
    repayment
                                
                                
                                –
                                
                                
                                
                                (280,382
                                )Bonds
      discount amortization
                                
                                
                                (51,537
                                )
                                
                                
                                (18,745
                                )Foreign
      currency translation differences
                                
                                
                                (291,869
                                )
                                
                                
                                –Other
                                
                                
                                (99
                                )
                                
                                
                                (91,624
                                )(923,418
                                )
                                
                                
                                (1,053,540
                                )Financial
      income:Interest
                                
                                
                                97,851
                                
                                
                                
                                53,298Foreign
      currency translation differences
                                
                                
                                –
                                
                                
                                
                                94,354Other
                                
                                
                                11,478
                                
                                
                                
                                –Total
                                
                                $
                                (814,089
                                )
                                
                                $
                                (905,888
                                )
 
 NOTE
16:– SEGMENT INFORMATION
  a.                 General:
  The
Company and its subsidiaries operate primarily in three business segments (see
Note 1.a. for a brief description of the Company’s business) and follow the
requirements of SFAS No. 131.
  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.
    F-35
 Table of Contents
  AROTECH
CORPORATION AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 
 In
U.S. dollars
  NOTE
15:– SELECTED STATEMENTS OF OPERATIONS DATA (Cont.)
  b.                 The
following is information about reported segment gains, losses and
assets:
  Training
      and Simulation
                    
                    
                    Armor
                    
                    
                    Battery
      and
                      Power
      Systems
                    
                    
                    All
      Others
                    
                    
                    Total2008Revenues
      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)
      (4)
                    
                    $
                    48,181,444
                    
                    
                    $
                    12,572,672
                    
                    
                    $
                    24,037,512
                    
                    
                    $
                    5,003,171
                    
                    
                    $
                    89,794,7992007(as restated; see
      Note 19)Revenues
      from outside customers
                    
                    $
                    27,760,858
                    
                    
                    $
                    18,724,107
                    
                    
                    $
                    11,234,596
                    
                    
                    $
                    –
                    
                    
                    $
                    57,719,561Depreciation
      , amortization and impairment expenses (1)
                    
                    
                    (1,037,064
                    )
                    
                    
                    (469,093
                    )
                    
                    
                    (1,024,434
                    )
                    
                    
                    (227,980
                    )
                    
                    
                    (2,758,571
                    )Direct
      expenses (2)
                    
                    
                    (22,241,359
                    )
                    
                    
                    (17,490,430
                    )
                    
                    
                    (11,023,839
                    )
                    
                    
                    (6,800,909
                    )
                    
                    
                    (57,556,537
                    )Segment
      net income (loss)
                    
                    $
                    4,482,435
                    
                    
                    $
                    764,584
                    
                    
                    $
                    (813,677
                    )
                    
                    $
                    (7,028,889
                    )
                    
                    $
                    (2,595,547
                    )Financial
      expenses
                    
                    
                    (14,610
                    )
                    
                    
                    (93,292
                    )
                    
                    
                    (176,834
                    )
                    
                    
                    (621,152
                    )
                    
                    
                    (905,888
                    )Net
      income (loss)
                    
                    $
                    4,467,825
                    
                    
                    $
                    671,292
                    
                    
                    $
                    (990,511
                    )
                    
                    $
                    (7,650,041
                    )
                    
                    $
                    (3,501,435
                    )Segment
      assets (3)
      (4)
                    
                    $
                    43,810,684
                    
                    
                    $
                    11,235,386
                    
                    
                    $
                    21,191,545
                    
                    
                    $
                    4,243,692
                    
                    
                    $
                    80,481,307
 _______________________
 (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.
 (4)
                Out
      of those amounts, goodwill in the Company’s Training and Simulation,
      Battery and Power Systems and Armor Divisions stood at $24,435,642,
      $6,015,469 and $1,799,392 as of December 31, 2008, and $24,235,419,
      $5,946,649 and $1,176,063 as of December 31,
  2007.
   F-36
 Table of Contents
  AROTECH
CORPORATION AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 
 In
U.S. dollars
  NOTE
15:– SELECTED STATEMENTS OF OPERATIONS DATA (Cont.)
 c.                 Summary
information about geographic areas:
  The
following presents total revenues according to the location of the end customer
for the years ended December 31, 2008 and 2007, and long-lived assets as of
December 31, 2008 and 2007:
  2008
                      
                      
                      2007Total
                        revenues
                      
                      
                      Long-lived
      assets
                      
                      
                      Total
                        revenues
                      
                      
                      Long-lived
      assetsU.S.
      dollarsU.S.A.
                      
                      $
                      49,386,798
                      
                      
                      $
                      31,794,288
                      
                      
                      $
                      45,198,904
                      
                      
                      $
                      31,714,391Germany
                      
                      
                      951,533
                      
                      
                      
                      –
                      
                      
                      
                      230,571
                      
                      
                      
                      –England
                      
                      
                      389,518
                      
                      
                      
                      –
                      
                      
                      
                      273,239
                      
                      
                      
                      –Thailand
                      
                      
                      –
                      
                      
                      
                      –
                      
                      
                      
                      –
                      
                      
                      
                      –India
                      
                      
                      1,854,052
                      
                      
                      
                      –
                      
                      
                      
                      1,153,521
                      
                      
                      
                      –Egypt
                      
                      
                      538,774
                      
                      
                      
                      –
                      
                      
                      
                      –
                      
                      
                      
                      –Israel
                      
                      
                      13,443,119
                      
                      
                      
                      12,382,351
                      
                      
                      
                      8,239,135
                      
                      
                      
                      12,560,612Other
                      
                      
                      2,385,175
                      
                      
                      
                      –
                      
                      
                      
                      2,624,191
                      
                      
                      
                      –$
                      68,948,969
                      
                      
                      $
                      44,176,639
                      
                      
                      $
                      57,719,561
                      
                      
                      $
                      44,275,003
  d.                 Revenues
from major customers:
 Year
      ended December 31,2008
                              
                              
                              2007Batteries
      and power systems:Customer A
                              
                              
                              9
                              %
                              
                              
                              6
                              %Customer B
                              
                              
                              3
                              %
                              
                              
                              0
                              %Armor:Customer C
                              
                              
                              13
                              %
                              
                              
                              6
                              %Customer D
                              
                              
                              6
                              %
                              
                              
                              19
                              %Training
      and Simulation:Customer E
                              
                              
                              37
                              %
                              
                              
                              27
                              %
  e.                 Revenues
from major products:
 Year
      ended December 31,2008
                          
                          
                          2007Water
      activated batteries
                          
                          $
                          1,861,958
                          
                          
                          $
                          1,629,014Military
      batteries
                          
                          
                          13,291,868
                          
                          
                          
                          9,605,582Car,
      aircraft  and other armoring
                          
                          
                          17,762,440
                          
                          
                          
                          18,724,107Simulators
                          
                          
                          36,032,703
                          
                          
                          
                          27,760,858Total
                          
                          $
                          68,948,969
                          
                          
                          $
                          57,719,561
 
  F-37
 Table of Contents
  AROTECH
CORPORATION AND ITS SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 
 In
U.S. dollars
  NOTE
17:–  ACCUMULATED OTHER COMPREHENSIVE INCOME
  Accumulated
other comprehensive income consists of currency translation adjustments of
$1,524,000 and $1,499,000 at December 31, 2008 and 2007, respectively, and
unrealized gains on marketable securities of $2,000 at both December 31, 2008
and 2007.
  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
Company’s interest in the net losses of the affiliated companies totaled
$452,166 and $40,230 in 2008 and 2007, respectively.
  NOTE
19:–  PRIOR PERIOD ADJUSTMENT
  The
accumulated deficit at January 1, 2007 was restated and increased by $400,000 to
$159,866,123 to reflect the correction of a deferred tax liability resulting
from a basis difference between book and tax for goodwill that arose from
acquisitions in previous years. Additionally, the deferred tax liability and
deferred income tax provision as of and for the year ended December 31, 2007
were increased by $445,000 as a result of this correction. The correction of the
2007 tax provision increased previously reported net loss for the year ended
December 31, 2007 by $445,000 or $0.04 per share.  This error
correction is the same issue that was disclosed in the 2007 financial statements
of the Company, and it was determined in 2008 that the previously reported
number was incorrect and was adjusted in these financials.
  2007
                    
                    As
      previously reported
                    
                    
                    Adjustment
                    
                    
                    Corrected
      amountIncome
      taxes
                    
                    $
                    (163,916
                    )
                    
                    $
                    (445,000
                    )
                    
                    $
                    (608,916
                    )Net
      loss
                    
                    $
                    (3,056,435
                    )
                    
                    $
                    (445,000
                    )
                    
                    $
                    (3,501,435
                    )Basic
      and diluted net loss per share
                    
                    $
                    (0.27
                    )
                    
                    $
                    (0.04
                    )
                    
                    $
                    (0.31
                    )
 
  
 F-38
 Table of Contents
   FINANCIALSTATEMENT SCHEDULE
 Arotech
Corporation and Subsidiaries
 
 Schedule
II – Valuation and Qualifying Accounts
  For the
Years Ended December 31, 2008 and 2007
  Description
                    
                    Balance
      at
                      beginning
                      of
      period
                    
                    
                    Additions
                      charged
      to
                      costs
      and
                      expenses*
                    
                    
                    Balance
      at
                      end
      of
                      periodYear
      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
                    
                    
                    $
                    39,679,000Year
      ended December 31, 2007
                      (as
      restated; see Note 19)Allowance
      for doubtful accounts
                    
                    $
                    159,000
                    
                    
                    $
                    (134,000
                    )
                    
                    $
                    25,000Allowance
      for slow moving inventory
                    
                    
                    1,573,000
                    
                    
                    
                    151,000
                    
                    
                    
                    1,724,000Valuation
      allowance for deferred taxes
                    
                    
                    39,457,000
                    
                    
                    
                    (1,704,000
                    )
                    
                    
                    37,753,000Totals
                    
                    $
                    41,189,000
                    
                    
                    $
                    (1,687,000
                    )
                    
                    $
                    39,502,000
 
 *The 2008
and 2007 valuation allowance includes an adjustment to the prior year provision
calculation due to changes recognized in the preparation of the actual
returns.
      F-39
 Table of Contents